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Article

“Collateral Damage” - Insights by HEC Professor Denis Gromb

Finance
Published on:
Updated on:
August 31st, 2020

Denis Gromb is the Antin I.P. Chair Professor of Finance at HEC Paris. In this short video, he answers four questions, explaining his key findings about the consequences of the use of "collateral" on companies and society.

Denis Gromb - HEC Paris

Your research is about collateral. Can you explain what this is?

Collateral is simply an asset that is used to guarantee a loan. Say you get a mortgage for a house, the house is the collateral. Companies use buildings or land as collateral for bank loans. The point of collateral is to give the bank priority over any other lender. If needed, the bank can seize the asset before any other lender.

 

The point of collateral is to give the bank priority over any other lender. If needed, the bank can seize the asset before any other lender.

 

So, what is the problem with collateral?

Companies and banks have been complaining about a shortage of collateral and, in response, some governments have expanded the set of assets that qualify as collateral.

 

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But your research shows that these measures can backfire… 

We think that increasing the supply of collateral can in fact increase the demand for collateral, not satisfy it. Here’s why.

Say you’re a bank considering making a loan to a firm, and you’re wondering whether to ask for collateral or not. The reforms have made collateral more available to you, but also to other lenders. So you worry that these other lenders are going to ask for collateral and gain priority over you. So, for protection, you ask for more collateral.

 

We think that increasing the supply of collateral can in fact increase the demand for collateral, not satisfy it.

 

What is the impact on society?

When companies need more collateral to borrow, they’re going to borrow less, and if they borrow less, they’re going to invest less, which means to lower employment, lower growth, and so on. So we hope our research can inform better policy in that respect.
 

Collateral research at the American Finance Association

Peter DeMarzo, Professor of Finance at Stanford University, built his 2019 American Finance Association presidential address on recent research on collateral by Denis Gromb and co-authors. Watch the video starting at 5'08 about collateral:

 

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“Collateral and Commitment”, Atlanta, January 5, 2019

 

Professor Denis Gromb explains: 

“Professor Peter DeMarzo’ speech proposes to rebuild a theory of corporate finance based on the two assumptions that our article explicitly proposes: borrowers have a hard time committing themselves to their lenders not to borrow more in the future, and the role of the collateral is to help them (to commit).”

Learn more in Professor Gromb's research paper, “The Paradox of Pledgeability”, written with Jason Roderick Donaldson (Washington University at St Louis) and Giorgia Piacentino (Columbia University), and to be published in The Journal of Financial Economics in 2019.

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