Using Collateral to Secure Loans BY YARON LEITNER any businesses post collateral as security for theoretical work on collateral has been driven by economists’ desire to provide M loans. Collateral protects the lender if the explanations for the use of collateral borrower defaults. However, not all borrowers that are consistent with this empirical finding among others. put up collateral when taking out loans. There’s even some evidence that loans with collateral COLLATERAL AND BORROWERS’ INCENTIVES attached may be riskier for lenders. Why is collateral We start by focusing on the way used sometimes, but not others? And why does collateral collateral affects a borrower’s incen- tives to ensure the business’s success. potentially involve more risk? In this article, Yaron Consider a loan contract where an Leitner considers these questions. He looks at some of the individual borrows some money to explanations for using collateral, focusing on its benefits start a new business. The success of the business often depends on actions and drawbacks. the borrower takes after the loan is signed, for example, the way he allo- cates money among different activities, and the effort he expends in choosing Collateral is a contractual device finance their investments. low-cost/high-value alternatives. Ideal- used by borrowers and lenders around Understanding collateral is im- ly, the loan contract would specify all the world. Collateral has also been portant because it is a characteristic of these actions. However, in many around for a long time. In one famous feature of bank loans, which help to cases, this is impossible because some 1 example, a pound of Antonio’s flesh channel resources to their best use. of these actions may not be observable collateralized Shylock’s loan to Bas- While early research focused mainly to a third party or even to the lender; sanio in Shakespeare’s “Merchant of on how collateral affects the borrower’s for example, it may be difficult for the Venice.” Generally, the term collateral behavior, recent research has also bank to argue in court that a borrower refers to assets pledged by a borrower incorporated lenders’ behavior, for did not exert enough effort in choosing to secure a loan. The lender can seize example, how collateral affects lenders’ the best alternatives.2 these assets if the borrower does not incentives to take care in evaluating If the borrower and lender had make the agreed-upon payments on a business’s prospects. Economists the same objectives, the fact that the the loan, so the lender has some pro- have also examined the relationship borrower’s actions are not observable tection if the borrower defaults. There- between collateral and risk, empirically to others would not be a problem. fore, the use of collateral can make verifying bankers’ common wisdom it easier for firms to obtain loans to that collateralized loans are riskier for the bank than noncollateralized 2 The finance and economics literature refers loans. To a significant extent, recent to this hidden action problem as moral hazard. Yaron Leitner is a This term, which was coined in the insurance senior economist industry, captures the idea that an individual in the Research who has insurance is less likely to take actions 1 Department of According to the Federal Reserve’s Surveys to avoid problems. For example, if you have of Terms of Business Lending, more than 50 comprehensive car insurance with no deduct- the Philadelphia percent of the value of all commercial and ibles, you may be less careful about locking your Fed. This article industrial loans made by domestic banks in the car or parking it in a safe spot. More broadly, is available free U.S. is currently secured by collateral (based on the term moral hazard refers to any contracting of charge at www. the surveys for February 2005, May 2005, and problem where the actions of one party cannot philadelphiafed.org/ August 2005). be observed by others. econ/br/index.html. www.philadelphiafed.org Business Review Q2 2006 9 The borrower would take the actions according to the lender’s wishes, but collateral would normally sell for. In that are best for him, and these ac- when these actions cannot be verified addition, businesses in a given industry tions would also be best for the lender. in court, such a promise is just cheap often fail together. But when many However, in practice, the borrower and talk. lenders try to sell at the same time, lender often have different objectives. Collateral May Induce the Bor- the market gets flooded and the price The lender wants to make sure that rower to Exert Effort… Suppose the they can obtain decreases. Overall, the loan is paid in full; the borrower borrower posts his house or some of his economists call this loss in asset value cares about the profits left after pay- business assets as collateral to secure a deadweight loss because the lender ing the loan. The borrower may also the loan. This may induce him to put does not gain as much as the borrower care about some perks that benefit more effort into ensuring the business loses. Another deadweight loss involves him, but not the business as a whole; succeeds because if the business fails, transferring control of the collateral- for example, the borrower may enjoy the borrower loses his collateral. In ized assets, which often involves legal expensive business meals, a private jet, other words, collateral can give the and other administrative costs. There- and so forth. borrower the incentive to work harder. fore, there is a tradeoff: Collateral re- Consider the following as an ex- ample of a conflict of interests between Collateral reduces the cost of borrowing borrowers and lenders: A business can either succeed or fail. If it fails, because it gives the borrower incentives to the loan cannot be repaid, and both work hard, but it also increases the cost of the borrower and lender get nothing. If the business succeeds, the loan is borrowing because the collateral may be worth paid in full, and the borrower is left more to the borrower than to the lender and with the rest of the profits. Now sup- because transferring control imposes costs. pose that the borrower can take an action that has the following effect: When the borrower works harder, the duces the cost of borrowing because it If the business is a success, the action business is more likely to succeed, and gives the borrower incentives to work increases profits; however, the action the borrower is less likely to default. hard, but it also increases the cost of reduces the chances that the business But then the lender may be more will- borrowing because the collateral may will succeed.3 The borrower may be ing to lend his money and at a lower be worth more to the borrower than happy to take such an action because it interest rate. to the lender and because transferring increases the money left for him — re- …But Using Collateral Is Costly. control imposes costs. member, he gets paid only if the busi- The benefit above comes at a cost. A A Long-Term Relationship with ness succeeds.4 The lender, however, is business might fail even if the borrower a Bank Can Reduce the Need for unhappy because he is less likely to get exerts a lot of effort; the borrower may Collateral. In their paper, Arnoud his money back. have bad luck. In this case, the bor- Boot and Anjan Thakor suggest that Anticipating the conflict of inter- rower loses the collateral, which may long-term relationships between a ests above, the lender may demand a be worth more to him than it is to the borrower and a lender can reduce the higher interest rate on the loan, and lender. For example, if the borrower need for collateral. When the loan in some cases, he may not lend at all. has posted his house as collateral, be- contract is a one-time transaction for Of course, the borrower can promise ing able to continue living there is the bank and borrower, there are two to take some agreed-upon actions important to the borrower but not the ways to induce the borrower to exert lender. Or if the borrower has posted effort. his business assets, they may be worth The first is to require collateral, 3 An example of such an action is a business expansion. If the business succeeds, there are more to him, since he knows how to as discussed above. The second is to more profits. But because the firm spends re- use those assets to produce goods, lower the interest rate on the loan. A sources on the expansion, it has less to spend cultivating its old customers. and the lender does not. The lender lower interest rate leaves more profits may choose to sell the collateral to for the borrower and therefore induces 4 Of course, many businessmen and -women are someone else, but since the lender has him to exert effort to make the busi- motivated by ethical concerns and their reputa- tions. For the most part, we ignore these moti- an incentive to sell as quickly as pos- ness succeed. However, if the interest vations to highlight the role of collateral. sible, he may obtain less than what the rate needed to induce the borrower to 10 Q2 2006 Business Review www.philadelphiafed.org exert effort is too low, the loan may the start of the relationship, and this COLLATERAL AND RISK not be profitable to the lender; he may compensates the bank for the loss of We have seen that collateral pro- be able to get a higher interest rate by profits later in the relationship.