What is Collateral?

Collateral is an asset that is used as a pledge against a financial obligation, such as a loan or bond. Generally, collateral may be repossessed by the secured entity and sold if the underlying obligation is not paid. 

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When is Collateral required?

Collateral is used to mitigate risk. Some common types of risks include:

• Payment delays and default and liquidity risk
• Geographical and sectoral risk diversification.
• Money flows' predictability
• The asset's legality and regulatory framework
• Additional assurances that are associated with the collateral
• Cross-collateralization where a group of assets is used so that in the case of failure of one the rest can be used to cover that asset.

Academic Research on Collateral

• Asymmetric valuations and the role of collateral in loan agreements, Chan, Y. S., & Kanatas, G. (1985). Journal of money, credit and banking, 17(1), 84-95. This paper examines the role played by collateral in the type of loan contract where the collateral is an additional asset that will be lost in the case of a default. It focuses mostly on the case where the borrower cannot take action that will change the return to the lender.
• Credit ratings, collateral, and loan characteristics: Implications for yield, John, K., Lynch, A. W., & Puri, M. (2003). The Journal of Business, 76(3), 371-409. This article investigates how collateral affects the yield of bonds and uses a big data set of public bonds to document that collateralized debt has a higher yield compared to general debt after the control for credit rating.
• Collateral, loan quality and bank risk, Berger, A. N., & Udell, G. F. (1990). Journal of Monetary Economics, 25(1), 21-42. This article presents empirical evidence that shows collateral is mostly associated with riskier borrowers, riskier loans and riskier banks.
• The loan market, collateral, and rates of interest, Barro, R. J. (1976). Journal of money, Credit and banking, 8(4), 439-456. This study creates a theoretical model in which collateral is used as a mechanism to enforce loan contracts.
• Collateral and rationing: sorting equilibria in monopolistic and competitive credit markets, Besanko, D., & Thakor, A. V. (1987). International economic review, 671-689. The main focus of this paper is finding out the role of market structure in credit allocation when there is an informational asymmetry.
• Collateral, type of lender and relationship banking as determinants of credit risk, Jimnez, G., & Saurina, J. (2004). Journal of banking & Finance, 28(9), 2191-2212. This article analyzes the determinants of the probability of default of bank loans and discusses the role of a limited set of variables while controlling for the explanatory variables.
• Incorporating collateral value uncertainty in loss given default estimates and loantovalue ratios, Jokivuolle, E., & Peura, S. (2003). European Financial Management, 9(3), 299-314. This paper presents a model of risky debt which has a collateral value that is correlated with the possibility of default. The model is used in the study of expected loss given default mainly as a function of collateral
• Collateral and competitive equilibria with moral hazard and private information, Chan, Y. S., & Thakor, A. V. (1987). The Journal of finance, 42(2), 345-363. This is an examination of the equilibrium credit contracts and allocations under differing specifications and an explanation of the economic roles of collateral under these specifications competitively.
• Loan collateral decisions and corporate borrowing costs, Booth, J. R., & Booth, L. C. (2006). Journal of Money, Credit and Banking, 67-90. This paper examines the borrowing costs' relationship with the presence of loan collateral and finds out that the presence of loan collateral increases with default risk.
• Role of collateral and personal guarantees in relationship lending: Evidence from Japan's SME loan market, Ono, A., & Uesugi, I. (2009). Journal of Money, Credit and Banking, 41(5), 935-960. This is an investigation of the determinants of the use of collateral and personal guarantees in SME loan market of Japan.
• The role of collateral in a model of debt renegotiation, Bester, H. (1994). Journal of money, credit and banking, 26(1), 72-86. This paper uses a simple model of borrowing and lending to with asymmetric information to determine how the prospect of future debt renegotiation affect the lender's security interests at the contracting date.
• Collateral pricing, Benmelech, E., & Bergman, N. K. (2009). Journal of financial Economics, 91(3), 339-360. This study uses a data set issued by US airlines to examine how collateral affects the cost of debt capital and to construct industry-specific measures of collateral deployability.