Fighting%20for%20the%20Best%2C%20Losing%20With%20the%20Rest%3AA%20Case%20for%20Restricting%20Credit%20to%20Business%20Start%2DUps

Discussion Papers

Fighting for the Best, Losing With the Rest:A Case for Restricting Credit to Business Start-Ups


CODE: IDB-DP-538
AUTHOR(s): Hernández, Juan , Wills, Daniel
PUBLISHED: September 2017
LANGUAGE: English
RELATED TOPICS: Macroeconomics
DOWNLOAD FILE IN: English

Abstract:

The Jumpstart Our Business Startups (JOBS) Act of 2012 aims at increasing funding access for young firms by easing securities regulation. Motivated by this, we ask if there is a role for the regulation of the market of funds for firms that lack collateral and have a large uncertainty about their ability to generate profits. To answer that we characterize optimal financial contracts in a competitive environment with risk, adverse selection and limited liability. We find that competition among financial intermediaries always forces them to fund projects with negative expected returns both from a private and from a social perspective. Intermediaries use steep payoff schedules to screen entrepreneurs, but limited liability implies this can only be done by giving more to all entrepreneurs. In equilibrium, competition for the best entrepreneurs forces intermediaries to offer better terms to all customers, there is cross-subsidization among entrepreneurs and intermediation profits are nil. The three main features of our framework (competition, adverse selection and limited liability) are necessary in order to get the inefficient laissez-faire outcome and a role for barriers to entry into financial intermediation. Our result remains robust when firms can collateralize some portion of the credit as long as there is still an unsecured fraction.

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