Soft Collateral, Bank Lending, and the Optimal Credit Rating System

45 Pages Posted: 9 Jan 2017

See all articles by Lixin Huang

Lixin Huang

Georgia State University

Andrew Winton

University of Minnesota - Twin Cities - Carlson School of Management; Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)

Date Written: November 8, 2016

Abstract

In this paper, we study the optimal credit rating system in an economy where agents need to borrow and have incentives to renege on debt repayments. We show that credit exclusion creates soft collateral in the form of a borrower’s reputation. Compared with individual lending, bank lending reduces search frictions, which increases the cost of credit exclusion, boosts the value of soft collateral, and facilitates borrowing and lending. A dynamic rating system allows agents’ ratings to migrate over time and fine-tunes agents’ incentives. By doing so, it reduces the agency cost, makes better use of soft collateral, and improves social welfare. We show that the optimal rating system is coarse, as we observe in the real world.

Keywords: Soft Collateral, Bank Lending, Credit Rating

JEL Classification: D83, D86, G21, G24, G28

Suggested Citation

Huang, Lixin and Winton, Andrew, Soft Collateral, Bank Lending, and the Optimal Credit Rating System (November 8, 2016). Available at SSRN: https://ssrn.com/abstract=2894446 or http://dx.doi.org/10.2139/ssrn.2894446

Lixin Huang (Contact Author)

Georgia State University ( email )

35 Broad Street
Atlanta, GA 30303-3083
United States

Andrew Winton

University of Minnesota - Twin Cities - Carlson School of Management ( email )

321 19th Avenue South
Department of Finance
Minneapolis, MN 55455
United States
612-624-0589 (Phone)
612-626-1335 (Fax)

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

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