AN ECONOMIC PERSPECTIVE ON THE ENFORCEMENT OF CREDIT ARRANGEMENTS: THE CASE OF DAYLIGHT OVERDRAFTS IN FEDWIRE

Economic Policy Review - Federal Reserve Bank of New York, Sep 2008 by Martin, Antoine, Mills, David C

Collateral

By posting collateral, the borrower offers a type of guarantee to the lender. Collateral may be something that has value to the lender so that the lender is at least partially compensated in case of default. In that particular case, the collateral plays an insurance role and need not have any value to the borrower. Collateral may also be something that has value to the borrower so that its loss punishes the borrower in case of default. In that case, the collateral plays an incentive role and need not have any value to the lender. In practice, collateral typically plays both roles in that it usually has some value to both the borrower and the lender. It is the incentive role that is most important from the perspective of reducing information frictions. Thus, collateral typically helps alleviate the incentive problems associated with moral hazard.

Various assets can be pledged as collateral. For example, loans for such durable goods as houses, cars, and boats are often secured by the goods themselves. In the financial sector, securities and other financial assets can be used as collateral for various types of loans. In our construction loan example, once a project is complete and a building is ready for sale, the contractor can convert the loan into a standard mortgage, which requires that the new building be pledged as collateral. This conversion can provide the borrower with more favorable terms, such as a lower interest rate.

Depending on the circumstances, some of these ways to alleviate enforcement problems may be more or less costly or efficient. Reputations may be costly or impossible to maintain if there are not enough opportunities to signal one's type-for example, if relationships are short lived or if the economic environment evolves quickly and in unpredictable ways. Monitoring can be difficult or costly because it may require very specific and technical knowledge or because it may be possible to misrepresent the true state of a project. The use of collateral, too, is not without cost; there are costs involved in valuing and managing it. The collateral may have more value to the borrower than the lender, which implies that, in the case of default, the collateral is transferred from one agent that gives it a higher valuation to another agent that assigns it a lower valuation. This reallocation results in a loss to society. There may also be a cost associated with rationing credit if the collateral is insufficient.

Finally, technological advances can also change the relative costs and benefits of the various ways of alleviating enforcement problems. For example, innovations in information technology have improved recordkeeping and the transmission of information. The effect of improvements in information technology has likely reduced the costs of reputation, monitoring, and collateral, making these tools more effective at reducing information problems. The ability to keep better records enables borrowers to signal information about their reputations. It also allows lenders to gather and evaluate information quickly, which reduces the cost of monitoring. Furthermore, better information technology can improve lenders' evaluations of certain assets that can be pledged as collateral, reducing some uncertainty regarding the collateral's value.