Monitoring Costs and Trade Credit

Abstract

This paper addresses the question of why non-financial firms engage in lending to their business partners. Such lending or trade credit is modeled as a second layer of financial intermediation. It is shown that when it is costly for a bank to inspect the borrower's revenue but not for the borrower's business partner, then saving in monitoring costs and the business partner's informational advantage together may lead to trade credit. This is shown analytically for two different types of monitoring cost functions. Welfare analysis in terms of total surplus shows that the equilibrium lending arrangement is not necessarily optimal.