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How Do Banks Pick Safer Ventures? A Theory Relating the Importance of Risk Aversion and Collateral to Interest Margins and Credit Rationing

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Author Info

  • Andrew E. Burke

    (University of Warwick & UCLA)

  • Aoife Hanley

    (University of Nottingham & The Credit Research Centre, University of Edinburgh)

Abstract

The paper augments the asymmetric information literature on bank lending to new ventures by focusing on the more neglected area of moral hazard; specifically the relationship between risk aversion, an entrepreneur?s wealth and the provision of collateral. The results highlight some interesting nuances which are not characteristic of the properties of models that have dominated the literature and which mainly focus on the problems of adverse selection. Contrary to models such as Evans and Jovanovic (1989) Blanchflower and Oswald (1998) our model shows that credit rationing does not necessarily have to be negatively related to an entrepreneur?s initial wealth. Our model shows that banks can use collateral as a means of affecting an entrepreneur?s risk aversion – the tactic being least effective for both very low and high wealth individuals. We show that this can cause banks to ration credit at both tails of the wealth distribution. Furthermore, we argue that credit rationing is likely to be less applicable to low wealth individuals, as a small increase in their initial wealth can have very dramatic effects on access to bank finance as it both increases the risk aversion of the borrower as well as the usual affect of raising the amount of the debt that is effectively securitized through borrower collateral. Thus, through this mechanism, low wealth individuals who can provide at least some collateral would have greater access to finance than previously supposed. The results also indicate why collateral to debt ratio need not be negatively related to interest rate margins.

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Bibliographic Info

Article provided by Pepperdine University, Graziadio School of Business and Management in its journal Journal of Entrepreneurial Finance and Business Ventures.

Volume (Year): 8 (2003)
Issue (Month): 2 (Summer)
Pages: 13-24

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Handle: RePEc:pep:journl:v:8:y:2003:i:2:p:13-24

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Postal: 24255 Pacific Coast Hwy, Malibu CA
Web page: http://bschool.pepperdine.edu/jef
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Related research

Keywords: Bank; Adverse Selection; Risk Aversion; Collateral; Credit Rationing;

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References

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  1. Bester, Helmut, 1987. "The role of collateral in credit markets with imperfect information," European Economic Review, Elsevier, vol. 31(4), pages 887-899, June.
  2. Besanko, David & Thakor, Anjan V., 1987. "Competitive equilibrium in the credit market under asymmetric information," Journal of Economic Theory, Elsevier, vol. 42(1), pages 167-182, June.
  3. Cressy, Robert, 1996. "Are Business Startups Debt-Rationed?," Economic Journal, Royal Economic Society, vol. 106(438), pages 1253-70, September.
  4. de Meza, David & Webb, David C, 1987. "Too Much Investment: A Problem of Asymmetric Information," The Quarterly Journal of Economics, MIT Press, vol. 102(2), pages 281-92, May.
  5. Andrew E. Burke & Felix R. FitzRoy & Michael A. Nolan, 2000. "Self-Employment Wealth and Job Creation: The Roles of Gender, Non-Pecuniary Motivation and Entrepreneurial Ability," CRIEFF Discussion Papers 0006, Centre for Research into Industry, Enterprise, Finance and the Firm.
  6. Bester, Helmut, 1985. "Screening vs. Rationing in Credit Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 75(4), pages 850-55, September.
  7. Milton Friedman & L. J. Savage, 1948. "The Utility Analysis of Choices Involving Risk," Journal of Political Economy, University of Chicago Press, vol. 56, pages 279.
  8. Burke, Andrew E & FitzRoy, Felix R & Nolan, Michael A, 2000. " When Less Is More: Distinguishing between Entrepreneurial Choice and Performance," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 62(5), pages 565-87, December.
  9. Blanchflower, D.G. & Oswald, A., 1991. "What Makes an Entrepreneur?," Economics Series Working Papers 99125, University of Oxford, Department of Economics.
  10. Churchill, Neil C. & Lewis, Virginia L., 1986. "Bank lending to new and growing enterprises," Journal of Business Venturing, Elsevier, vol. 1(2), pages 193-206.
  11. Evans, David S & Jovanovic, Boyan, 1989. "An Estimated Model of Entrepreneurial Choice under Liquidity Constraints," Journal of Political Economy, University of Chicago Press, vol. 97(4), pages 808-27, August.
  12. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  13. Boot, Arnoud W A & Thakor, Anjan V & Udell, Gregory F, 1991. "Secured Lending and Default Risk: Equilibrium Analysis, Policy Implications and Empirical Results," Economic Journal, Royal Economic Society, vol. 101(406), pages 458-72, May.
  14. de Meza, David & Southey, Clive, 1996. "The Borrower's Curse: Optimism, Finance and Entrepreneurship," Economic Journal, Royal Economic Society, vol. 106(435), pages 375-86, March.
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Cited by:
  1. Andrew Burke & André Stel & Chantal Hartog & Abdel Ichou, 2014. "What determines the level of informal venture finance investment? Market clearing forces and gender effects," Small Business Economics, Springer, vol. 42(3), pages 467-484, March.
  2. André van Stel & Kashifa Suddle & Andrew Burke & Chantal Hartog, 2008. "How does Entrepreneurial Activity Affect the Supply of Business Angels?," Scales Research Reports H200813, EIM Business and Policy Research.

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