Why do banks ask for collateral in SME lending?

Abstract

Following the common use of collateral in SME lending, this article aims attesting empirically the three major theoretical reasons for using collateral: reduction of loan loss in the event of default, adverse selection and moral hazard. We use a unique dataset of 735 bank loans granted to French distressed SMEs, which contains full information on the type and value of collateral, and the cause of firm default. We observe that collateral contributes to reduce loan loss in the event of default, with differences among types of collateral in terms of the recovered value for a given initial value. However, we tend to show that collateral does not solve adverse selection problems, as there is a positive relationship between collateral and risk premium, nor moral hazard, as secured loans are not associated with a lower probability of moral hazard behaviour. These findings are observed for all types of collateral. Therefore, our work suggests that information asymmetries are not of prime importance in the decision of the bank to secure loans to SMEs. The reduction of the loan loss and the observed-risk hypothesis may explain the use of collateral.