TY - JOUR

T1 - Reexamining the empirical relation between loan risk and collateral

T2 - the roles of collateral liquidity and types

AU - Berger, Allen N.

AU - Frame, W. Scott

AU - Ioannidou, Vasso

N1 - This is the author’s version of a work that was accepted for publication in Journal of Financial Internediation. Changes resulting from the publishing process, such as peer review, editing, corrections, structural formatting, and other quality control mechanisms may not be reflected in this document. Changes may have been made to this work since it was submitted for publication. A definitive version was subsequently published in Journal of Financial Internediation, 26, 2016 DOI: 10.1016/j.jfi.2015.11.002

PY - 2016/4

Y1 - 2016/4

N2 - This paper offers a possible explanation for the conflicting results in the literature concerning the empirical relation between collateral and loan risk. We posit that differences in collateral characteristics, such as liquidity, may be associated with the empirical dominance of different risk-collateral relations implied by economic theory. Using credit registry data and a novel identification strategy to control for borrower and lender selection effects allows us to differentiate between the ex ante and ex post theories of collateral. We find that collateral overall is associated with lower risk premiums and higher default rates. The results indicate an important role for collateral in mitigating losses and reducing risk-taking incentives, consistent with ex post theories. Liquid collateral is associated with especially low risk premiums, and these loans perform better than those with illiquid collateral or no collateral. We also find that individual collateral types exhibit significant variation in terms of risk-collateral relations, with some consistent with ex ante theories and others with ex post theories. Our results suggest that the conflicting results in the literature may occur because different samples may be dominated by different types of collateral with different economic characteristics.

AB - This paper offers a possible explanation for the conflicting results in the literature concerning the empirical relation between collateral and loan risk. We posit that differences in collateral characteristics, such as liquidity, may be associated with the empirical dominance of different risk-collateral relations implied by economic theory. Using credit registry data and a novel identification strategy to control for borrower and lender selection effects allows us to differentiate between the ex ante and ex post theories of collateral. We find that collateral overall is associated with lower risk premiums and higher default rates. The results indicate an important role for collateral in mitigating losses and reducing risk-taking incentives, consistent with ex post theories. Liquid collateral is associated with especially low risk premiums, and these loans perform better than those with illiquid collateral or no collateral. We also find that individual collateral types exhibit significant variation in terms of risk-collateral relations, with some consistent with ex ante theories and others with ex post theories. Our results suggest that the conflicting results in the literature may occur because different samples may be dominated by different types of collateral with different economic characteristics.

KW - Collateral

KW - Asymmetric information

KW - Banks

U2 - 10.1016/j.jfi.2015.11.002

DO - 10.1016/j.jfi.2015.11.002

M3 - Journal article

VL - 26

SP - 28

EP - 46

JO - Journal of Financial Intermediation

JF - Journal of Financial Intermediation

SN - 1042-9573

ER -