"Moral Hazard and Debt Maturity"
Working Paper,
February
2011
Publication type: Working paper
Research Archive Topic: Business Economics and Public Policy, Corporate Finance
Abstract
This paper presents a model of the maturity of a bank's uninsured debt. Deciding on asset risk after borrowing the necessary funds and being the residual claimant of asset payoffs, the bank will choose an excessive level of risk. This moral hazard problem may result in the infeasibility of debt financing. Short-term debt may act as a disciplinary device when interim information regarding the assetsírisk is revealed. The paper characterizes the conditions under which short-term and long-term debt are feasible, and shows circumstances under which only short-term debt is feasible. It also shows that short-term debt may dominate long-term debt when both are feasible, even though the former may lead to inefficient liquidation.
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