Credit Collateral Research Articles

Failure at the Lower Levels

This case study analyzes the reasons for failures by Credit Suisse banking advisors prior to the recent financial crisis and attempts to develop a strategy for international law that will dis-incentivize advisors from failing, thereby averting consumer losses in the future. The paper does not focus on failures at the level of dealers in the financial markets but on potential malpractice of banking advisors who recommend hazardous investments and who might be held responsible for overoptimistic valuation of credit collateral. The case of Credit Suisse is widely recognized as an example of systematic, quasi-fraudulent advisory service that led to severe losses for low-income clients and precipitated an unprecedented consumer trust crisis. A crucial goal of this analysis is to discover the incentives that motivated the banking advisors to engage in this activity and to describe potential, internationally appropriate, legal means to overcome this trust crisis. The study concludes that banks will need to fundamentally change the incentives of their advisors to achieve high advisory quality and regain their clients’ trust. These changes will most notably comprise financial (counter-) incentives such as the abolition of commissions, a new structure of profit-related salaries, and penalties for nontransparent advisory behavior. Parallel to the need for action within the banks, is government responsibility to legally coerce banks into setting so-modified incentives. By these means, cases such as the one of Credit Suisse will be prevented. Furthermore, these measures can help to mitigate future trust crises and thereby add to the stability of banking business.

Valuation of credit guarantee funds in Poland

In the scope of the financial crisis and constraints in SMEs financing special attention is focused on the guarantee schemes and funds. The purpose of the article is to present the Polish guarantee funds valuation based on the funds’ activity data. The article highlights the guarantee schemes concept as a credit collateral and gives the broad overview of the Guarantee System in Poland, also the conceptual characteristics and good practices of the European guarantee systems.

Competitive product lines with quality constraints

Competing firms often use product lines to screen different types of customers. Examples include, in general markets, product lines that screen the purchasing ability or preference for quality; in credit markets, product lines that screen the risk of the projects with different collateral; in insurance markets, product lines that screen the risk of accident with different coverage; and in labor markets, wage schedules that screen the employees’ abilities with different education levels. In some of these markets there can be some natural quality constraints: a maximum available quality in general markets, no negative collateral in credit markets; coverage not above 100% in insurance markets; minimum education level in labor markets. We present sufficient conditions for the existence of a pure strategies equilibrium (in such markets) under differentiation and a continuous distribution of customer types. We show that the equilibrium exists if there is a sufficiently high degree of differentiation among firms. Furthermore, we show that this equilibrium involves, under certain general conditions, pooling of customer types at the top and at the bottom of the distribution of customer types. The middle types may still be screened by the firms.

On the Use of Collateral

This paper surveys existing explanations for the pervasive use of collateral in credit markets and relates them to the empirical evidence on the subject. Collateral may be used as a screening or an incentive device in markets characterized by various forms of asymmetric and biased information. The evidence is incompatible with the use of collateral as a signal of projects’ quality, while broadly consistent with explanations based on its incentive properties and asymmetric evaluation of projects.

Transformation and Rural Finance

In the process of transformation from a centrally-planned to a market-orientated economy, the domestic financial sector plays two important roles. First, the financial sector itself has to be fundamentally restructured, and second, its efficient functioning is a crucial precondition for the necessary economic transformation. During the central-planning era, the financial sector typically carried out fiscal functions, namely it distributed subsidies and supported production plans. In a market-orientated economy, this fiscal function of the financial sector has to be altered to one of financial intermediation, in which the financial intermediaries mobilize, and efficiently allocate, capital. This includes the selection and monitoring of investment projects. In addition to the more general set of problems associated with macro-economic instability, which slows down the development of the financial market overall, rural financial institution-building faces specific obstacles. These obstacles include difficulties relating to the provision of credit collateral due to an unclear land property situation; the relatively high transaction costs related to supplying financial services to small enterprises, the still prevalent misuse of the financial sector to supply subsidies to bankrupt state enterprises and the related poor financial discipline and credit repayment behaviour. The consequence is the development of weak financial intermediaries with large portfolios of non-performing loans. Also, these intermediaries fail to address the medium- and long-term credit demand of private enterprises for capital investments. At the macro-economic level, reforms and innovations are necessary to foster economic stability and public confidence in the reliability and efficiency of the domestic financial sector. This includes the establishment of an independent central bank and effective internal and external mechanisms for the control of banking operations. At the level of the financial intermediaries, the restructuring of the organization and its management and the adoption of innovative financial instruments are necessary in order to increase the efficiency of financial intermediation. More efficient financial intermediation will allow the needs of cost-intensive market segments formerly ignored by commercial banks, such as the rural clientele, to be addressed.

The role of collateral in credit markets with imperfect information

The paper analyzes the structure of credit market equilibrium under imperfect information. Collateralization and credit rationing are compared as alternative means to cope with problems of adverse selection and moral hazard. It is shown that lenders may use collateral as a self-selection and incentive mechanism. Rationing occurs only if the borrowers' collaterizable wealth is too small to allow perfect sorting or to create sufficiently strong incentives. Whenever there is rationing in an equilibrium, some borrowers are charged the maximum amount of collateral.