Default Risk and Collateral in the Absence of Commitment

Default risk is an important concern for lenders and is a main reason they require borrowers to pledge collateral. There are two reasons for this. The first is that collateral provides some incentive for the borrower to not strategically default. The second is that, in the event of default, the lender can liquidate the collateral and salvage some value from the failed credit relationship. This paper provides a model to study properties of allocations that arise when collateral is part of an optimal lending contract that looks much like a repurchase agreement. In particular, a lack of commitment to future actions implies that collateral must be used to alleviate strategic default. Moreover, because collateral is held by lenders during the credit relationship, there is also a potential incentive for lenders to default on returning collateralized assets. Thus, the optimal contract requires the satisfaction of an incentive constraint for the lender, in addition to the one that must be satisfied for the borrower. The paper then discusses how the need to satisfy both constraints places certain restrictions on the allocations that arise when collateral is part of an optimal contract. We conclude by comparing the allocation to a world where agents can commit to future actions