A Study on Collateral Valuation of the Borrowers and Loan Contracts

Abstract

This study explains that the collateral valuation can be different among the borrowers and the efficiency of the bank loan contract could be improved by considering it. Lenders usually have asymmetric information about the borrower’s project which is financed by loan contracts. Bester (1985) argues that collateral can be alternative means to cope with problems of adverse selection or moral hazard, instead of credit rationing. We generalize the collateral valuation of the borrowers and show that more diverse separating equilibrium is possible. In the loan contracts, the expected collateral value is the product of two factors: the borrower’s default probability and the collateral value. Existing literature assumes that the lender’s valuation of the collateral is less than the borrower’s one. We take additional assumption that the collateral valuation is different between the firms due to the asset specificity which is independent of the firm’s default risk. Although the bank’s profits are not affected by the specificity of the collateral, the firms consider it when they select the loan contract menu. The implication is that the borrower’s characteristics can be used to separate the borrower’s risk types, even though they are independent of the default risks.