The optimal design of a loan contract is one of the topics most intensively analyzed in institutional economics. Particularly, the importance of collateral in mitigating problems of asymmetric information due to credit risk is pointed out in a large theoretical and empirical literature. Ever since the mid 70s, informational asymmetries have been highly emphasized in economic theory. On the one hand, moral hazard provides risk incentive arising when a borrower protected by limited liability has the choice between different levels of risk (cf. Jensen and Meckling 1976).
On the other hand, within an adverse selection setting, less risky projects may be crowded out. As Stiglitz and Weiss (1981) have pointed out, the lender cannot be compensated for increased risk by an additional risk premium because under both regimes, moral hazard and adverse selection, higher contractual interest rates imply even worse incentives. Therefore, increasing the interest rate may lead to a decrease in the lender’s expected return. This, in turn, implies the possibility of equilibrium credit rationing.
Apart from a higher interest rate, the introduction of collateral to loan contracts increases the lender’s expected return, ceteris paribus, and improves the borrower’s incentives. Bester (1985, 1987) has shown that under adverse selection or moral hazard, collateral reduces agency costs associated with debt financing. In both cases, collateral should be used in financing less risky projects while debt contracts specified for riskier projects should not include collateral. Under adverse selection, borrowers endowed with a less risky project provide collateral in order to send a signal which is too costly for borrowers with a riskier project to imitate.
Under moral hazard, the use of costly collateral only pays off if the borrower cannot commit himself to a less risky project otherwise. If he cannot commit himself to that less risky project even using costly collateral, he will certainly refrain from doing so. Therefore, both types of debt models imply that collateral should be associated with low-risk projects.
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Risk and the Role of Collateral in Debt Renegotiation
