Collateral in credit rationing in markets with asymmetric information

We study an incentive model of lending in which a borrower can pledge a personal asset as outside collateral. We examine how the value of the collateral affects the borrower's incentives and the lender's returns. In some scenarios moral hazard is avoided without the collateral but the introduction of the collateral may generate negative incentives. The borrower attempts to save his collateral asset by gambling for resurrection with the project output or by gambling with the value of the collateral. These negative incentives make credit rationing optimal. The findings provide recommendations on the optimal use of collateral. (C) 2017 Board of Trustees of the University of Illinois. Published by Elsevier Inc. All rights reserved.