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Corporate Borrowing and Collateral
Corporations, like individuals, use collateral to lower their cost of financing. Yet years of research on corporate borrowing shows that, on average, corporations who pledged collateral paid a higher loan rate. Thunderbird Professor Dr. Lena Booth and research partner Dr. James Booth set out to solve this puzzle and statistically proved what was intuitively true.
Conflicting Evidence
While theoretical models vary as to whether the presence of collateral is associated with higher or lower default risk, most empirical evidence to date shows that the presence of collateral is associated with riskier loans and/or riskier borrowers. Evidence also suggests that the presence of collateral is associated with higher loan spreads.
The direct costs of pledging collateral such as reporting, bonding and monitoring costs are relatively low. The benefits include risk reduction. Yet there is a relatively high incidence of unsecured loans in the market. Traditional studies focusing on the direct costs and benefits of pledging collateral have not explained this discrepancy. One theory involves information spillover to other creditors that comes from the generalized bank monitoring required with unsecured loans. That is, firms may be motivated to pay a higher cost to borrow unsecured in order to gain the benefits of generalized bank monitoring.
The Method
To examine the decision to pledge collateral in relation to direct bank borrowing costs, Booth and Booth explicitly controlled for the interdependence between the presence of loan collateral and borrowing costs. This allowed them to determine 1) whether firms pledge collateral in order to minimize direct bank borrowing costs, or 2) whether firms are motivated to borrow unsecured loans to reap potential benefits associated with generalized monitoring, even though the direct borrowing costs would have been lower if they had pledged collateral.
They examined the factors determining the presence of collateral in a sample of large commercial bank loans from publicly-traded firms. Specifically, they examined whether the probability of a loan being secured is a function of default risk and various pricing options. They also examined the borrowing costs for secured and unsecured loans, using variables believed to affect borrowing costs, and controlling for interdependence between the decision to pledge collateral and loan spreads. They then estimated the borrowing costs (corrected for selectivity bias) for both secured and unsecured loans. Finally, they compared their results to estimates of loan spreads for different types and sizes of loans.
The Results
Booth and Booth found that a number of observable risk characteristics are related to the probability that a loan is secured. These include loan maturity, the size of the initial commitment fee, the purpose of the loan, and whether the bank prime rate is used in pricing. The results confirm that high-risk loans are more often secured and borrowers generally choose the least costly form of borrowing. Specifically, secured loans have predicted loan spreads substantially lower than if they had been unsecured. Alternatively, unsecured loans have estimated loan spreads not substantially different than if they had been secured. These results suggest that firms choosing to borrow unsecured loans would not have been able to reduce their borrowing costs had the loans been secured, i.e., they were low-risk, high-quality borrowers who qualified for lower loan rates.
Having corrected for the selectivity bias that earlier research contained, the researchers were able to identify two sets of corporate borrowers with different risk profiles. High-risk borrowers pledge collateral because they have no choice. Low-risk borrowers do not need to pledge collateral and rarely do, as it does not reduce their cost of financing.
The full version of this article, "Loan Collateral Decisions and Corporate Borrowing Costs," will be published in a forthcoming issue of Journal of Money, Credit and Banking.
Dr. Lena Booth (boothl@t-bird.edu) holds a Ph.D. in finance from Arizona State University. She specializes in financial management, corporate finance, investment banking, and Asian financial markets and has published extensively on these topics.
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