Pledgeability and Bank Lending Technology

An increase in collateral availability can reduce the need for bank auditing. We test this hypothesis using reforms which expanded the set of pledgeable assets in secured lending, and find heterogeneous effects in the cross-section of banks. Smaller (relationship) banks are safer and earn a lower risk-adjusted net interest income post-reform, after controlling for lending volume; a fall in their operating costs offsets the negative effect. Larger (arm's-length) banks increase lending volume but are not more profitable. We guide our empirical analysis using an adverse selection lending model in which collateral and auditing are substitute screening devices.