Debt Seniority and the Lenders' Incentive to Monitor: Why Isn't Trade Credit Senior?

Many papers in the financial literature argue that monitoring lenders should hold senior debt. Trade creditors monitor their customers. However, their claims are usually not senior. This paper develops a model to show that it is optimal for trade creditors to hold junior debt. Two important characteristics of trade creditors lead to this result. First, because trade creditors are not specialized financial institutions, they have higher funding costs than banks. Second, trade creditors have the ability to seize and repossess part of the borrowers' assets before the formal liquidation process starts. This paper provides an example for the idea of Fama (1990) that junior lenders have a stronger incentive to monitor.