Credit and Collateral

Vania Sena

• Publisher: Taylor & Francis
• Year: 2007
• Print ISBN: 9780415341172
• eBook ISBN: 9781134296415
• Edition: 1
• Topic: Economics
• Subtopic: Economic Conditions
• Index: Economics

Collateral - generally defined as an asset used to provide security for a lender's loan - is an important feature of credit contracts and all the available evidence suggests that its use is getting more pervasive. This informative book builds upon recent research into this topic. Sena analyses three case-studies that revolve around the impact that financial constraints have on economic outcomes. In the first case-study, the relationship between firms' technical efficiency and increasing financial pressure is explored. The author then goes on to show, in the second case study, that under specific circumstances, increasing financial pressure and increasing product market competition can jointly have a positive impact on firms' technical efficiency, while not being true for all types of firms. In the third case, she analyses the impact that finance constraints have on women's start-ups.

Unique and revealing, this is the first book to deal so extensively with the topic of collateral, and as such, is a valuable reference to postgraduates and professionals in the fields of macroeconomics, monetary and business economics.

1 Introduction

Credit rationing is a pervasive feature of the competitive equilibrium in the credit market in both developed and less developed countries. The reasons why this is the case are well established in the academic literature (for a survey of the relevant literature see Gertler and Gilchrist, 1993; Hubbard, 1995); in the credit market, information (about either the future profitability of a project or the creditworthiness of a potential borrower) is distributed asymmetrically between borrowers and lenders (Stiglitz and Weiss, 1981, 1985; Farmer, 1985; Williamson, 1986, 1987a, 1987b; Riley, 1987). Indeed, financial institutions may not be in a position of knowing ex ante either the degree of riskiness of a project (moral hazard) or the creditworthiness of the potential applicant who is seeking funds (adverse selection); therefore they face the problem of devising some mechanism that allows to separate the high-risk applicants from the low-risk ones. In both cases, making the loans costlier (by increasing the interest rate on loans, for instance) may not be a solution; in the case of adverse selection, increases of the interest rate required by the bank may have an adverse impact on the average riskiness of a bank’s pool of applicants as these may induce riskier individuals to join the pool of applicants. Equally in the presence of moral hazard, an increase of the interest rate may induce the potential applicants either to choose the riskier projects or to choose an action that can affect negatively the outcome of the project (Williamson, 1986, 1987a, 1987b). Therefore, ceteris paribus, a lender will prefer to ration credit in equilibrium (rather than increasing the interest rate) and not to lend to individuals who are deemed to be risky.

Who will be rationed in equilibrium? A rich literature on the consequences of credit rationing and the impact of the resulting financial constraints has shown that when credit rationing is a permanent feature of the credit market equilibrium, then the financial and personal characteristics of both the borrowers and lenders will affect the demand and the supply of credit and so the characteristics of the equilibrium (Chirinko, 1987; Gertler, 1988; Calomiris and Hubbard, 1990; Chirinko and Schaller, 1995). For instance, in conjunction with the characteristics of the investment project, the borrower’s creditworthiness and the size of the collateral that can be offered by the borrower along with both the monitoring capabilities of the lender and the degree of competition in the credit market are all likely to affect the amount of financial resources the borrower will be seeking and how much the lender is willing to lend (Fazzari et al., 1988). A very clear prediction from this literature is that rationed borrowers tend to be firms that either do not have enough collateral to offer as a guarantee to the bank or do not have a long track record in the industry (and therefore can be deemed risky) (Fazzari et al., 1988).

However, credit rationing is not the only consequence of asymmetric information in the credit market. Financial constraints can have additional indirect effects upon which the economic literature has not lingered on long enough. This point was first made by Nickell and Nicolitsas (1999) who have investigated the impact of the increase of financial pressure on several indicators of firms’ performance (like total factor productivity, employment demand and so on) using a data-set of UK companies. Their results suggest that increases in the financial pressure can have a positive effect on productivity, although small. The argument put forward by the two authors to explain these results is quite simple and relies on the risk-aversion of the managers that run a firm; indeed they point out that when financial pressure increases, risk-averse managers may want to cut organizational slack so to reduce the probability of the firm going into bankruptcy and eventually losing their position in the company.

More generally, these results obviously indicate that financial constraints generated by the existence of credit rationing of various types clearly alter the types of incentives the economic agents are exposed to and this way, the economic outcomes as well. I conjecture there are two main mechanisms that make this possible: first, I argue that financial constraints act as mechanisms that affect the ex post distribution of rents among the many agents that have contributed to create them. So in this perspective, a tightening of the financial constraints (or even an expectation of an increase in financial pressure) changes (or is expected to change) the way the rents are distributed ex post and if the increase in financial constraints is deemed to be permanent, this will directly affect the behaviour of the economic agents that contribute to the generation of these rents. So for instance consider a firm that is financially constrained as it cannot have access to the full amount of financial resources it requires to fund its productive activities. The direct effect of these financial constraints is obviously the increase of the cost of capital and therefore a reduction in the investment expenditure. However, the impact of financial constraints may be felt more by the managers than by the owners of the firm as the increasing financial pressure may reduce the managers’ financial bonuses rather than the dividends to the shareholders. In this case eventually managers may decide to increase effort as long as there is a link between managers’ effort and their financial bonuses. So one additional consequence generated by the additional financial pressure is that of increasing the managers’ effort in my example. In this case, the distribution of the rents generated by the firm is shifted in favour of the shareholders following an increase of the financial constraints and therefore managers have now the incentive to change their behaviour and contribute more to the firm’s activity (by increasing their effort). Second, if an economic agent is financially constrained then this indicates that the contractual relationship between borrowers and lenders is in favour of the lenders so that most of the surplus generated by the borrowers will be appropriated by the lender through the repayments and the interest rates. So, if an individual expects particularly unfavourable credit conditions, then he may decide not to seek external funding altogether and may give up a potentially profitable project. A typical example is the case of self-employment: consider an individual who because of his personal characteristics (gender, personal background, residence in a poor area and so on) expects to be financially constrained (on the basis of some aggregate indicator, like average number of successful loan applicants from disadvantaged areas and so on). In this case, just the expectation of future financial constraints can induce this individual to give up setting up a new company and what is observed in the aggregate is a small number of new firms led by individuals from disadvantaged areas, for instance (or with some specific personal characteristics, more generally).

These considerations drive the overall theoretical perspective that underlies this book. Indeed in this study, I argue that financial constraints can have additional effects on economic outcomes that may not be necessarily negative and all this by influencing the way the surplus (generated either in a firm or in a relationship) is shared among economic agents. Now, if this is a correct interpretation of how finance constraints work, then a few questions emerge that are the central questions of this book. To what extent can a tightening of financial constraints (or the expectation of increasing financial constraints in the future) have a positive impact on the performance of economic agents? This question starts from the observation that several parties in a firm contribute to the creation of surplus in a firm and that these parties (or economic agents) can have different objective functions. So, for instance, workers and managers both contribute to the surplus generation in a firm by supplying effort and managerial skills. Obviously, they will decide to supply the amount of effort that maximizes their own trade-off between leisure and effort; however, the supplied effort may not necessarily be the optimal one from the standpoint of the firm’s ownership and this generates what can be labelled “technical inefficiency” in the firm. This problem (known as the “hold-up” problem) is very common in all modern corporations and one mechanism that is commonly used to solve it is by linking the monetary compensation of both workers and managers to the firm’s performance. This mechanism creates the conditions for a positive link between increasing financial pressure and firms’ performance: indeed an increase in the financial pressure faced by a firm means for both workers and managers a decrease in their remuneration and the only way to counterbalance the negative impact of the shock is by increasing their effort with the additional effect that the firm’s organizational slack reduces.

Also, if it is accepted the notion that financial constraints reallocate ex post the generated surplus among the several parties in a firm, then as shown above this implies that financial constraints can be used to re-align the interests of the many agents in a firm to those of the ownership and so this may help to improve the firm’s performance. This echoes the effect of product market competition on a firm’s performance. So a legitimate question at this point is the following: are financial pressure and state of competition in the product market complementary or substitutes? It is usually claimed that these two mechanisms are complementary as it is usually assumed that the main channels through which they exert a positive impact on firms’ performance is by reducing organizational slack; so in this case firms with a higher debt repayment obligation will try to improve their technical efficiency if the competitive pressure is increasing. Therefore the net impact on technical efficiency of increasing product competition and financial pressure is positive. However, the empirical evidence on this point is rather ambiguous. Indeed, increasing competition appears to increase productivity growth in firms with low debt pressure (Nickell et al., 1997). Also, there is no evidence of a positive interaction between increasing product market competition and financial pressure in fostering firms’ innovation and then productivity (Aghion et al., 2003). These results have cast some doubts on the extent to which slack reduction is the main channel through which competition enhances productivity: indeed it may well be that in the presence of increasing product market competition the rents earned by the managers may reduce and reduction of the slack may not be enough to offset the reduction in rents (Aghion and Griffith, 2005).

Finally, there exists a rich literature that shows that financial constraints affect adversely the rate of new business formation in the economy in general and of women-led companies in particular. This claim is based on the consistent evidence from empirical studies that shows low levels of involvement in enterprise among women and individuals from minority backgrounds. Indeed, there is a belief that the level of female participation is well below the social optimum and therefore this warrants some government attention. So the argument here is that potential applicants with certain personal characteristics (gender, for instance) may be credit-rationed because of their personal characteristics. This view finds particular support when policy-makers and pundits try to explain the low proportion of female entrepreneurs in most OECD countries as gender is the most obvious personal characteristic that can be used to discriminate potential applicants for external funds. This has provided the background for national enterprise-support agencies (such as the Small Business Service (SBS) in England) to intervene actively in order to strengthen the role of women in the entrepreneurial activity. Also policy-makers across OECD countries have long recognized the barrier posed by the lack of access to credit and designed various schemes to overcome it.¹ While this hypothesis is rather intuitively appealing, the economic literature and empirical evidence on this point is rather ambiguous. Indeed, some authors claim that the indirect evidence in favour of financial discrimination against women is the low rate of approved loans to women-owned businesses once it is compared to that of men-owned businesses. However, there exists some economic literature that claims that it is not gender per se that determines whether or not the applicant will experience financial constraints; on the contrary, it is suggested that this low rate can be simply explained by the fact that usually female applicants are characterized by poor collateral, and limited experience that can have an adverse impact on the profitability of a future company. In other words, once these variables are controlled for, the gender effect should disappear. The literature in this area seems to support this point, as in most empirical studies the evidence in favour of the financial discrimination hypothesis is not robust. So the question is: how really important are finance constraints (or even the expectation of future financial constraints) to explain the low rate of self-employment among women?

I argue that the reason why there is no convergence of opinion over whether women are financially discriminated is because gender and financial constraints interact in a subtler way than first hypothezised. The “financial discrimination” hypothesis as suggested in the literature so far assumes that women apply for funds and then financial institutions either deny them or award them but at worse conditions than applied to men. However, I suggest that financial constraints work in a different way. Indeed, in my theoretical perspective, finance constraints affect the distribution of rents ex post. If one of the two contractual parts expects that rents will be mostly transferred to the other part, then he will not participate in the relationship. This is not very different from what happens in the relationship between potential lenders and potential borrowers. The debt contract may affect the distribution of the surplus generated by the female entrepreneur and if there is the expectation that this will be distributed entirely or mostly to the lender, then the applicant will prefer not to enter into this type of relationship. In other words, the applicant will self-select him(her)self and will not apply for external funding. So what is observed in the aggregate is a small proportion of loans granted to female applicants. However, what the literature appears to suggest is that once this early stage is overcome, there is no real difference between either female- or men-led companies in terms of access to external funds.

In this book, I discuss and test empirically the relevance of these questions by considering three cases. In the first one, I show analytically the specific circumstances under which increasing financial pressure can improve a firm’s technical efficiency. Then I test the impact of finance constraints on technical efficiency on a panel of firms from Italian manufacturing over the period 1989–1994. In the second case, I show that under specific circumstances, increasing financial pressure and increasing product market competition can jointly have a positive impact on firms’ technical efficiency. However, this is not true for all types of firms. Indeed, a necessary condition for this to happen is the existence of a link between the firms’ performance and the workers’ financial remuneration. This requirement is usually satisfied in cooperatives where for organizational reasons the workers receive from the co-op a share of the profits in addition to the wage (whether members or not). Therefore the empirical analysis focuses on the producers’ cooperatives where I test whether financial pressure and increasing product market competition can either help or offset each other in improving co-ops’ technical efficiency, by using data on producers’ cooperatives in the Italian wine industry. In the third case, I analyse the impact that finance constraints have on women’s start-ups. I suggest that financial constraints can stop the formation of new business by women. This point has been put forward several times in the literature but here I observe that financial constraints can affect adversely the rate of formation of women-led companies by deterring them from applying for external funds. To test this hypothesis, I estimate a set of self-selection models by using English data on the individuals’ intentions of becoming self-employed, drawn from the Household Survey of Entrepreneurship, 2003.

The book is composed of six chapters (this one included). In Chapter 2, I analyse the main themes from the theoretical and empirical literature on financial constraints. The last 30 years have witnessed a dramatic revival of research on the impact of asymmetric distribution of information among borrowers and lenders on the optimal properties of the competitive equilibrium in the credit market and on firms’ capital accumulation process (Bernanke, 1983; Hubbard et al., 1995; Schiantarelli, 1996). This interest is due to the pathbreaking developments in the economics of information and incentives after Akerlof’s seminal paper (1970) on the potential inefficiencies in trade arising when either of the parties involved has an informational advantage. Thanks to a series of influential papers by Stiglitz and Weiss (1981) and Williamson (1986) the formal apparatus devised to analyse trade under imperfect information has been extended naturally to the study of the credit market. They both conclude that informational asymmetries create an incentive problem inducing banks to ration credit. Indeed, in both adverse selection and moral hazard an increase of the interest rate on loans may adversely affect the rate of return to banks and therefore these may wish to hold the interest rate below the market clearing level since raising the rate would lower their returns. Therefore some borrowers will be rationed in equilibrium and will not get enough financial resources to carry out their activities.

Afterwards, a complementary stream of literature (mainly empirical) has analysed the implication of these informational imperfections on firms’ productive activities and new business formation, among the others. Indeed, a prediction of these models of credit rationing is that some classes of firms (usually the youngest and smallest) will not get the necessary resources to finance their investments. Therefore a rationed firm’s demand for investment will depend positively on its balance sheet position as a strengthened balance sheet implies a borrower has more available resources to either use directly for project finance or as collateral to obtain outside funds. This prediction has been extensively tested and the empirical findings support it generally (Fazzari et al., 1988; Devereux and Schiantarelli, 1989; Hoshi et al., 1991). Equally, the formation of new business will be affected by the availability of personal financial resources of the potential new entrepreneurs. Indeed, when there are financial constraints, external funds may be unavailable or insufficient for the set-up of the new company and this creates a link between the wealth of the potential entrepreneur and the decision to start a business as wealthier individuals will be more likely to start a business. In this context, financial constraints will cause the supply and the demand for credit to be related to the personal characteristics of the borrower; for instance, the borrower’s creditworthiness will be judged against some criteria that take into account the personal history of the potential applicant. So, for instance, it is often argued that women from ethnic backgrounds are discriminated against in credit markets. This view is supported by the small number of women-run businesses from an ethnic background that rely on loans from the credit market. This view assumes that lenders reject loans applications from female potential entrepreneurs for a variety of reasons – like lack of collateral (as women do not tend to have control over economic resources), limited education and the unpaid reproductive responsibilities (Goffee and Scase, 1983; Aldrich, 1989) – that may or may not affect the future company’s creditworthiness.

This chapter prepares the ground for the following empirical analysis as the key themes from the reviewed literature will be developed in the remaining chapters. Chapter 3 analyses the impact of finance constraints on technical efficiency (or organizational slack) using a sample of firms from Italian manufacturing over the period 1989–1994. The analysis is conducted in two stages. I first consider theoretically the relationship between finance constraints and technical inefficiency and to this purpose I derive analytically the relationship between a firm’s technical efficiency and the measure of financial constraints. There are many reasons why a company may appear inefficient but here I assume that inefficiency may be produced by the lack of alignment of interests among different agents working in the firm. For instance, it is well known that because of the split between ownership and control (typical of the modern capitalist firm) managers may have some freedom to pursue their interests (Hermalin, 1992; Martin, 1993) that may not necessarily be consistent with those of the ownership. In my model I assume that managers may decide to enjoy more leisure than it would be optimal for the firm and that therefore the firm will appear inefficient because low effort causes production to be below the maximum effort frontier. In this type of environment, a negative shock to the firm with a consequent increase in the bankruptcy probability will mean for the manager the loss of the financial benefits attached to his position with the firm. In this case, the managers may anticipate these negative outcomes and therefore may decide to increase their effort with the result that the firm’s efficiency increases. This theoretical result entails a clear empirical prediction: increasing financial pressure (due to a permanent negative productivity shock, for instance) may induce a firm to improve technical efficiency as long as there exists already technical inefficiency in the organization and there is a clear link between the manager’s effort, the financial benefits he receives and the firm’s performance. Another way to generalize this result is by considering that a firm that cannot have access to additional external resources to maintain its level of production will try to improve technical efficiency over time to gain productivity. Therefore, I expect that financially constrained firms usually have a better performance in terms of technical efficiency over time than firms that do not experience financial constraints. My model shows that tighter financial constraints create an incentive for firms to improve efficiency. Second, I empirically test this prediction on a panel of Italian firms from 1989 to 1994, divided into eight sectors. The empirical analysis uses frontier analysis techniques that allow firms to compute the firm-specific technical efficiency scores while controlling for the factors that can affect the mean level of efficiency, like the availability of financial resources (Grosskopf, 1993; Battese and Coelli, 1995). The results show that financial constraints positively influence efficiency in most sectors, though it is interesting to notice that the size of the effect varies across sectors and within the same sector according...

Table of contents

• Cover Page
• Half Title page
• Series Page
• Title Page
• Copyright Page
• Dedication
• Contents
• List of Tables
• Acknowledgements
• 1 Introduction
• 2 Credit constraints and economic outcomes A short survey
• 3 Technical efficiency and finance constraints An empirical analysis for Italian manufacturing, 1989–1994
• 4 Product market competition, financial pressure and producers' cooperatives
• 5 Self-employment and gender How important are financial constraints?
• 6 Conclusions
• Notes
• References
• Index