Collateral vs. Project Screening: A Model of Lazy Banks
RAND Journal of Economics, Vol. 32, No. 4, Winter, 2001
CSEF WORKING PAPER No. 10
22 Pages Posted: 1 Dec 1998 Last revised: 30 Dec 2010
Date Written: November 1, 1998
Many economists argue that the primary economic function of banks is to provide cheap credit, and to facilitate this function, they advocate the strict protection and enforcement of creditor rights. But banks can serve another important economic function: through project screening they can reduce the number of project failures and thus mitigate their private and social costs. Strict protection of creditor rights would leave the tradeoff between these two banking functions to the market. In this paper, we show that because of market imperfections in the banking industry, strong creditor protection may lead to market equilibria in which cheap credit is inappropriately emphasized over project screening. Restrictions on collateral requirements and the protection of debtors in bankruptcy proceedings may redress this imbalance and increase credit-market efficiency.
JEL Classification: D8, G2, K2
Suggested Citation: Suggested Citation