Collateral, heterogeneity in risk attitude and the credit market equilibrium

This paper examines the argument that the availability of collateral rules out credit rationing. A model of the credit market with ex-ante asymmetric information and heterogeneous entrepreneurs' attitudes toward risk is set u p. It is shown that, due to the interplay between project choice and entrep reneurs' preferences, using collateral as a signal to screen safer projects may prove impossible. Instead, a partially separating two-contract equilib rium with rationing at one contract emerges. Contrary to previous theoretic al research and consistently with conventional wisdom and systematic eviden ce, the use of collateral is never negatively correlated with project risk. (C) 1999 Elsevier Science B.V. All rights reserved.