Explain how lenders use collateral as part of loan agreements to cope with the problem of asymmetric information.
Labels: Exam 2 Question 10
posted by Eschenfelder at 8:54 AM
Money and Banking Spring 2006
The following posts are the questions which appeared on last semester's exams. Students should use the comment sections to answer the questions and respond to the posts of other students.
Thursday, February 22, 2007
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Contributors
2 Comments:
Lenders use collateral as part of loan agreements to cope with the problem of asymmetric information by forcing borrowers to put up their possession(s) in the hope of causing borrowers to reduce risk taking behavior and thus avoid moral hazard.
Lenders use collateral as part of loan agreements to cope with asymmetric information because of the inability of the lender to know exactly what the borrower is planning to do with the loan. Collateral is used as a form of insurance if the company was to go bankrupt and it helps to reduce the risk taking behavior of companies. A company could pledge the plant and equipment that it is planning to purchase with the loan. In this case, if the company were to go bankrupt, the lender has the right to petition the bankruptcy court to sell the collateral and use the proceeds to pay off the loan. The company’s owner/manager could also pledge some personal assets such as, marketable securities or real estate as collateral. By using collateral, lenders are assured that they will be able to recover the loan, regardless of the risks the borrower takes on.
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