A LENDER-BASED THEORY OF COLLATERAL

Abstract

We offer a novel explanation for the use of collateral based on the dual function of banks to provide credit and assess the borrower’s credit risk. There is no moral hazard or adverse selection on the part of borrowers–the only inefficiency is that banks cannot contractually commit to providing credit as their credit assessment is subjective. Without collateral, a bank may deny credit even if its credit assessment suggests that the project is marginally profitable. Collateral improves the bank’s payoffs from financing such marginally profitable projects, thus mitigating the inefficiency arising from discretionary credit decisions. Unlike models of borrower adverse selection, our model suggests that high-quality borrowers post less collateral than low-quality borrowers, which is consistent with the empirical evidence.