A Lender-Based Theory of Collateral

Abstract

We offer a novel explanation for collateral based on the notion that lenders make discretionary credit decisions that are too conservative. There is no borrower asymmetric information or moral hazard. Rather, the problem is that if lenders cannot extract the full surplus from the projects they finance (e.g., due to credit market competition), they may reject low-, but positive-NPV projects. Collateral provides lenders with additional protection in bad states, thus improving their payoffs from projects with a relatively high likelihood of bad states and thus precisely from those projects that are inefficiently rejected. Our model is consistent with existing empirical evidence and provides new empirical predictions.