Formation of Multi-Sector Economies and Trade-Credit: Can Banks Amplify Contagion Risk?

Abstract

In this paper we develop a simple model of endogenous formation of input-output economies to address the theoretical nexus between trade-credit, bank credit and credit contagion. We make two contributions. First, we show that competitive markets in which heterogeneous price-taker firms compete strategically by setting trade-credit maturities have a unique symmetric equilibrium in trade-terms and the equilibrium dictates the production flow along the supply chains. Secondly, we find that the network can have a role either as shock absorber or shock amplifier and this is determined by a testable condition which holds for a general class of trade-credit networks. On these grounds, we argue that the proportional credit rationing used by banks (i.e., richer borrowers obtain larger loans) may have ambiguous effects on systemic vulnerability. In fact, if for intermediate levels of bank-credit only a subset of firms substitute trade-credit in favor of bank-credit, the bank may worsen the quality of the inter-firm credit network, thus increasing the systemic vulnerability above the contagion threshold.