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

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.