Why do Banks Ask for Collateral?

Abstract:     
In spite of the massive use of collateral, there exist only few studies on the reasons of the use of collateral. This paper aims at testing empirically the three major theoretical reasons for using collateral: reduction of loan loss in the event of default, adverse selection, and moral hazard. We use a dataset of 735 bank loans on French distressed firms, which contains the full information on debt contract characteristics including collaterals. This dataset allows providing a complete empirical framework to test the three theoretical arguments in connection with the type and the value of collaterals.

Our conclusions are: (a) Collateral contributes to reduce loan loss in the event of default, with differences among types of collaterals in terms of the recovered value for a given initial value. (b) Collateral does not solve adverse selection problems, as there is a positive relationship between collateral and risk premium. (c) Collateral does not solve moral hazard, as secured loans are not associated with a lower probability of moral hazard behavior. Therefore, our work suggests that information asymmetries are not of prime importance in the decision of the bank to secure a loan, while the reduction of the loan loss and the observed-risk hypothesis may explain the use of collateral.

Keywords: Bank, collateral, credit risk

JEL Classifications: G21

Working Paper Series