DP5695 A Lender-Based Theory of Collateral

Author(s): Roman Inderst, Holger M Mueller
Publication Date: June 2006
Keyword(s): collateral, relationship lending vs transaction lending, soft information
JEL(s): G21, G32
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5695

We consider an imperfectly competitive loan market in which a local (e.g., relationship) lender has valuable soft, albeit private, information, which gives her a competitive advantage vis-à-vis distant transaction lenders who provide arm?s-length financing based on hard, publicly available information. The competitive pressure from transaction lenders forces the local lender to leave surplus to borrowers, which distorts the local lender?s credit decision in the sense that she inefficiently rejects marginally profitable projects. Collateral mitigates this inefficiency by 'flattening' the local lender?s payoff function, thus improving her payoff from precisely those projects that she inefficiently rejects. Our model predicts that technological innovations such as small business credit scoring that narrow the information advantage of local lenders vis-à-vis transaction lenders lead to higher collateral requirements, thus strengthening the role of collateral in local lending relationships.