Collateral plays an important role in debt contracts. It not only allows a creditor to reduce its potential loss from the loan in case of default but it also helps in alleviating market frictions due to moral hazard and adverse selection.
Sumit Agarwal et al. (2015) study the role of a personal guarantee in the peer-to-peer lending market in China. The authors take advantage of a special setting in which the personal guarantee is not strictly built on a relationship. This setting demonstrates an economically large effect of the personal guarantee in facilitating debt financing. Having a guarantee in the loan is associated with a higher probability of getting the loan, a shorter time interval between posting and closing, greater bidding activity, and a lower cost of debt. However, the loans with guarantees exhibit a higher delinquency rate on average. A further analysis evaluate two mechanisms for this bad performance: adverse selection and moral hazard. The evidence is consistent with the moral hazard theory because a loan without a relationship alters the borrower’s incentive that leads to worse performance.
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