The maturity rat race

It is a common phenomenon nowadays for a lot of firms and financial institutions to invest long-term but at the same time finance themselves short-term. So, why do firms expose themselves to significant risk? This paradox might be the result of an inefficient dynamic that we call a “maturity rat race” ( Markus Brunnermeier, Martin Oehmke, April 2013, The Journal of Finance 68(2)).

First of all, let's assume that we have a borrower who borrows from multiple creditors to finance long-term investments with different expected maturities. So when the interim information coming out at the rollover dates is negative and increases the probability of default rather than to the possible recovery of funds when default occurs, the borrower has the incentive and will probably try to approach one of his creditors and suggest him a change from long-term financing to short-term financing contract. Those shorter maturity claims diminish value of longer maturity creditor’s claims. As a result, the remaining creditors will chase an even shorter maturity for their contacts. This continuous conflict between long-term and short-term creditors leads eventually to a rat race where all the creditors demand short-debt .

This maturity rat race can create serious implications for the future of the firm, since excessive short-term funding leads to extreme rollover risk and causes inefficient liquidation of the long-term investment projects after the negative interim information. At the same time, the rat race leads to underinvestment, with some positive NPV projects not getting started in the first place, and value destruction is observed. This is in contrast with some of the most influential theories on maturity mismatching. An example is the theory of Diamond and Dybvig  (1983), which argues that maturity mismatching facilitates long-term investment projects while serving investors’ liquidity needs. However, it does seem to be consistent with both general theorems and empirical research on the importance of maturity matching in determining an optimal debt maturity structure, stemming from the initial research of Morris (1976). He argues that mismatching maturities creates unnecessary risks for a firm and that it should therefore be avoided. The same tendency comes forward in the "maturity rat race".

Last but not least, during economic crises, when the environments are increasingly volatile and there is no stability, the incentive to shorten the maturity structure is particularly strong, which facilitates the maturity rat race even more . This is because the probability of default is higher and investors try to protect their claims. The authors in the end suggest that future financial regulation should limit maturity mismatches in the financial system especially during future crises for all the above mentioned reasons.