Adverse selection and small business finances

This paper builds a directed search model with asymmetric information and argues that small firms hold liquid assets not only to self-finance investment but also to show their investment quality to obtain better loan terms. Because self-finance is an outside option of borrowing, it affects bank loans and the credit market structure. Monetary policy affects the cost of self-finance and hence affects the market structure and the screening regimes in the credit market. An increase in the policy rate can trigger banks to use screening contracts, which distort allocations and reduce welfare. I find that a negative pass-through from the policy rate to the real lending rate is possible. I also show that when the equilibrium is distorted, constrained efficiency can be restored via an appropriately designed tax scheme that involves taxing the high type borrowers and subsidizing the low type borrowers.