Abstract
We show that collateral plays an important role in the design of debt contracts, the provision of credit, and the incentives of lenders to monitor borrowers. Using a unique dataset from a large bank containing timely assessments of collateral values, in conjunction with a legal reform that exogenously reduced those values, we find that the bank responded to this change by increasing interest rates, tightening credit limits, and reducing the intensity of its monitoring of borrowers and collateral, spurring delinquency of borrowers on outstanding claims. We so explain why banks are senior lenders and quantify the value of claimant priority.
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