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Credit Rationing, Bankruptcy Cost, and Optimal Debt Contract for Small Business

  • Ying Yan

    (Federal Reserve Bank of Cleveland)

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    This paper examines the relationship between debt contract and the process of resolving financial distress, through either debt restructuring or bankruptcy procedure. It effectively justifies the popularity of the standard debt contract by demonstrating that the standard debt contract is the optimal debt contract for small business with the costly random verification scheme. Although this result is quite different from Townsend (1979) and Williamson (1986,1987), it is compatible with their results and serves as a good supplement. This paper relates credit rationing directly to bankruptcy cost. It is shown that credit rationing, characterized as a loan amount granted less than requested, becomes more severe as bankruptcy cost rises. This result supports 1994 amendments to the Bankruptcy Code since it shows that simplifying bankruptcy procedure for small business reduces credit rationing, therefore, enhance lending.

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    Paper provided by EconWPA in its series Finance with number 9612003.

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    Length: 26 pages
    Date of creation: 13 Dec 1996
    Date of revision:
    Handle: RePEc:wpa:wuwpfi:9612003
    Note: Type of Document - Word 6.0; prepared on IBM ; to print on HP/PostScript; pages: 26 ; figures: none
    Contact details of provider: Web page: http://econwpa.repec.org

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    1. Besanko, David & Thakor, Anjan V, 1987. "Collateral and Rationing: Sorting Equilibria in Monopolistic and Competitive Credit Markets," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 28(3), pages 671-89, October.
    2. Berger, Allen N & Udell, Gregory F, 1992. "Some Evidence on the Empirical Significance of Credit Rationing," Journal of Political Economy, University of Chicago Press, vol. 100(5), pages 1047-77, October.
    3. Stephen D. Williamson, 1984. "Costly Monitoring, Loan Contracts and Equilibrium Credit Rationing," Working Papers 572, Queen's University, Department of Economics.
    4. Aghion, P. & Hart, O. & Moore, J., 1992. "The Economics of Bankruptcy Reform," Working papers 92-11, Massachusetts Institute of Technology (MIT), Department of Economics.
    5. Aivazian, Varouj A. & Callen, Jeffrey L., 1983. "Reorganization in bankruptcy and the issue of strategic risk," Journal of Banking & Finance, Elsevier, vol. 7(1), pages 119-133, March.
    6. Jaffee, Dwight M & Russell, Thomas, 1976. "Imperfect Information, Uncertainty, and Credit Rationing," The Quarterly Journal of Economics, MIT Press, vol. 90(4), pages 651-66, November.
    7. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
    8. Giammarino, Ronald M, 1989. "The Resolution of Financial Distress," Review of Financial Studies, Society for Financial Studies, vol. 2(1), pages 25-47.
    9. Paul Asquith & Robert Gertner & David Scharfstein, 1991. "Anatomy of Financial Distress: An Examination of Junk-Bond Issuers," NBER Working Papers 3942, National Bureau of Economic Research, Inc.
    10. Farmer, Roger E A, 1984. "A New Theory of Aggregate Supply," American Economic Review, American Economic Association, vol. 74(5), pages 920-30, December.
    11. Kreps, David M & Wilson, Robert, 1982. "Sequential Equilibria," Econometrica, Econometric Society, vol. 50(4), pages 863-94, July.
    12. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
    13. Stephen D. Williamson, 1984. "Costly Monitoring, Financial Intermediation, and Equilibrium Credit Rationing," Working Papers 583, Queen's University, Department of Economics.
    14. Webb, David C, 1987. "The Importance of Incomplete Information in Explaining the Existence of Costly Bankruptcy," Economica, London School of Economics and Political Science, vol. 54(215), pages 279-88, August.
    15. Gertner, Robert & Scharfstein, David, 1991. " A Theory of Workouts and the Effects of Reorganization Law," Journal of Finance, American Finance Association, vol. 46(4), pages 1189-1222, September.
    16. Hillier, Brian & Ibrahimo, M V, 1993. "Asymmetric Information and Models of Credit Rationing," Bulletin of Economic Research, Wiley Blackwell, vol. 45(4), pages 271-304, October.
    17. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
    18. Diamond, Douglas W., 1993. "Seniority and maturity of debt contracts," Journal of Financial Economics, Elsevier, vol. 33(3), pages 341-368, June.
    19. Baird, Douglas G, 1993. "Revisiting Auctions in Chapter 11," Journal of Law and Economics, University of Chicago Press, vol. 36(1), pages 633-53, April.
    20. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 647-63, October.
    21. Mookherjee, Dilip & Png, Ivan, 1989. "Optimal Auditing, Insurance, and Redistribution," The Quarterly Journal of Economics, MIT Press, vol. 104(2), pages 399-415, May.
    22. Ronald A. Dye, 1986. "Optimal Monitoring Policies in Agencies," RAND Journal of Economics, The RAND Corporation, vol. 17(3), pages 339-350, Autumn.
    23. Haugen, Robert A. & Senbet, Lemma W., 1988. "Bankruptcy and Agency Costs: Their Significance to the Theory of Optimal Capital Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 23(01), pages 27-38, March.
    24. Sris Chatterjee & Upinder S. Dhillon & Gabriel G. Ramirez, 1996. "Resolution of Financial Distress : Debt Restructurings via Chapter 11, Prepackaged Bankruptcies, and Workouts," Financial Management, Financial Management Association, vol. 25(1), Spring.
    25. Chan, Yuk-Shee & Kanatas, George, 1985. "Asymmetric Valuations and the Role of Collateral in Loan Agreements," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 17(1), pages 84-95, February.
    26. Gilson, Stuart C. & John, Kose & Lang, Larry H. P., 1990. "Troubled debt restructurings*1: An empirical study of private reorganization of firms in default," Journal of Financial Economics, Elsevier, vol. 27(2), pages 315-353, October.
    27. Townsend, Robert M., 1988. "Information constrained insurance : The revelation principle extended," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 411-450.
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