Why Do Banks Ask for Collateral?

34 Pages Posted: 5 Mar 2005

See all articles by Régis Blazy

Régis Blazy

University of Strasbourg

Laurent Weill

University of Strasbourg - LaRGE Research Center (Laboratoire de Recherche en Gestion et Economie)

Date Written: February 28, 2005

Abstract

In spite of the massive use of collateral, there exist only few studies on the reasons of the use of collateral. This paper aims at testing empirically the three major theoretical reasons for using collateral: reduction of loan loss in the event of default, adverse selection, and moral hazard. We use a dataset of 735 bank loans on French distressed firms, which contains the full information on debt contract characteristics including collaterals. This dataset allows providing a complete empirical framework to test the three theoretical arguments in connection with the type and the value of collaterals.

Our conclusions are: (a) Collateral contributes to reduce loan loss in the event of default, with differences among types of collaterals in terms of the recovered value for a given initial value. (b) Collateral does not solve adverse selection problems, as there is a positive relationship between collateral and risk premium. (c) Collateral does not solve moral hazard, as secured loans are not associated with a lower probability of moral hazard behavior. Therefore, our work suggests that information asymmetries are not of prime importance in the decision of the bank to secure a loan, while the reduction of the loan loss and the observed-risk hypothesis may explain the use of collateral.

Keywords: Bank, collateral, credit risk

JEL Classification: G21

Suggested Citation

Blazy, Régis and Weill, Laurent, Why Do Banks Ask for Collateral? (February 28, 2005). Available at SSRN: https://ssrn.com/abstract=675803 or http://dx.doi.org/10.2139/ssrn.675803

Régis Blazy

University of Strasbourg ( email )

61, avenue de la foret noire
Strasbourg, Alsace 3000
France

Laurent Weill (Contact Author)

University of Strasbourg - LaRGE Research Center (Laboratoire de Recherche en Gestion et Economie) ( email )

61 Avenue de la Forêt Noire
F-67085 Strasbourg Cedex
France

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