Uncovering Frictions to Long-Term Borrowing

Firms with higher leverage and shorter debt maturity contract investment more after a financial shock. What can be learned from these heterogeneous responses? The paper presented in this ZEW Research Seminar develops a tractable quantitative model of firms’ optimal leverage and debt maturity choice in an environment with interest rate shocks. Long-term debt is used to hedge the interest rate risk rising from long-term investment projects. The authors utilize the model to disentangle the quantitative importance of different frictions in accounting for firms’ sensitivity to financial shocks. They show that absent heterogeneity in borrowers’ term-premium, shorter debt maturity does not lead to higher firm sensitivity to a financial shock, suggesting the importance of frictions to long-term borrowing. The authors use the quantitative model to measure and evaluate the cost of frictions to long-term borrowing. The welfare cost of these frictions amounts to a permanent fall of consumption of 0.5%.