Asymmetric information between banks and firms can preclude financing of valuable projects. Trade credit alleviates this problem by incorporating in the lending relation the private information held by suppliers about their customers. Incentive compatibility conditions prevent collusion between two of the agents (e.g., the buyer and the seller) against the third (e.g., the bank). Consistent with the empirical findings of Petersen and Rajan (1995), firms without relationships with banks resort more to trade credit, and sellers with greater ability to generate cash lows provide more trade credit. Finally, small firms react to monetary contractions by using trade credit, consistent with the empirical results of Nilsen (1994). Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
