Blockchain Monitored Debt and Capital Structure under Moral Hazard

Abstract

The unobservability of the borrower's action is a major reason that smaller enterprises face high financing costs and credit rationing. We show that bank loans fully monitored by blockchain allow poor firms with low working capital to eliminate this agency cost. Interestingly, this is achieved by financing all production using fully monitored debt and leaving all internal capital unused; because the use of private, unmonitored internal capital creates unobservability whereas all-debt financing provides full transparency of operations. In contrast, rich firms find it costly to eliminate moral hazard via transparency and they prefer a mix of internal capital and unmonitored debt to finance production. We identify the working capital level at which a firm is indifferent between using all-debt or mixed financing for production. A poor firm with working capital below this indifference level strictly prefers all-debt financing and a rich firm above the level strictly prefers a debt-equity mix. We extend our results to a supply chain and show that the entire supply chain benefits from the use of monitored debt by an individual firm. The inefficient bankruptcy cost can create value under blockchain by mitigating the deadweight loss due to decentralization.