Tests of Ex Ante versus Ex Post Theories of Collateral

The following post comes to us from Allen Berger, Professor of Finance at the University of South Carolina; W. Scott Frame of the Federal Reserve Bank of Atlanta; and Vasso Ioannidou, Professor of Financial Intermediation at Tilburg University.

In our paper, Tests of Ex Ante versus Ex Post Theories of Collateral Using Private and Public Information, forthcoming in the Journal of Financial Economics, we test the empirical predictions generated by two broad classes of theories about why borrowers pledge collateral. The first set of theories motivates collateral as a way for good borrowers to signal their quality under conditions of ex ante private information. The second set of theories explains collateral as an optimal response to ex post contract frictions like moral hazard. A growing body of literature that empirically tests these models and the on-going financial crisis have raised significant academic and policy interest in understanding the role of collateral in debt contracts.

This paper improves upon the empirical literature by using data from the Bolivian public credit registry that provides us with important risk information about the borrower that is not known to the lender.

Thus, we have both “private” and “public” information about the firm. Using this information structure, we are able to construct measures of both observed and unobserved risk and hence more effectively test the two sets of collateral theories. The data also allows us to explore the role of banking relationships and how information gleaned from relationships reduces private information.

We present results that suggest roles for both sets of theories, although the ex ante private information theories appear to hold only for customers with short relationships that are relatively unknown to the lender. The data also suggest that the ex post theories tend to empirically dominate for firms with long relationships, where private information is less important.

Our analysis represents an important contribution to the literature seeking to understand the motivation for collateral in debt contracts. First, the issue has clearly been on the minds of market participants and policymakers in places like Japan and the United States owing to significant shocks to collateral values.

Second, we use credit registry data that allows us to produce clean measures of private and public information, as well as providing a rich set of controls at the loan and bank level and bank and time fixed effects to account for unobserved bank heterogeneity and changes in the lending environment, respectively. Our approach might also be relevant to World Bank efforts to encourage the establishment of the development of credit registries in the developing world. Our findings suggest that the information provided by such registries might be useful in eliminating the need for costly collateral.

The full paper is available for download here.

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