best secured loans
Article
any businesses post collateral as security for
loans. Collateral protects the lender if the
borrower defaults. However, not all borrowers
put up collateral when taking out loans.
There’s even some evidence that loans with collateral
attached may be riskier for lenders. Why is collateral
used sometimes, but not others? And why does collateral
potentially involve more risk? In this article, Yaron
Leitner considers these questions. He looks at some of the
explanations for using collateral, focusing on its benefits
and drawbacks.
finance their investments.
Understanding collateral is important because it is a characteristic
feature of bank loans, which help to
channel resources to their best use.
1
While early research focused mainly
on how collateral affects the borrower’s
behavior, recent research has also
incorporated lenders’ behavior, for
example, how collateral affects lenders’
incentives to take care in evaluating
a business’s prospects. Economists
have also examined the relationship
between collateral and risk, empirically
verifying bankers’ common wisdom
that collateralized loans are riskier
for the bank than noncollateralized
loans. To a significant extent, recent
theoretical work on collateral has been
driven by economists’ desire to provide
explanations for the use of collateral
that are consistent with this empirical
finding among others.
COLLATERAL AND
BORROWERS’ INCENTIVES
We start by focusing on the way
collateral affects a borrower’s incentives to ensure the business’s success.
Consider a loan contract where an
individual borrows some money to
start a new business. The success of
the business often depends on actions
the borrower takes after the loan is
signed, for example, the way he allo
ichael Manove, Jorge Padilla, and Marco
Pagano’s model illustrates what economists call the screening role of collateral.
In their model, collateral helps the bank
distinguish between firms that are likely
to have positive net present value (NPV)
projects and firms that are likely to have negative NPV
projects.
Suppose there are two types of firms: firms with high
operating costs and firms with low operating costs. When
a firm applies for a loan, it knows its operating cost, so it
has an idea of whether its project is likely to be successful
and have a positive NPV. But since there are other factors
affecting the project’s success, the firm cannot know for
sure. The bank can find out whether the firm has high
costs or low costs as well as other information about the
firm’s project, but only after some investigation. Before
the bank investigates, all firms look identical to the bank.
To recoup the cost of evaluation the bank must
charge some fee. To make sure it puts the appropriate
amount of effort into evaluating the loan, the bank charges only those firms whose loans are approved. Otherwise,
the bank can make money by charging a fee without doing an evaluation and then rejecting all applicants.
aIn
turn, firms whose loans are approved end up subsidizing
the firms whose loans are not approved. But since the
low-cost firms are the ones whose loans are more likely to
a
In the real world a bank that acted this way would develop a bad reputation and lose loan applicants. The reader should interpret the story in the
model as a stark version of the real-world problem that if all applicants are charged a fee upfront, the bank will have an incentive to exert too little
effort in monitoring.
b
Economists refer to this scenario, where one firm distinguishes itself from another firm, as a separating equilibrium. Note that if separation works,
the firm can avoid investigation by posting less collateral than in the case where all firms behave the same. Since the bank concludes that a firm
that posts collateral has low cost, further investigation is not likely to change the bank’s decision.
Helmut Bester first introduced the idea that a borrower who thinks his project is likely to succeed prefers to pledge more collateral than a borrower was thinks his project is likely to fail. One of the problems with this type of model is that the “inherently good” borrowers (for example, those
with low cost) are the ones who post more collateral. This seems inconsistent with the empirical evidence and with the common wisdom in the
banking industry.
be approved, they know they are the ones subsidizing the
high-cost firms.
To avoid this, low-cost firms may try to distinguish
themselves from high-cost ones by offering to post collateral. An economist would say that the low-cost firm is
using collateral to signalits information to the bank. Posting collateral is costly to the firm because the firm loses it
if its project fails. However, since the firm’s costs are low,
it knows the project is very likely to succeed and the risk
of losing collateral is not large.
However, low-cost firms can signal their information
using collateral only if high-cost firms find it unprofitable
to mimic low-cost firms by posting collateral, too. This is
the case if the high- and low-cost firms differ enough. For
a high-cost firm, the cost of putting up collateral is much
higher than for a low-cost firm because the firm knows it
is more likely to default. The result is that low-cost firms
post collateral and high-cost firms do not.
The bank can then distinguish between the two
firms. If a firm is willing to post collateral, the bank concludes that the firm has low costs and approves the firm’s
project without an evaluation; in this case, a careful evaluation is not likely to change the bank’s decision. If a firm
is not willing to post collateral, the bank concludes the
firm has high costs and evaluates the project; in this case,
the bank’s evaluation may indicate that the firm’s project
has a positive NPV, even though the firm has high costs.b