Asymmetric Valuations and the Role of Collateral in Loan Agreements

Abstract

Collateral can serve as a source of additional, indirect information in a rational expectations signalling context. The collateral chosen by the borrower provides a signal to the lender of the borrower's info., and in a rational expectations equiilibrium, the signal can be fully revealing. They conclude that it is the lower-quality, small and middle-size firms that provide collateral; in contrast, emphasising the use of collateral as a response to asymmetric valuations between transactors predicts that it is the better-quality firms in these size categories taht offer collateral.