Collateral and relationship lending in loan pricing: Evidence from UK SMEs

This study investigates how the use of collateral affects incentives for borrowers and lenders and the resulting loan pricing relationship. With data from the UK Survey of Small and Medium-Sized Enterprises 2008, a simultaneous equation approach reveals that high quality borrowers choose contracts with more collateral and lower interest rates, which suggests that collateral acts as an incentive in credit markets. By distinguishing business from personal collateral, the present study also reveals that personal collateral seems more effective as a sorting device, in line with screening models. Regarding the nature of the borrower–lender relationship, a substitution effect arises between relationship length and collateral requirements, but a primary bank uses an explicit loan interest rate as a loss leader to secure long-term rents on relationship business, suggesting the possibility of intertemporal shifting rents.