Wealth, Endogenous Collateral Quality, and Financial Crises

Abstract

Markets with wealthier lenders experience more severe financial crises. To investigate this puzzle, we propose a model of collateralized lending in which: (1) borrowers endogenously determine collateral quality, and (2) lenders can produce costly information about collateral. When lenders are wealthier, borrowers use lower quality collateral to suppress costly information production, however, lower collateral quality in turn leads to more severe financial crises. Empirically, we find a negative relation between wealth and collateral quality, and during crises, wealth is negatively related to loan growth, investment, productivity, and output, with evidence that the effect of wealth goes through the collateral channel.