Abstract

We develop a model in which collateral serves to protect creditors from the claims of other creditors. We find that, paradoxically, borrowers rely most on collateral when pledgeability is high. This is when taking on new debt is easy, which dilutes existing creditors. Creditors thus require collateral for protection against possible dilution by collateralized debt. There is a collateral rat race. But collateralized borrowing has a cost: it encumbers assets, constraining future borrowing and investment. There is a collateral overhang. Our results suggest that policies aimed at increasing the supply of collateral can backfire, triggering an inefficient collateral rat race. Likewise, upholding the absolute priority of secured debt can exacerbate the rat race.

Citation

Piacentino, Giorgia, Jason Donaldson, and Denis Gromb. "The Paradox of Pledgeability." Journal of Financial Economics (forthcoming).

Each author name for a Columbia Business School faculty member is linked to a faculty research page, which lists additional publications by that faculty member.

Each topic is linked to an index of publications on that topic.