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I am especially grateful to Don Davis, Amit Khandelwal, and David Weinstein for their constant encouragement, and thank to Mariana Colacelli, Alexander McQuoid, Marge Miller, Mika Saito, Yoichi Sugita, Eric Verhoogen, Jon Vogel, Anna Watson, and seminar participants at various institutions for their very helpful comments.
In general, trade finance refers to any type of financing that uses trade credit (i.e., accounts receivable) as collateral. This paper defines international trade finance only as a letter of credit and working capital financing for international transactions, opposed to domestic trade finance defined as working capital financing for domestic transactions. The main result of the model will be readily extended to other types of trade finance facilities (e.g., export credit insurance) by introducing risk averse agents.
The screening technology adopted in this paper follows closely the ones developed in banking literature. Broecker (1990) introduced this particular form of technology in the context of inter-bank competition in credit markets. Flannery (1996) also modeled an identical type of screening test to show the possibility of loan market failure due to an increase in uncertainty during a financial crisis. Freixas and Holthausen (2004) incorporate the screening test into the inter-bank loan market. Hauswald and Marquez (2003, 2006) use the framework to study banks competition through information acquisition. Unlike them, this paper explores the cyclical property of the screening test and endogenizes its precision level.
The excess sensitivity of trade relative to domestic output has long been a well-established phenomenon (Engel and Wang, 2011). Most recently, Freund (2009) documents the historical evidence that trade is more responsive to GDP during global downturns.
According to the Society for Worldwide Interbank Financial Telecommunication (SWIFT), nearly 90% of letters of credit transactions are cross-border transactions (ICC, 2010).
The literature has various views on what determines the use of trade credit (i.e., open account system): transaction costs motive (Ferris, 1981), suppliers’ informational advantage on buyers (Biais and Gollier, 1997; Smith, 1987) or better ability in monitoring buyers’ moral hazard (Burkart and Ellingsen, 2004)). For further reference, please refer to the references in Petersen and Rajan (1997).
Greenaway, Guariglia, and Kneller (2007) find that the strong correlation between firms’ financial health and exporting status rather comes from the reverse causality, i.e., exporting improves firms’ financial health.
A more general version of the model in Ahn (2011) features, among others, firm heterogeneity in the degree of collaterallizable assets to generate differing borrowing costs across firms. The heterogeneity helps the model to replicate the presence of multiple types of payment systems in an economy because this serves as the factor that determines the optimal payment system for each transaction. The resulting predictions on the optimal payment system are consistent with empirical findings that financially constrained firms tend to receive more credit and offer less credit (Petersen and Rajan, 1997; Love, Preve, and Sarria-Allende, 2007).
Essentially, this can be more generalized to capture any other exogenous factors that makes international transactions more costly. For example, weaker contract enforcement across borders considered in Schmidt-Eisenlohr (2009), Olsen (2010), and Antràs and Foley (2011) can be collapsed into τF. It is straightforward that adding country specific enforcement level to the current model will provide additional testable prediction across country that are consistent with evidence in Schmidt-Eisenlohr (2009) and Antràs and Foley (2011). Similarly, allowing market size to differ across country will yield richer empirical predictions, leaving the key idea of this paper untouched.
We defer our discussion on the letter of credit to section 4. As for the cash-in-advance system, it is exactly the mirror image of the open account system in that the payment by buyers is made to suppliers prior to the production or delivery of the intermediate goods. For further details, please refer to Ahn (2011).
The common aggregate market demand level assumption essentially shuts down demand channel effects and leave trade financing as a sole factor that operates in the model.
On the contrary, Feenstra, Li, and Yu (2011) consider the case in which a bank cannot verify whether the loan is used to cover the costs of production for domestic sales or for exports. Also, we rule out the possibility of cross-pledging by which one transaction serves as collateral for the other transaction.
Factoring helps a seller transfer a buyer’s non-payment risk to a factor. In return for the assumed risk, a factoring company charges discount to a seller, which is based on the buyer’s creditworthiness.
This is common to both suppliers and buyers: μG = μG,s = μG,b
Hence, λ(1 − μG) is the economy wide default rate. This may include both voluntary and involuntary default but the distinction is not relevant in the current model.
In short, under the open account system, the supplier’s bank screens the supplier with the precision level αC, and the domestic buyer with the precision level αD, but screens the foreign buyer with the precision level αF.
Similarly, the probability of firms not defaulting, conditional on observing a bad signal is:
In fact, we can introduce fixed costs for production explicitly and derive this as a result of the model rather than an assumption. Footnote 22 discusses the condition for this assumption in detail.
A bank lends to local domestic suppliers only and the corresponding buyers could be either domestic or foreign. This implies that the screening test used for suppliers has the precision level αC; while the one for buyers is αj for j = D, F.
This is the rationale for Assumption 1. Bad signaled transactions (i.e., the supplier-buyer pairs in which at least one party receives a bad signal) face higher borrowing costs than good signaled transactions (i.e., the supplier-buyer pairs in which none receives a bad signal) due to a lower probability of loan repayment. This means that bad signaled transactions generate lower revenue, and hence lower profits due to a higher final goods price and elastic demand. We can introduce the fixed cost such that the bad signaled transactions end up with negative profits, and hence full repayment cannot occur. Knowing this is going to happen, a bank will not provide a loan for such transactions. The corresponding fixed cost that satisfies the condition lies in the range between
It is plausible to assume that marginal costs of acquiring local firms information is lower than marginal costs of acquiring foreign firms information, which will strengthen the results of this paper. However, this assumption is not made throughout the paper in order to highlight the endogenous nature of asymmetric screening tests.
In this figure, marginal gains curves are drawn as upward sloping. This is always true when μG = 1/2. Otherwise, it is ambiguous whether the curves are upward or downward sloping, but this does not affect the following Proposition.
Alternatively, we can think of a decrease in the share of good firms (μG) during the recession. This gives qualitatively identical results.
This corresponds to the irrevocable confirmed letters of credit. Detailed descriptions on various kinds of letters of credit can be found, for example, in Venedikian and Warfield (2000).
Instead of introducing Assumption 3, we could have the precision level of inter-bank screening
Note that a buyer’s screening is done by the buyer’s local bank with borrower screening precision level (αC), while a supplier’s screening is done by the supplier’s local bank with borrower screening precision level (αC).
For a letter of credit to be used for a transaction, it is necessary that a buyer passes a screening test by the buyer’s local bank (with probability γC), and a supplier and the buyer’s bank pass screening tests by the supplier’s local bank (with probability γCγbank).
The case in which the supplier has the bargaining power to choose the optimal payment system delivers qualitatively similar results.
“Amended Schedules of Assets and Liabilities for Lehman Brothers Holdings INC. CASE NO. 08-13555 (JMP)” by United States Bankruptcy Court Southern District of New York.