The effects of collateral on firm performance

This paper examines how collateral and personal guarantees affect firms’ ex-post performance employing a propensity score matching estimation approach. Based on a unique firm-level panel data set of more than 500 small-and-medium-sized borrower firms in Japan, we find that borrowers with high observed riskiness are more likely to pledge collateral. In addition, we find that borrowers that provide collateral to lenders experience larger increases in profitability and reductions in riskiness than borrowers that do not. The main channel through which the borrower enhances its profitability is cost-cutting restructuring. These findings are consistent with the hypothesis that collateral reduces moral hazard by providing borrowers with an incentive to enhance their creditworthiness.

► We examine how collateral and personal guarantees affect firms’ ex-post performance. ► Borrowers with high observed riskiness are more likely to pledge collateral. ► Borrowers that provide collateral to lenders increase their profitability and reduce riskiness. ► The findings are consistent with the moral hazard hypothesis of collateral.