Date Added: Jan 2011
Which of the strategies for financing constraints in economic models is the most empirically plausible? This paper tests two commonly used models of financing constraints, costly state verification (Townsend, 1979) and moral hazard (Holmstrom and Tirole, 1997), using a comprehensive data set of US small business credit contracts. The data include detailed information about the business, its owner, bank balance sheet information, and the terms of credit. In line with the predictions of models of financing constraints, the author finds that an additional dollar of net worth accounts for about 30 cents of external finance. More than two thirds of the business credit contracts can be rationalized by one period debt contracts with costly state verification.