There are two fundamental puzzles about trade credit: why does it appear to be so expensive, and why do input suppliers engage in the business of lending money? This paper addresses and answers both questions analysing the interaction between the financial and the industrial aspects of the supplier-customer relationship. It examines how, in a context of limited enforceability of contracts, suppliers may have a comparative advantage over banks in lending to their customers because they hold the extra threat of stopping the supply of intermediate goods. Suppliers may also act as lenders of last resort, providing insurance against liquidity shocks that may endanger the survival of their customers. The relatively high implicit interest rates of trade credit result from the existence of default and insurance premia.
The paper also explains other stylised facts such as the relative importance of trade credit in small and startup firms and its extensive use in periods of financial distress. The implications of the model are examined empirically using parametric and nonparametric techniques on a panel of UK firms.
