Trade Credit, Collateral, and Adverse Selection

Abstract

We show how trade credit use depends on the value of collateral in a repossession, as well as the extent to which firms face adverse selection problems when dealing with an outside investor. The theory explains: why trade credit is short term credit, why firms simultaneously take and extend credit to other firms with similar levels of creditworthiness, why firms whose prospects start to deteriorate, often respond by increasing the extent to which they offer trade credit to their buyers. The theory implies that in developing economies it may be efficient for suppliers to act as financial intermediaries. Trade credit economizes on the need to raise funds from inefficient financial markets while still permitting profitable real transactions to take place.