Mike Burkart and Tore Ellingsen In-kind finance: a theory of trade credit Article (Published version) (Refereed) Original citation: Burkart, Mike and Ellingsen, Tore (2004) In-kind finance: a theory of trade credit. American Economic Review, 94 (3). pp. 569-590. ISSN 0002-8282 DOI: 10.1257/0002828041464579 © 2004 American Economic Association This version available at: http://eprints.lse.ac.uk/69548/ Available in LSE Research Online: February 2017 LSE has developed LSE Research Online so that users may access research output of the School. Copyright © and Moral Rights for the papers on this site are retained by the individual authors and/or other copyright owners. Users may download and/or print one copy of any article(s) in LSE Research Online to facilitate their private study or for non-commercial research. You may not engage in further distribution of the material or use it for any profit-making activities or any commercial gain. You may freely distribute the URL (http://eprints.lse.ac.uk) of the LSE Research Online website. In-Kind Finance: A Theory of Trade Credit By MIKE BURKART AND TORE ELLINGSEN* It is typically less profitable for an opportunistic borrower to divert inputs than to divert cash. Therefore, suppliers may lend more liberally than banks. This simple argument is at the core of our contract theoretic model of trade credit in competitive markets. The model implies that trade credit and bank credit can be either com- plements or substitutes. Among other things, the model explains why trade credit has short maturity, why trade credit is more prevalent in less developed credit markets, and why accounts payable of large unrated firms are more countercyclical than those of small firms. (JEL G32) A remarkable feature of short-term commer- time?1 Third, why is trade credit less cyclical cial lending is the central role played by input than bank credit?2 suppliers. Suppliers not only sell goods and In the presence of specialized financial inter- services, but extend large amounts of credit as mediaries, it is far from obvious why the ex- well. Available evidence on trade credit poses change of goods is bundled with a credit three broad challenges to economic theory. First transaction: When trade credit is cheaper than and foremost, why does trade credit exist at all, bank credit, as is often the case, the puzzle is with a majority of nonfinancial firms simulta- that suppliers are willing to lend. When trade neously taking credit from their suppliers and credit is more expensive, the puzzle is that giving credit to their customers? Second, why banks are unwilling to lend. Indeed, a sizable does the magnitude of trade credit vary across fraction of firms repeatedly fail to take advan- countries, across categories of firms, and over tage of early payment discounts and thus end up borrowing from their suppliers at annual inter- est rates above 40 percent, having already ex- * Burkart: Department of Finance and SITE, Stockholm hausted their bank credit line (Petersen and School of Economics, Sveava¨gen 65, Box 6501, SE-113 83 Rajan, 1994, 1997). Why do not banks increase Stockholm, Sweden (e-mail: [email protected]); Elling- these firms’ credit lines instead? sen: Department of Economics, Stockholm School of Eco- A common explanation for trade credit is that nomics, Sveava¨gen 65, Box 6501, SE-113 83 Stockholm, suppliers have a monitoring advantage over Sweden (e-mail: [email protected]). This paper is pro- duced as part of a CEPR project on Understanding Financial banks. In the course of business, suppliers ob- Architecture: Legal Framework, Political Environment, and tain information about the borrower which other Economic Efficiency, funded by the European Commission lenders can only obtain at a cost, as argued by under the Human Potential-Research Network Training pro- Robert A. Schwartz and David Whitcomb gram (contract number HPRN-CT-2000-00064). Financial support from Riksbankens Jubileumsfond is gratefully ac- knowledged. We thank Denis Gromb, Bengt Holmstro¨m, Andreas Madestam, Raghuram Rajan, Andrei Shleifer, 1 In the early 1990’s accounts receivable of listed firms Javier Suarez, Jean Tirole, and seminar participants at Bank in the G7 countries varied from 15 to 30 percent of assets on of Norway, Bank of Sweden, CentER (Tilburg), the CEPR average. Accounts payable were slightly smaller, typically workshop on Banking and Financial Markets (Barcelona, about 15 percent of assets on average (Raghuram G. Rajan 1999), ESSFM 2001, European Central Bank, IUI (Stock- and Luigi Zingales, 1995). Trade credit tends to be rather holm), Norwegian School of Economics and Business Ad- more important for unlisted firms (Mariassunta Giannetti, ministration, Norwegian School of Management, Saı¨d 2003), except possibly in the United States (Mitchell A. Business School (Oxford), SITE (Stockholm), and at the Petersen and Rajan, 1997). For a historical account of trade Universities of Basel, Lausanne, Munich, Salerno, and credit, see Rondo Cameron (1967). Stockholm for their comments. The comments of three 2 See Allan H. Meltzer (1960), Valerie A. Ramey (1992), anonymous referees were particularly helpful. Any remain- Stephen Oliner and Glenn Rudebusch (1996), and Jeffrey H. ing errors are our own. Nilsen (2002). 569 570 THE AMERICAN ECONOMIC REVIEW JUNE 2004 (1978, 1979), Gary Emery (1987), Xavier across time can also be understood within our Freixas (1993), Bruno Biais and Christian Gol- model. With perfect legal protection of credi- lier (1997), Neelam Jain (2001), and others. tors, trade credit loses its edge, because it be- While the monitoring advantage theory is intu- comes as difficult to divert cash as to divert itively appealing, existing models suffer from inputs. More generally, the importance of trade two shortcomings. First, they often fail to ex- credit compared to bank credit should be greater plain why a bank, being specialized in the eval- when creditor protection is weaker, and when uation of borrowers’ creditworthiness, would firms are undercapitalized due to entrepreneurs’ frequently have less information than suppliers lack of wealth. This may explain the finding by do. Second, if we accept that many suppliers Asli Demirgu¨c¸-Kunt and Vojislav Maksimovic have information that banks do not have, why is (2001) that trade credit is relatively more prev- the suppliers’ lending so closely tied to the alent in countries with worse legal institutions. value of the input transaction? That is, the the- As for variation over the business cycle, ories do not explain why suppliers regularly Meltzer (1960) famously argued that trade lend inputs, but only very rarely lend cash. credit provides a cushion through which In the present paper, we develop a new theory wealthy firms insure poorer firms against the of trade credit. Like earlier theories it attributes consequences of tight money. Our model ex- a monitoring advantage to the supplier, but the plains why the cushion is provided by most advantage applies exclusively to input transac- suppliers, not just the wealthy ones, and sug- tions. Hence, our theory is immune to the above gests that the cushion against tight money is criticisms. Specifically, we argue that the source most valuable for entrepreneurs with intermedi- of the suppliers’ informational advantage is the ate amounts of wealth. Very wealthy entrepre- input transaction itself. Unlike other lenders, an neurs do not need the cushion, and very poor input supplier automatically knows that an input entrepreneurs should see their trade credit limits transaction has been completed. Other lenders move in tandem with their bank credit limits. can only obtain this information by incurring This is consistent with Nilsen’s (2002) finding monitoring costs. The value of input monitoring that trade credit is more countercyclical for stems in turn from the fundamental difference large firms (except for firms with a bond rating, between inputs and cash. Cash is easily di- as these firms never need to take costly trade verted, in particular if diversion is interpreted credit). broadly as any use of resources which does not Many firms offer trade credit despite having maximize the lenders’ expected return. Most to take (bank and) trade credit to finance their inputs are less easily diverted, and input illi- operations. We argue that firms simultaneously quidity facilitates trade credit. give and take trade credit because receivables A salient result of our model is that the avail- can be collateralized. Once an invoice is ability of trade credit increases the amount that pledged as a collateral, it becomes completely banks are willing to lend. For a given bank loan, illiquid from the firm’s perspective, and the firm additional trade credit permits the borrower can obtain additional bank credit against the higher levels of diversion as well as investment. receivable. Thus, offering an additional dollar However, due to the relative illiquidity of trade of trade credit does not force a firm to reduce its credit the borrower’s return from investing in- real investment by one dollar. However, since creases by more than the return from diversion. banks optimally cap their lending against re- Anticipating that available trade credit boosts ceivables, there is some crowding out. Accord- investment rather than diversion, banks are will- ingly, firms that are credit constrained but ing to increase their lending. Hence, bank credit highly profitable abstain from investing in re- and trade credit are complements for firms ceivables, leaving the extension of trade credit whose aggregate debt capacity constrains in- to firms that either have better access to funds or vestment. By contrast, for firms with sufficient are constrained and relatively unprofitable. Pe- aggregate debt capacity, trade credit is a substi- tersen and Rajan (1997) document that firms in tute for bank credit. financial distress increase their supply of trade Variation in trade credit across countries and credit, a result that they consider surprising.