Reexamining the Empirical Relation between Loan Risk and Collateral: The Role of the Economic Characteristics of Collateral

Abstract: This paper offers a possible explanation for the conflicting results in the literature concerning the empirical relation between collateral and loan risk. We posit that certain economic characteristics of collateral may be associated with the empirical dominance of different risk-collateral channels implied by economic theory, namely the “lender selection,” “borrower selection,” “risk-shifting,” and “loss mitigation” channels. Each of these four channels has different predictions regarding the empirical relations between collateral and loan risk. For our sample of commercial loans, we find that the “lender selection” channel appears to be especially important for outside collateral, the “risk-shifting” and “loss mitigation” channels are important for liquid collateral, and the “borrower selection” channel appears to hold weakly for nondivertible collateral. Our results suggest that the conflicting results in the extant riskcollateral literature may occur because different samples may be dominated by collateral with different economic characteristics.