Funding Liquidity, Debt Tenor Structure, and Creditor's Belief: An Exogenous Dynamic Debt Run Model

TL;DR

This paper develops a structural credit risk model that integrates insolvency and illiquidity risks, analyzing how a firm's liquidity structure influences default probability through endogenous debt run barriers.

Contribution

It introduces a unified model capturing both insolvency and liquidity risks, with a novel threshold strategy for debt runs based on dynamic creditor coordination.

Findings

Existence of a unique debt run barrier for short-term creditors

Decomposition of credit risk into insolvency and illiquidity components

Relationship between debt structure and default probability

Abstract

We propose a unified structural credit risk model incorporating both insolvency and illiquidity risks, in order to investigate how a firm's default probability depends on the liquidity risk associated with its financing structure. We assume the firm finances its risky assets by mainly issuing short- and long-term debt. Short-term debt can have either a discrete or a more realistic staggered tenor structure. At rollover dates of short-term debt, creditors face a dynamic coordination problem. We show that a unique threshold strategy (i.e., a debt run barrier) exists for short-term creditors to decide when to withdraw their funding, and this strategy is closely related to the solution of a non-standard optimal stopping time problem with control constraints. We decompose the total credit risk into an insolvency component and an illiquidity component based on such an endogenous debt run barrier together with an exogenous insolvency barrier.