Outside Collateral, Preserving the Value of Inside Collateral and Sorting

Schmalenbach Business Review (sbr), Vol 53, October 2001

Posted: 23 Oct 2002

See all articles by Dorothea Schaefer

Dorothea Schaefer

German Institute for Economic Research (DIW Berlin); JIBS

Abstract

Within a framework of debt renegotiation and a priori private information, what is the role of outside and inside collateral? The literature shows that unobservability of the project's returns implies that the high-risk borrower is more inclined to pledge outside collateral than is the low-risk borrower. However, this finding does not hold when the bank can observe neither the project's returns nor the borrower's risk class. We show that in this scenario, low-valued outside collateral enables the low-risk entrepreneur to select himself, but high value outside collateral has no sorting potential at all. We also show that a bank's incentive to sort borrowers may induce investment to preserve the value of the inside collateral and to build up restructuring know-how. If self-selection via outside collateral is operating, restructuring know-how reduces the cost of separation. If outside collateral gives rise to pooling, restructuring know-how may restore sorting.

JEL Classification: D82, G21, G33

Suggested Citation

Schaefer, Dorothea, Outside Collateral, Preserving the Value of Inside Collateral and Sorting. Schmalenbach Business Review (sbr), Vol 53, October 2001, Available at SSRN: https://ssrn.com/abstract=304446

Dorothea Schaefer (Contact Author)

German Institute for Economic Research (DIW Berlin) ( email )

Mohrenstraße 58
Berlin, 10117
Germany
+49 30 8978 9162 (Phone)
+49 30 8978 9104 (Fax)

JIBS ( email )

Jönköping, 55111
Sweden

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