Research Discussion Papers, Bank of Finland
Moral hazard in the credit market when the collateral value is stochastic
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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