Part 2.

Asymmetric Information: Problems and Solutions

A. Theory
o *Slides
o *Chapter 5 from Freixas and Rochet
B. Empirics
o *Slides
o *Luck and Santos (2019) The valuation of collateral in bank lending, mimeo, Federal Reserve
Bank of New York
o *Berger, Frame and Ioannidou (2011), Tests of ex ante versus ex post theories of collateral
using private and public information, Journal of Financial Economics, 85-97.

OUTLINE
A. Theory
i. Equilibrium credit rationing
i. Definition
ii. Credit rationing due to adverse selection
iii. Credit rationing due to moral hazard
ii. Collateral
i. Ex-ante theories: Screening versus rationing (Bester (1985))
ii. Ex-post theories: the role of frictions

B. Empirics

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Goal:
• aim to understand what equilibrium credit rationing means and how it potentially can be
resolved

• understand the difference between ex-ante theories and ex-post theories of collateral.

• From a borrower’s perspective, aim to understand under which conditions it may be

beneficial to pledge collateral to the lender
•
• From a researcher’s perspective, design an empirical setting where ex-ante and ex-post
theories can be identified

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A. THEORY

I. Equilibrium credit rationing

i. Definition of equilibrium credit rationing (Baltensperger 1978): equilibrium credit

rationing occurs whenever some borrower’s demand for credit is turned down, even if this
borrower is willing to pay all the price and nonprice elements of the loan contract

 Price: interest rate -- rationing as a result of a ceiling is not specific to credit market
 Non-price elements: e.g. collateral
 Red-lining (i.e., refuse (a loan or insurance) to someone because they live in an area
deemed to be a poor financial risk). Red-lining is not equal to rationing: some
categories of borrowers are totally excluded from credit market as they do not have
enough future cash-flows or collateral to match their demand for credit.

Disequilibrium rationing may apply when there is a ceiling on interest rates or when price
discrimination is not allowed for (e.g., uniform interest rates charged to observably different
risks)

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Adverse selection and moral hazard (i) may lead to the following expected return for the bank

And (ii) may lead to equilibrium credit rationing

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 If demand is L1D, then equilibrium at R1
 If demand is L2D, then credit rationing with interest rate R*

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ii. Credit rationing due to adverse selection

 Borrowers differ by a risk parameter θ which is privately observed

 Bank knows only the distribution of θ => have to resort to uniform pricing
 Bank offers standard debt contract: repay R or cash-flow is seized
 Consider situation where all firms have collateral with value C

 A firm’s profit function then becomes

 Graphically

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If second effect dominates, then is not optimal for the bank to increase further interest rates as
borrowers get adversely selected.
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 iii. Credit rationing due to Moral Hazard:

- Firms choose between

“Good” technology G with prob  G

0 with prob 1   G

“Bad” technology B with prob  B

0 with prob 1   B

 G G   B B
and    B   G
BG 
Loan contract specifies R in case of success (one plus the interest rate)

 Good technology is chosen if

 G G  R    B B  R 

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 ˆ  GG   B B
RR
G  B

Graphically:

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II. Collateral

a. Ex-ante theories: Screening versus rationing (Bester (1985))

Banks may aim to employ a menu of contracts in order to sort out borrowers.

Consider the setting of Bester (1985):

 banks decide on interest rate Ri and collateral requirements Ci i.e., they offer a menu of contracts

 two types of entrepreneurs: high-risk ones θH and θL

 collateral has a larger value to the firm than to the bank, i.e., there is a cost to collateralization

 We have separating contracts when 𝛾 ≠ 𝛾 ;

 when 𝛾 = 𝛾 , we have a pooling equilibrium

 competition between banks implies that bank’s expected profit is zero, i.e.,

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The bank offers two contracts

 the high risk type chooses a high interest rate with no collateral
 a low risk type chooses a low interest rate with high collateral requirements.
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 b. Ex-post theories regarding collateral: solving ex-post frictions.

 A bank may ask for collateral as collateral serves as a commitment against moral hazard. More
risky types may need to pledge more collateral; collateral reduces or removes agency risk

 The bank observes the quality of the borrower and hedges by asking more risky types more or
better collateral. Transfer the risk from the bank to the borrower.

The ex post theories predict that observably riskier borrowers are more likely to be required to
pledge collateral.

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B. EMPIRICS

 Many papers have empirically studied how collateral impacts on interest rates, with mixed support
for the ex-ante and ex-post theories.
The typical regression equation is

Interest rate = f(collateral pledged or not, control variables) + error term

See Luck and Santos

B1. Luck and Santos (2019, revised version April 2022) “The valuation of collateral in bank
lending”

- Research question: what is impact of (different types of) collateral on loan pricing (for different
types of firms)?
- The authors use a novel loan-level data source to identify the pricing collateral by comparing loans
made by the same bank, to the same firm, at the same origination date

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- Data:

o The authors use data from the US, where since 2011 large banks with more than $50 billion
in assets are required to report any C&I loan on their balance sheet with a commitment of one
million USD or more. Data period 2012:Q3 to 2019:Q4.
o Beyond reporting prices, loan volumes, and maturity, the data document the type of collateral
pledged and whether a loan is newly originated or not.
o there is a large number of borrowers that receive multiple loans from the same bank at the
same time, with some loans being unsecured and some being secured. Among borrowers with
multiple loans, there is significant variation in the combinations of collateral assets pledged
by each borrower, including real estate, marketable securities, accounts & receivables, blanket
lien, and fixed assets other than real estate.
o Data limitations: Banks do not report the degree a loan is collateralized or the value of the
collateral, but only the most important type of collateral the borrower pledged on the loan.

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o Table 1 provides an overview of the different types of collateral that are pledged

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- Empirical model:

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- Results

1) For all firms:

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2) By firm type: - lower spreads mostly for more opaque firms (smaller, private)

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Summarizing:
- Cross-sectional identification (i.e., between firms) is problematic as it does not adequately control
for unobserved heterogeneity. Unobserved risk may explain the higher spreads
- Identification from comparing within the same bank-firm-time-loan type: securing a loan
reduces the spread by 23 basis points on average. There is a large variation in the price effect across
collateral types, but in line with banks assigning higher valuations to assets whose value is less
prone to be affected by borrowers. For instance, we find that marketable securities and real estate
are by far the most valuable types of collateral and reduce the spread 33 and 22 basis points,
respectively. In contrast, loans secured by fixed assets and blanket lien are priced as if they were
unsecured loans.
- Most of the effects seem to come from opaque (i.e., small firms).

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B2. Berger, Frame and Ioannidou (2011) : offer an interesting setting to identify the importance of
both theories.
Their analysis discriminates between ex-ante and ex-post theories in the following way
- Information available to prospective lenders (public information that is disclosed by credit
registry)
- information that is available within a credit registry (and known to the researchers)

Dataset employed in Berger et al. (2011): Bolivian credit registry for period 01/1998- 12/2003
- each loan by a bank operating in Bolivia is submitted to the credit registry
- for each loan: date of origination, maturity date, contract terms, and ex post performance
- for each borrower: information on industry, physical location, legal structure, banking
relations, delinquent or defaulted on past loans

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 - credit registry makes some information available to potential lenders:
o obtains a credit report, which contains information on all outstanding loans of the
customer for the previous two months. Originating bank, loan amount, type of loan,
value of collateral, value of overdue payments, and borrower’s credit rating from
originating bank.
o Loans with overdue payments remain in the registry until they are paid off, even if they
are past maturity.
 Delinquencies in the past two months and past defaults from any previous period are observable
to other lenders through the registry.
 Delinquencies that were paid off more than two months ago are not observable to other lenders
through the registry

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Indicators of observed risk: (help to test the ex-post theories)
 Default_Observable_Registry:a dummy variable that equals one if the borrower defaulted with
any bank in the previous12 months,
 Npl_Observable_Registry: a dummy variable that equals one if the borrower had been 30+ days
delinquent with any bank in the previous two months
 Npl_Observable_Relation: a dummy variable that equals one if the loan is given to a borrower
that had been 30+days delinquent with the same bank any time from 3 to 12 months prior.

Prob Collateral: the hypothesis is that a positive sign on any of these variables is in line with ex-
post theories

Indicators of unobserved risk: (help to test the ex-ante theories)

 Npl_Unobservable: a dummy variable that equals one if the borrower had 30+days delinquencies
at other banks three to 12 months prior to the loan origination

Prob Collateral: We expect a negative sign

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- Descriptives dataset

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- Empirical analysis

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- Results

 The observed risk variables pop up with a positive coefficient in line with ex-post theories:
observably riskier borrowers have to pledge more often collateral
o Having observable risk versus not increases the likelihood of pledging collateral with about 4
to 13% depending upon the dummy variable
 The unobserved risk variable suggests that the ex-ante theories are at work when relationship length
is short.

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