Contestability and Collateral in Credit Markets with Adverse Selection
- 1 Department for Prime Minister and Cabinet, Rome, Italy
Abstract
The work discusses a basic proposition in the theory of competition in markets with adverse selection. By working out the sequence of market transactions, we show that the effectiveness of collateral in avoiding equilibrium rationing depends on an assumption of uncontestability of the loan market. If contestability is restored to its proper place, the sepa- ration of borrower by means of sufficient collateral does not impede the emergence of credit rationing, which results from a coordination failure among risk-neutral banks. As a consequence, even in a risk-neutral environment with suitable endowments, the use of collateral in credit contracts could not be a socially efficient screening-device. Our conclu- sion on rationing does not stand in contrast with a general result from Gale.
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