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Understanding the use of long-term finance

Maria Soledad Martinez Peria's picture

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.

Long-term finance will be “supplied” (see Figure 1) when users want to finance long-term projects and want to avoid rollover risks and when providers/intermediaries have long-term liabilities and want to match the maturity of their assets and liabilities. However, providers of financing may at times prefer short-term contracts to guard against moral hazard and agency problems in lending. Financing contracts with a short maturity improve the lender’s ability to monitor borrowers through the implicit threat of restricted access to credit in the future in case of default. At the same time, users might also prefer short-term finance in some instances in order to match the maturity of their assets and liabilities. In this situation, long-term finance is “not preferred” (see Figure 1).

Moreover, even in situations when users and providers of finance would ideally prefer long-term finance contracts, market failures such as information asymmetries and coordination problems may cause the amount contracted in equilibrium to be lower than desired by both parties. In this situation long-term finance is “scarce” or undersupplied (see Figure 1). Information asymmetries could prevent the creditor from knowing the true repayment capacity and willingness to pay of the borrower, thus making the creditor reluctant to agree to the amount of long-term finance requested. Coordination problems between lenders and borrowers may trigger a “maturity rat race” in which lenders shorten the maturity of contracts to protect their claims and shorten the average maturity of debt contracts available in equilibrium.

Governments have a role to play in promoting long-term finance when it is undersupplied or scarce because of market failures and policy distortions. The government can promote long-term finance without introducing distortions by  pursuing policies that foster macroeconomic stability, low inflation, and viable investment opportunities;   promoting a contestable banking system with healthy entry and exit and supported with strong regulation and supervision; putting in place a legal and contractual environment that adequately protects the rights of creditors and borrowers; fostering financial infrastructure that limits information asymmetries; and promoting the development of capital markets and institutional investors. In contrast, efforts to promote long-term finance through directed-credit, subsidies, and government-owned banks have not been successful in general due to political capture and poor corporate governance practices, and have proven costly for taxpayers.

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