Sme Loan Contract Design: The Screening Role Of Collateral

Abstract

The current collapse of credit markets due to the so-called sub-prime crisis has left small and medium enterprises (SMEs) facing severe credit rationing, which erodes working capital and severely impacts the viability of investment projects. With credit markets frozen and borrowers competing for what credit is available, the practice of screening borrowers by risk level has become a paramount consideration for both lenders and firms. Among the extant screening mechanisms, Bester (AER, 1985) describes one in which lenders offer a menu of contracts with different interest rates and collateral combinations that acts as a firm self-selection mechanism, despite an imperfect information setting. This paper represents the first empirical test of the Bester model, and also represents the first empirical test of the screening role of loan contracts that consider collateral-interest margins simultaneously. For our empirical analysis, we use a unique data set composed of bank loans granted by 28 Spanish banks to SMEs and backed by a Spanish mutual guarantee institution. This data set allows us to use ex post loan performance on a loanby-loan basis to proxy ex ante borrower risk. Our results suggest that by combining collateral appropriately with interest rate, borrowers with different risk levels are separated; high-risk borrowers accept loans without collateral and with high interest rates, whereas low-risk borrowers accept loans with real estate collateral and with low interest rates. Hence, we provide the first empirical evidence of the effectiveness of collateral as a screening mechanism, when it is adequately combined with interest rates.