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

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. * This paper is developed from one chapter of my doctorial thesis. I would like to thank Michael Balch, Andreas Blume, Jocelyn Evans, Jennifer Reinganum, Calvin Siebert, and Steve Williamson for their helpful comments on early versions of this paper. I am grateful for the suggestions and comments of seminar participants at Federal Reserve Bank of Cleveland, especially those of Joseph Haubrich and Stanley Longhofer. All remaining errors and omissions are mine. Phone: (216) 579-2417 Fax:(216) 579-3050 Email: [email protected]