The impact of collateral on credit risk is a subject that has raised a good deal of debate. From a theoretical perspective, there are two alternative interpretations that lead to different empirical predictions. On the one hand, the collateral pledged by borrowers may help attenuate the problem of adverse selection faced by the bank when lending [Stiglitz and Weiss (1981), Bester (1985), Chan and Kanatas (1985), Besanko and Thakor (1987a, b) and Chan and Thakor (1987)]. Lower risk borrowers are willing to pledge more and better collateral, given that their lower risk means they are less likely to.
