European Central Bank working paper finds overcollateralised corporate loans can have higher default probability as collateral becomes riskier

The European Central Bank released a working paper analysing how collateralisation relates to corporate loan default risk across the euro area using loan-level AnaCredit data. It finds that, after controlling for time-varying bank and firm risk factors, default probability is U-shaped in the collateral-to-loan ratio, with additional collateral initially associated with lower default risk but very high collateral ratios associated with higher default probabilities. The analysis draws on a dataset covering virtually all euro area corporate loans, including the appraised value of collateral at origination and monthly market values thereafter, as well as banks’ ex ante 12-month probability-of-default assessments. Higher initial collateral ratios correlate with greater variance in collateral market values after origination, and the estimated turning point where the collateral-default relationship reverses is around a collateral ratio of 2.8; a 10 percentage point increase in the collateral ratio is associated with a 3.88% increase in collateral value variance over the following year. Results are reported as robust to alternative samples and restrictions, hold across physical and non-physical collateral, and are not observed for loans with full credit risk guarantees. A theoretical model with moral hazard and fluctuating collateral values is used to rationalise the findings, linking overcollateralisation and riskier collateral to weaker borrower effort incentives and higher default risk. The working paper is published as research and does not represent the views of the European Central Bank or the Eurosystem.