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

Abstract

This paper examines whether the costly random verification scheme affects the optimal debt contract for small business. It finds, contrary to Townsend (1979) and Williamson (1986, that the standard debt contract is the optimal debt contract with the costly random verification scheme. Credit rationing, characterized as a loan granted in an amount less than requested, becomes more severe as the bankruptcy cost rises. This result supports the 1994 amendments to the Bankruptcy Code, since it shows that simplifying the bankruptcy procedure for small business reduces credit rationing and therefore enhances lending.