Why Do Banks Ask for Collateral?
34 Pages Posted: 5 Mar 2005
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: Suggested Citation
Do you have a job opening that you would like to promote on SSRN?
Recommended Papers
-
Default Predictors and Credit Scoring Models for Retail Banking
By Evžen Kočenda and Martin Vojtek
-
Can the Market Fix a Wrong Administrative Decision? Massive Delisting on the Prague Stock Exchange
-
A Forecasting Model for the Likelihood of Delinquency, Default or Prepayment: The Case of Taiwan
By Chin-tsai Lin and Shih-yu Yang