Screening in the credit market: the role of collateral

In this paper, we study the role of collateral in the market for business loans when the problem of adverse selection arises. Exploiting the monotonic relationship that exists between the riskiness of firms and their collateral-interest rate trade-off, banks try to induce self-selection among firms. Even when restrictive regularity conditions are imposed on the model, we show that there are serious limits to the possibility of using collateral as a screening device. We prove that the possibility of screening firms according to their riskiness crucially depends on the proportion of low- and high-risk firms, and we study the properties of the second-best contracts that prevail in the market.