A Lender-Based Theory of Collateral
University of Frankfurt; Imperial College London
Holger M. Mueller
New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)
CEPR Discussion Paper No. 5695
We consider an imperfectly competitive loan market in which a local (e.g., relationship) lender has valuable soft, albeit private, information, which gives her a competitive advantage vis-à-vis distant transaction lenders who provide arm's-length financing based on hard, publicly available information. The competitive pressure from transaction lenders forces the local lender to leave surplus to borrowers, which distorts the local lender's credit decision in the sense that she inefficiently rejects marginally profitable projects. Collateral mitigates this inefficiency by 'flattening' the local lender's payoff function, thus improving her payoff from precisely those projects that she inefficiently rejects. Our model predicts that technological innovations such as small business credit scoring that narrow the information advantage of local lenders vis-à-vis transaction lenders lead to higher collateral requirements, thus strengthening the role of collateral in local lending relationships.
Number of Pages in PDF File: 47
Keywords: Collateral, relationship lending vs transaction lending, soft
JEL Classification: G21, G32working papers series
Date posted: August 4, 2006
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