Collateral is a prominent feature of debt contracts. Residential and commercial mortgages, motor vehicle and equipment loans, and inter-bank repurchase agreements all rely heavily on readily marketable assets to secure funding. Interestingly, other debt contracts, like bank loans to small and medium-sized enterprises (SMEs), only sometimes require collateral, and the pledged assets tend to be quite heterogeneous.
The use of collateral in debt contracts can be costly for lenders, borrowers, and (in some cases) even society at-large. Lenders incur costs of screening and monitoring the pledged assets, as well as any enforcement and disposal expenses in the case of repossession. The use of collateral may impose opportunity costs on borrowers by tying up assets that might otherwise be put to more productive uses. Borrowers may also suffer fluctuations in their credit availability as the values of their securable assets vary.
Collateral may also result in social costs (externalities) when changes in the value of widely pledged assets, like real estate, are correlated across borrowers and act to amplify the business cycle through procyclical changes in access to credit (e.g., Bernanke and Gertler 1989, 1990, Kiyatoki and Moore 1997). Recent research suggests that the significant decline in real estate collateral values in Japan in the early 1990s played an important role in reducing debt capacity and investment in that nation (Gan 2007). A similar procyclical effect is now occurring in U.S. mortgage markets and, by extension, global financial markets.
Given that collateral is costly and yet widely employed, it is natural to inquire as to the economic function of collateral pledges. Economic theory largely explains collateral as an attempt to compensate for ex ante asymmetric information problems or as a method of reducing ex post incentive problems. Specifically, one set of theoretical models explains collateral as arising from ex ante information gaps between borrowers and lenders that can otherwise lead to an equilibrium characterized by adverse selection and credit rationing in the spirit of Stiglitz and Weiss (1981).
In this case, collateral allows lenders to sort observationally equivalent loan applicants through signaling. Lenders offer a menu of contract terms such that applicants with higher-quality projects choose secured debt with lower risk premiums, while those with lower-quality projects self-select into unsecured debt with higher risk premiums (e.g., Bester 1985, 1987, Besanko and Thakor 1987a, 1987b, Chan and Thakor 1987, Boot, Thakor and Udell 1991, Beaudry and Poitevin 1995, and Schmidt-Mohr 1997). A second set of theoretical models motivates collateral as being part of an optimal debt contract by invoking ex post frictions, including moral hazard concerns (e.g., Aghion and Bolton 1997, Holmstrom and Tirole 1997); difficulties in enforcing contracts (e.g., Banerjee and Newman 1993, Albuquerque and Hopenhayn 2004, Cooley, Marimon, and Quadrini 2004); and costly state verification (e.g., Townsend 1979, Gale and Hellwig 1985, Williamson 1986, Boyd and Smith 1994).
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Tests of Ex Ante versus Ex Post Theories of Collateral using Private and Public Information
