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Asymmetric Information, Collateral, and Moral Hazard

Published online by Cambridge University Press:  06 April 2009

Kazuhiro Igawa  and
George Kanatas
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Abstract

In a credit market characterized by a priori asymmetric information, collateral not only can identify credit applicants but also can result in moral hazard involving the borrower's use of pledged assets. The borrower's other alternatives are to apply for unsecured bank credit and be priced as “average,” or to acquire financing by selling an asset and subsequently renting it for continued use. The optimal secured loan contract for higher quality firms is shown to involve overcollateralization. There is underinvestment relative to first best in maintenance of the pledged assets but overinvestment relative to the level that would be chosen without bank monitoring. Self-financing and unsecured credit are chosen by the intermediate and lowest quality groups, respectively.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 25 , Issue 4 , December 1990 , pp. 469 - 490
Copyright
Copyright © School of Business Administration, University of Washington 1990

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