chapter  9
14 Pages

Depositor myopia and banking sector behaviour

In the literature, maturity of private debt contracts has a greater significance than term structure of deposits due to the link between firms’ problems and investment financing. There are two opposing claims regarding the consequences of short-term debt on economic performance. First, Calomiris and Kahn (1991) and Flannery (1994) assert that shortening of debt maturity is an effective way of disciplining bankers and mitigating agency problems inherent in banking: the threat of withdrawal of funds increases the likelihood of profitable investment opportunities. Second, Diamond and He (2014) and Diamond and Rajan (2012) claim that short-term debt harms the real economy by decreasing real investment levels. Diamond and He (2014) show that short-term debt can hinder current investment:

1 when the volatility of firm value is higher in bad times than in good times; 2 in a dynamic setting with future investment opportunities, when the reduction

in equity value is very large as a result of a combination of bad times and shorter-term debt;

3 when investment benefits are inter-temporally linked, short-term debt may reduce future growth as a result of earlier future default.