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Optimal loan-to-value ratio and the efficiency gains of default

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  • Li Lin

Abstract

We study the optimal loan-to-value (LTV) ratio in a monetary general equilibrium model with heterogeneous agents, collateral default, production and a banking sector. We find that the welfare of the debtor is not monotonically increasing in the LTV ratio, i.e. tighter financing constraints can be welfare-improving for the debtor. Moreover, the optimal LTV ratio for both the debtor and the creditor allows for the possibility of ex post default. Collateral default enhances efficiency by allowing for better consumption smoothing and risk hedging. Our result improves the argument in Dubey et al. (Econometrica 73(1):1–37, 2005 ) and Zame (Am Econ Rev 83(5):1142–1164, 1993 ), which use default penalties instead of collateral to induce repayment and show the efficiency gains of default. Copyright Springer-Verlag Berlin Heidelberg 2014

Suggested Citation

  • Li Lin, 2014. "Optimal loan-to-value ratio and the efficiency gains of default," Annals of Finance, Springer, vol. 10(1), pages 47-69, February.
    • Handle: RePEc:kap:annfin:v:10:y:2014:i:1:p:47-69
    DOI: 10.1007/s10436-013-0232-7
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    Cited by:

    1. M. Peiris & Alexandros Vardoulakis, 2015. "Collateral and the efficiency of monetary policy," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 59(3), pages 579-603, August.
    2. Jacobi Osnat & Sher Noam, 2015. "A Commitment Mechanism to Eliminate Willful Contract Litigation," Review of Law & Economics, De Gruyter, vol. 11(2), pages 231-266, July.

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    More about this item

    Keywords

    Loan-to-value; Borrowing constraint; Default; Collateral; E4; G0; G1; G2;
    All these keywords.

    JEL classification:

    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • G0 - Financial Economics - - General
    • G1 - Financial Economics - - General Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services

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