This blog post is part of a series highlighting the key findings of the Global Financial Development Report 2015 | 2016: Long-Term Finance. You can view all the posts in the series at http://blogs.worldbank.org/allaboutfinance/category/tags/gfdr2015.
Long-term finance—defined here as any source of funding with maturity exceeding at least one year—can contribute to economic growth and shared prosperity in multiple ways. Most importantly, it reduces firms’ exposure to rollover risks, enabling them to undertake longer-term fixed investments and it allows households to smooth income over their life cycle and to benefit from higher long-term returns on their savings.
But how are we to think about the actual use of long-term finance by firms and households? Chapter 1 of the 2015 Global Financial Development Report presents a conceptual framework for understanding the use of long-term finance summarized in Figure 1 below. In essence, the use of long-term finance can be best understood as a risk-sharing problem between providers and users of finance. Long-term finance shifts risk to the providers because they have to bear the fluctuations in the probability of default and the loss in the event of default, along with other changing conditions in financial markets, such as interest rate risk. In contrast, short-term finance shifts risk to users because it forces them to roll over financing constantly. Therefore, long-term finance may not always be optimal. Providers and users will decide how they share the risk involved in financing at different maturities, depending on their needs.