Does rollover restriction of short-term loans exacerbate market instability? Evidence from a natural experiment in China

Purpose In a market with incomplete information, banks’ unwillingness to pay excessive attention to the monitoring role of information led to a significant amount of short-term loans. This imbalance in the credit structure prevents the credit market from clearing efficiently, potentially masking substantial risks. These risks leave entire economies vulnerable to collapses in output and investment due to capital-account reversals. Using a natural experiment as an exogenous shock, we examine whether imposing stricter standards on the renewal of short-term loans in China increases liquidity risk and exacerbates market instability. Design/methodology/approach Using the 2007 short-term debt rollover restriction policy in China and a sample of Chinese A-share stocks, we conduct a difference-in-differences (DID) analysis to investigate the impact of short-term loan renewals on market stability, proxied by stock price crash risk. To ensure robustness, we perform various checks, including a parallel trends test, time-varying fixed effects models, a placebo test, dosage effects and propensity score matching-DID (PSM-DID) analysis. Additionally, we explore the economic mechanisms underlying the negative relationship between rollover restrictions and firm-specific crash risk while examining the differential effects across various firm characteristics and monitoring mechanisms. Findings We find that the 2007 rollover restriction policy altered banks’ lending behavior. However, rather than creating potential liquidity risks, the policy reduced future stock price crash risks. Our channel analysis reveals that the policy compelled banks to fulfill their information monitoring responsibilities, thereby enhancing firms’ information disclosure and reducing market risks. More importantly, the improvement in information disclosure quality also enhanced the allocation efficiency of the credit market. Furthermore, the evidence indicates that the effect of the rollover restriction policy is stronger for non-state-owned firms and firms with weaker monitoring mechanisms. Originality/value This study contributes to the literature on the role of bank supervision by focusing on the absence of effective bank monitoring in the presence of information asymmetry. Our findings suggest that, in the face of such market failures, regulatory authorities should implement strict policies, particularly regarding the issuance and renewal of short-term loans, to encourage banks to fulfill their supervisory responsibilities. Additionally, this study highlights the economic consequences of strengthening credit policies and provides an important supplement to the literature on the corporate governance effects of short-term loans.