Collateralization, Bank Loan Rates and Monitoring: Evidence from a Natural Experiment

Collateral is one of the most important features of a debt contract. A substantial theoretical literature motivates the use of collateral as a means to alleviate ex-ante and ex-post information asymmetries between borrowers and lenders and the incidence of credit rationing. Through its seniority effect, collateral may also affect banks’ incentives to monitor borrowers. There is little empirical evidence, however, on the precise workings of collateral, its interaction with other contract terms, and its impact on banks’ monitoring incentives. We study a change in the Swedish law that exogenously reduced the value of all outstanding company mortgages, i.e., a type of collateral that is comparable to the floating lien. We explore this natural experiment to identify how collateral determines borrower quality, loan terms, access to credit and bank monitoring of business term loans. Using a differences-in-differences approach, we find that following the change in the law and the loss in collateral value borrowers pay a higher interest rate on their loans, receive a worse quality assessment by their bank, and experience a substantial reduction in the supply of credit by their bank. Consistent with theories that consider collateral and monitoring to be complements, the reduction in collateral precedes a decrease in bank monitoring intensity and frequency of both collateral and borrower.