Collateral, loan guarantees, and the lenders’ incentives to resolve financial distress

This paper proposes that the timing for when collateral is pledged will affect the lenders’ incentives to resolve financial distress. It demonstrates that, if the amount of collateral pledged in a loan contract exceeds a critical value, the borrower's project may be inefficiently liquidated once he becomes financially distressed. It also shows that a fairly priced loan guarantee provided by a third party can partially alleviate this inefficient liquidation problem. This paper predicts that riskier borrowers will pledge more collateral, which is consistent with the empirical findings of Berger and Udell [Berger, A. N., & Udell, G. F. (1990). Collateral, loan quality, and bank risk. Journal of Monetary Economics, 25, 21–42] and Leeth and Scott [Leeth, J. D., & Scott, J. A. (1989). The incidence of secured debt: evidence from the small business community. Journal of Financial and Quantitative Analysis, 24, 379–394].