Effect of collateral floors on collateral setting in adverse selection credit markets

Adverse selection in credit markets occupies a large volume within the economic literature. Most of this literature is dedicated to studying interest rate setting behaviour. This paper instead studies collateral setting behaviour by lenders and primarily how a collateral floor set by policy makers can influence the behaviour of lenders. Analysing the credit market using a model of asymmetric information yields interesting results. In a market free from intervention, no pure strategy equilibrium exists, instead a mixed strategy equilibrium arises due to the informational advantage of one lender. Lenders compete with each other in this equilibrium by demanding various amounts of collateral from their borrowers. If a collateral floor is imposed, assumptions on borrower behaviour crucially influence the equilibrium outcome of the credit market. When borrowers tend to always switch to competitor lenders, a pure strategy equilibrium arises. Contrary, when borrowers tend to always stay with their current lender, the mixed strategy equilibrium prevails. Ultimately this determines whether borrowers are made better off or worse off by the collateral floor.