Collateral in banking policy: On the possibility of signaling

• We analyze signaling by collateral in a banking model.
• We study the validity of the assertion that collateral is in a position to signal the degree of borrowers’ riskiness.
• Cash flows are described by a continuous density and projects are classified by second-order stochastic dominance.
• If collaterals are bounded by the initial project outlay the positive role of collateral can no longer be ensured.

In this paper we study the validity of the assertion that collateral is in a position to signal the degree of borrowers’ riskiness. We use a framework in which the cash flow from the risky project is described by means of a continuous density and projects are classified by second-order stochastic dominance. We show that if collateral is assumed bounded by the initial project outlay the positive role of collateral, namely truthfully conveying the private information about the project risk by the collateral amount, can no longer be ensured.