How do Banks Pick Safer Ventures? Theory and Evidence of the Importance of Collateral, Interest Margins and Credit Rationing

This paper uses unique data and augments existing theory focussing on bank’s lending to new ventures. We are primarily concerned with banks’ use of collateral and interest margins in terms of reducing adverse selection and moral hazard problems. We find a trade-off between interest margins and collateral per unit borrowed. Margins are insensitive to the magnitude of collateral per unit of borrowing but borrowers who post no collateral are associated with higher interest margins. Our theory and evidence suggests that liquidity constraints may be less prevalent at low borrower wealth than presupposed. We conclude that it is more the offering rather than the amount of collateral that matters to banks. JEL classification: D82, D81