Verifying the state of financing constraints: evidence from U.S. business credit contracts

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, I find 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. The parameter values obtained in the costly state verification model imply bankruptcy costs of 28% of expected output and a rate of return ranging between 5% and 8% annually, which are consistent with studies on bankruptcy incidences and returns to entrepreneurial investment. The moral hazard model, however, performs poorly. The correlation between model implied interest rates and actual interest rates paid is close to zero because the bank variables emphasized by this model do not explain loan interest rates.