Adverse Selection and Small Business Finances

This paper develops a competitive search model with asymmetric information and argues that small firms hold liquid assets not only to self-finance their investments but also to signal their investment quality, thereby obtaining better loan terms. Because self-finance is an outside option of borrowing, it affects bank loans and the credit market structure. Monetary policy affects the cost of self-finance and hence affects the market structure and the screening regimes in the credit market. An increase in the policy rate can trigger banks to use screening contracts, which distort allocations. Using U.S. data, I document that dispersion in firms’ cash-to-asset ratios is hump-shaped in policy rates, consistent with the model’s prediction that firms use liquidity holdings to signal. (Copyright: Elsevier)