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Working Paper

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

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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, 1987), 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.
03.01.1997ISSN 2573-7953 WP 97-02DOI 10.26509/frbc-wp-199702
JEL Classification Codes G2, G3, K2, D8

Working Papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views expressed in this paper are those of the authors and do not represent the views of the Federal Reserve Bank of Cleveland or the Federal Reserve System.

Suggested Citation

Yan, Ying. 1997. “Credit Rationing, Bankruptcy Cost and the Optimal Debt Contract for Small Business.” Federal Reserve Bank of Cleveland, Working Paper No. 97-02. https://doi.org/10.26509/frbc-wp-199702