Endogenous Debt Maturity and Rollover Risk

Abstract

We challenge the common view that short-term debt, by having to be rolled over continuously, is a risk factor that exposes banks to higher default risk. First, we show that the average effect of expiring obligations on default risk is insignificant; it is only when a bank has limited access to new funds that maturing debt has a detrimental impact on default risk. Next, we show that both limited access to new funds and shorter maturities are causally determined by deteriorating market expectations about the bank's future profitability. In other words, short-term debt is not a cause of fragility but the result of creditors losing faith in the long-run prospects of the bank, hence forcing it to shorten its debt maturity. Finally, we build a model that endogenizes the debt maturity structure and predicts that worse market expectations lead to a maturity shortening.JEL classification: G01, G21, G32.We are greatly indebted to Eyal Dvir for his invaluable guidance during the early stages of the project. We are also grateful to Review 102, 88-94. He, Zhiguo, and Wei Xiong, 2012b, Dynamic debt runs, Review of Financial Studies 25, 1799-1843. He, Zhiguo, and Wei Xiong, 2012c, Rollover risk and credit risk, Journal of Finance 67, 391-430. Hu, Xing, 2010, Rollover risk and credit spreads in the financial crisis of 2008, Princeton University Working Paper . Johnson, Shane, 2003, Debt maturity and the effects of growth opportunities and liquidity risk on leverage, Review of Financial Studies 16, 209-236.