Adverse Selection and Small Business Finances

Thu, 01 Jan 2026 00:00:00 +0000

This paper asks why small firms hold large quantities of liquid assets — cash and cash equivalents that earn low or negative real returns — even when external credit is available. The conventional answer is a precautionary motive: liquidity buffers the risk of being shut out of credit markets. Liang proposes a second, complementary motive: a signaling motive, whereby firms hold liquid assets specifically to pledge as collateral and credibly signal their repayment ability to lenders, thereby obtaining better loan terms. The empirical backdrop is striking: about 28% of small business assets are cash and cash equivalents (Kauffman Firm Survey 2011 wave); about 7% of commercial business loans are secured by liquid collateral (SSBF 2003); and 43% of small firms sought a commercial business loan in 2020.

Fan Liang | Macro Paper Warehouse

Adverse Selection and Small Business Finances