The Screening Cost of Liquidity
TLDR
Principals use above-market borrowing rates as a screening device, balancing liquidity advances with contingent transfers to separate counterparty types.
Key contributions
- Finance structure serves as a screening device, with principals forcing counterparties to borrow at above-market rates.
- Advances provide liquidity but pool types; contingent transfers separate types, imposing financing costs.
- Optimal contracts balance liquidity and screening by preserving outside-finance exposure.
- Explains why early payment and contingent compensation coexist in trade credit, VC, and internal capital markets.
Why it matters
This paper reveals how financing terms are strategically used for screening, not just capital provision. It offers a unified explanation for complex financial structures observed across various markets. Understanding this mechanism is crucial for designing effective contracts and policies in corporate finance.
Original Abstract
A principal with cheap capital optimally forces her counterparty to borrow at above-market rates. The reason: the form of finance is a screening device. Advances provide liquidity but pool types; contingent transfers separate types, but, because they are not pledgeable, impose financing costs. The optimal contract preserves outside-finance exposure to maintain screening power. Two sufficient statistics pin down the optimal advance share. With complementary counterparties, a uniform subsidy that cheapens finance across every relationship can reduce the value of each. This explains the coexistence of early payment and contingent compensation in trade credit, venture capital, and internal capital markets.
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