Does collateral cause inefficient resource allocation?

This paper studies the determination of the optimal loan contracts and resource allocation in a competitive credit market with asymmetric information. It focuses on an economy with risky investment projects that require two goods as inputs, only one of which is accepted by lenders as collateral. Results show that low-risk entrepreneurs tend to choose contracts with a combination of more collateral and lower rates of interest. Under the circumstance that low-risk entrepreneurs have insufficient general capital (which is assumed to be accepted as collateral) to secure the loan, they are forced to face the binding collateral constraint. In order to finance their production projects, entrepreneurs tend to increase the size of loan and allocate a relatively high proportion of the general capital, leading to problems of inefficient resource allocation and over-borrowing in the credit market.