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

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.