Secured Lending and Default Risk: Equilibrium Analysis, Policy Implications and Empirical Results

The authors examine collateral in a competitive equilibrium in which borrowers can choose hidden actions and may additionally possess hidden knowledge. Apart from explaining the widespread use of collateral despite deadweight costs, they show that an increase in the riskless interest rate causes equilibrium loan rates and collateral requirements to increase, a decline in the deadweight costs of collateral reduces the equilibrium collateral use under moral hazard, and an increase in the borrower's project size reduces equilibrium collateral use under moral hazard. Some of these predictions are tested and found to be supported by the data.