Risk and the Role of Collateral in Debt Renegotiation

Abstract

In his basic model of debt renegotiation, Bester (1994) argues that collateral is more effective if high risk projects are financed. This result, however, cru-cially depends on the definition of risk. Using the second-order stochastic dominance criterion introduced by Rothschild and Stiglitz (1970), we show that it is not a project’s high risk, induced by a high probability of default, that makes collateral more effective. Instead it turns out that, given the expected return, the probability of default has no impact on the collateral’s effective-ness. Moreover, an increasing risk of the project caused by an increasing loss given default makes the use of collateral even less effective.

Keywords: Debt renegotiation, Collateral, Risk, Stochastic dominance

JEL Classification: D81, D82, G21, G32