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Too much of a good thing? A theory of short-term debt as a sorting device

Author

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  • König, Philipp Johann
  • Pothier, David

Abstract

This paper shows that the liquidity risk associated with short-term debt financing can be used to sort insolvent firms out of financial markets when their solvency risk is private information. Notwithstanding this sorting role of short-term debt, unregulated financial firms tend to choose an inefficiently short debt maturity structure. This inefficiency arises for two reasons. First, by issuing more short-term debt, low-risk firms reduce their expected funding costs. This leads to a misalignment of private and social incentives as firms fail to fully internalize the social costs of becoming illiquid. Second, while the sorting role of short-term debt is reflected in a decline of long-term interest rates when more short-term debt is issued, creditors’ inability to observe firms’ solvency risk leads to an excessive reduction of long-term interest rates. This further distorts firms’ funding choice towards short-term debt.

Suggested Citation

  • König, Philipp Johann & Pothier, David, 2016. "Too much of a good thing? A theory of short-term debt as a sorting device," Journal of Financial Intermediation, Elsevier, vol. 26(C), pages 100-114.
    • Handle: RePEc:eee:jfinin:v:26:y:2016:i:c:p:100-114
    DOI: 10.1016/j.jfi.2015.12.001
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    Cited by:

    1. Joana F. Pimentel & Sujiao Zhao, 2018. "The Maturity Rat Race and Short-Termism," Economic Bulletin and Financial Stability Report Articles and Banco de Portugal Economic Studies, Banco de Portugal, Economics and Research Department.
    2. repec:hum:wpaper:sfb649dp2016-045 is not listed on IDEAS
    3. repec:ptu:bdpart:r201807 is not listed on IDEAS
    4. Koenig, Philipp & Pothier, David, 2016. "Information acquisition and liquidity dry-ups," SFB 649 Discussion Papers 2016-045, Humboldt University Berlin, Collaborative Research Center 649: Economic Risk.

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