Collateral and bank screening as complements: A spillover effect

I analyze a novel spillover effect from collateralized to uncollateralized loans. High-type borrowers have good projects, while low-type borrowers do not know their project quality. High-type borrowers post collateral, and a monopolist bank screens only low-type borrowers’ projects. Different from existing models, equilibrium collateral requirements are stricter than the minimum necessary to achieve separation, even if collateral is costly. When high-type borrowers post more collateral, the bank charges a higher interest rate to low-type borrowers. This, in turn, enhances the bank’s incentives to screen the low-types’ projects, thereby improving the average quality of uncollateralized loans.