Collateral and the Debt Maturity Choice Under Asymmetric Information: A Signaling Model

Abstract

This paper analyzes the choice of signaling mechanisms by firms in a loan arrangement with banks. In a world of asymmetric information, firms have several debt instruments and hence can use them simultaneously to self-select. It is shown that different separating equilibria may result for self-selection. If separation occurs, low-quality firms will always borrow long-term debt without collateral, while high-quality firms will borrow long-term debt with collateral or borrow short-term debt with or without collateral. The optimal loan policy depends on the relative signaling costs of the different signaling mechanisms. Separation will be more likely if the proportion of low-quality firms in the market is higher.

Keywords: Debt maturity, asymmetric information, signaling, collateral

JEL Classification: D82, G21, G32