Scandinavian Working Papers in Economics
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Bank of Finland Research Discussion Papers, Bank of Finland

No 22/2010:
Moral hazard in the credit market when the collateral value is stochastic

Juha-Pekka Niinimäki ()

Abstract: This theoretical paper explores the effects of costly and non-costly collateral on moral hazard, when collateral value may fluctuate. Given that all collateral is costly, stochastic collateral will entail the same positive incentive effects as nonstochastic collateral, provided the variation in collateral value is modest. If it is large, the incentive effects are smaller under stochastic collateral. With non-costly collateral, stochastic collateral entails positive incentive effects or no effects, if the variation in collateral value is modest. If it is large, the incentive effects may be positive or negative. Thus, collateral can increase moral hazard. The findings are related to the topical subprime crisis and the fluctuating value of real estate collateral.

Keywords: banking; collateral; moral hazard; subprime lending; (follow links to similar papers)

JEL-Codes: G21; G22; G28; (follow links to similar papers)

24 pages, December 21, 2010

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