Do good or bad borrowers pledge more collateral?

Abstract

Purpose

The purpose of this article is to determine the optimal use of collateral in order to maximize the borrower's wealth by reducing the interest rate payments. This analysis is to shed light on the fundamental question whether good or bad borrowers pledge more collateral.

Design/methodology/approach

The analysis bases on a simple firm value model similar to Merton's but with the additional feature that the borrower can bring in collateral. This article not only presents the case with perfect information between borrowers and lenders but also regards the consequences arising from asymmetric information.

Findings

A bad borrower, who is characterized by higher bankruptcy costs, riskier projects, and a lower contribution to the project value, typically pledges more collateral than a good borrower. These relationships base on the existence of perfect information between borrowers and lenders. If asymmetric information in terms of the project's riskiness or the contribution of the borrower to the project is present, these relationships invert and good borrowers tend to pledge more collateral. As a result, the allocation of information between a borrower and a lender is crucial for the optimal choice of collateral.

Research limitations/implications

This research underlines the potential for firms to add firm value by pledging collateral because collateral reduces interest rates and therefore results in more attractive terms of the loan. On the other hand, further empirical research can be done to verify our theoretical finding that under perfect information bad borrowers pledge more collateral, while under asymmetric information primarily good borrowers use collateral.

Originality/value

This paper introduces a new motive for the use of collateral and explains – in contrast to many other theoretical models – why bad borrowers tend to pledge more collateral.

Citation

Koziol, C. (2007), "Do good or bad borrowers pledge more collateral?", International Journal of Managerial Finance, Vol. 3 No. 2, pp. 132-163. https://doi.org/10.1108/17439130710738709