Interest Rates in Trade Credit Markets

Klenio Barbosa, Humberto Moreira, Walter Novaes
2010 Social Science Research Network  
Despite strong evidence that suppliers of inputs are informed lenders, the cost of trade credit typically does not vary with borrowing firm characteristics. We solve this puzzle by demonstrating that it is optimal for suppliers to keep the riskier firms indifferent between trade credit and loans from uninformed lenders. Because these uninformed loans vary across industries but not with firm characteristics, the same pattern applies to the cost of trade credit. The model predicts that the cost
more » ... cts that the cost of trade credit is more likely to vary with firm characteristics in industries that are plagued by moral hazard problems or financial distress. JEL: G30, G32 bank. The firms seek financing to undertake a profitable project, whose possible outcomes are two: a positive return on the investment (success) or total loss (failure). While a bank loan is the standard source of external financing, some firms may have the option of using trade credit to finance the project. An informational advantage explains why suppliers offer trade credit in our model. We assume that the probability that the project succeeds depends on firm-specific risk factorsthe types -that are distributed in the positive interval [t, 1]. Without loss of generality, the probability of success, p t , increases with the firm's type. When firms seek financing to the project, they know their own types and so do their main suppliers. The other suppliers and the bank, on the other hand, do not know the types. Will the informed suppliers vary the cost of trade credit with the firm-specific risk factors? To answer this question, we build upon a key observation: private information gives market power to the informed suppliers. As suggested by standard monopoly pricing, a sufficiently inelastic demand for inputs (and, by extension, for credit) makes it optimal for the informed suppliers to raise the cost of trade credit until it reaches the cost of the borrower's outside option, which, in our model, is the interest rate of a bank loan. 3 Since the bank cannot vary the cost of its loans with information that is privy to the informed suppliers, the latter cannot use their information either, if they match the cost of trade credit to the bank rate. Accordingly, we demonstrate that, in equilibrium, the cost of trade credit does not vary with firm characteristics, if the elasticity of the demand for inputs is below a certain threshold¯ . If the elasticity of demand is larger than¯ , then it is optimal for the informed suppliers to lower the cost of trade credit for the safer firms in order to boost their demand for trade credit. Firms that have access to trade credit are therefore split into two groups: The riskier ones get trade credit offers whose cost matches the interest rate of a bank loan, and the safer firms pay lower interest rates that decrease with their probability of success. This implication of our model is interesting, for two reasons. First, there is evidence that suppliers do not treat all customers alike when they negotiate trade credit contracts. For instance, Ng, Smith and Smith (1999) show that suppliers occasionally waive penalties for 3 Brennan, Maksimovic and Zechner (1988) also argue that the elasticity of the demand for inputs determines the cost of trade credit. In their model, the supplier is a monopolist in the product market.
doi:10.2139/ssrn.1344400 fatcat:phoagd4vnrgg7gd4dx7ion6nqm