The empirical relation between loan risk and collateral in the shadow banking system: Evidence from China's entrusted loan market

Based on evidence from China's entrusted loan market (2004-2014), we examine the effect of collateral in the shadow banking system. We find that collateral generally accompanies higher loan risk premiums and a higher probability of ex-post loan nonperformance (i.e., loan extension). Furthermore, the evidence shows that the types of collateral pledges, borrower heterogeneity and equity ties make a difference in the channel by which collateral works. Our findings suggest that in entrusted loan shadow banking, the lenders likely require collateral from observably riskier borrowers (unlisted or non-affiliated borrowers) to control ex-post contract conflict, and the lender selection effect is particularly strong for outside collateral. The paper sheds light on risk management in the shadow banking system and offers a possible explanation for the conflicting empirics concerning the relation of loan risk and collateral.