Is there adverse selection in the credit market?

Abstract

Despite a huge theoretical literature on credit markets charaterized by asymmetric information little is known about the structure of real world credit contracts or the nature of the underlying informational regime on which they are predicated. A model is constructed and tested that enables delineation of credit contract features and establishment of the nature of the underlying informational regime. Large sample estimates based on individual loans from a major UK bank are shown to support both the symmetric and asymmetric information variants of the model: better borrowers get larger loans and lower interest rates; collateral provision and loan size reduce the interest rate paid. However, consistent with a regime of symmetric information collateral levels are found to be independent of borrower type. Finally, in line with the insurance literature, the bank is shown to use qualitative as well as quantitative information in the structuring of loan contracts to small businesses.

The role of demographics in small business loan pricing

“…Large loans are cheaper than smaller ones, consistent with previous evidence (see Table 1). Collateral has a significant negative influence on the loan rate, which confirms the result of Cressy and Toivanen (2001). Regression II shows the influence of firm-specific variables.…”

Collateral requirements of SMEs: The evidence from less-developed countries

“…As noted by Godlewski and Weill (2011), there is a clear dearth of substantial empirical support for the adverse selection hypothesis with respect to the use of collateral. Although several studies support the role of collateral as a tool for mitigating adverse selection problems (Jiménez et al, 2006;Berger et al, 2011b), other investigations (Cressy and Toivanen, 2001) find evidence that risk and collateral are not significantly correlated. Instead, a positive relationship between collateral and loan spread is consistently demonstrated: in other words, because banks are able to distinguish among borrowers of different quality, these financial institutions charge higher interest rates and require higher collateral for riskier borrowers, confirming the observed-risk hypothesis (Berger and Udell, 1990;Berger and Udell, 1995;Jiménez and Saurina, 2004;Gonas et al, 2004;Chen, 2006;Menkhoff et al, 2006;Chakraborty and Hu, 2006;Brick and Palia, 2007) 6 .…”

Banks' risk assessment of Swedish SMEs

“…Investors have strong incentive to use their own money for the projects 6 where returns are certain and attempt to borrow money for riskier projects. Hence, adverse selection may lead SMEs to only ask for external funding for their riskiest projects, but it is difficult for potential lenders and investors to find out if this is the case because of information asymmetry (Cressy and Toivanen, 2001). …”