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Outside Collateral, Preserving The Value Of Inside Collateral And Sorting

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  • Dorothea Schäfer

Abstract

Within a framework of debt renegotiation and a priori private information, what is the role of outside and inside collateral? The literature shows that unobservability of the project’s returns implies that the high-risk borrower is more inclined to pledge outside collateral than is the low-risk borrower. However, this finding does not hold when the bank can observe neither the project’s returns nor the borrower’s risk class. We show that in this scenario, low-valued outside collateral enables the low-risk entrepreneur to select himself, but high value outside collateral has no sorting potential at all. We also show that a bank’s incentive to sort borrowers may induce investment to preserve the value of the inside collateral and to build up restructuring know-how. If self-selection via outside collateral is operating, restructuring know-how reduces the cost of separation. If outside collateral gives rise to pooling, restructuring know-how may restore sorting.

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Bibliographic Info

Article provided by LMU Munich School of Management in its journal Schmalenbach Business Review.

Volume (Year): 53 (2001)
Issue (Month): 4 (October)
Pages: 321-350

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Handle: RePEc:sbr:abstra:v:53:y:2001:i:4:p:321-350

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