Interest Rate Ceilings and the Role of Security and Collection Remedies in Loan Contracts

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NEELA D. MANAGE

Collateral or other security for personal loans and restrictions on creditor remedies for the collection of debts have varying effects on the price and quantity of credit which depend in turn on the level of interest rate ceilings. We report here on reduced-form equations of a supply-demand model estimated for five states with different interest rate restrictions. Interest rate ceilings limit how far lenders can raise loan rates to compensate for expected default losses but restrictions on collection remedies are generally associated with a higher interest rate.

I. INTRODUCTION

The role of collateral in loan contracts has been the focus of many recent studies on credit markets. This paper examines the role of collateral in personal loan contracts when government regulations, such as usury laws and restrictions on late charges and wage garnishment limit the responses of creditors to increases in default risk. Special attention is given to the use of the borrower's future income as a form of collateral in personal loan markets and the effect of laws governing garnishment and wage assignment which limit the lender's claim to the borrower's income.

Theoretical studies by Barro [1976], Benjamin [1978], and Harris [1978] discuss the effects of collateral on the interest rate, loan size and other features of the loan contract, particularly when the collateral has a different value to the borrower and to the lender. More recent studies by Rea [1984], Schwartz [1981; 1984], Hess [1985], Eaton [1986], and Hess and Knoeber [1987] further analyze the role of collateral in loan contracts. Hess [1985], in particular, evaluates the earlier work done by Benjamin [1978] and develops an excellent analysis of the relation between collateral and other terms of the loan such as loan rates and loan size.

The regulations governing personal loan markets that have been most frequently analyzed are interest rate ceilings and restrictions on the remedies available to creditors attempting to collect on delinquent or defaulted accounts. Empirical studies by Shay [19701, Benston [1973; 1977], Greer [1973; 1975], Aho et al. [1979], Barth and Yezer [1977], Barth et al. [1983], Manage [1983), and Peterson [1979] analyze several personal loan market relationships. These studies differ widely in terms of scope, type of data used (with respect to both geographical coverage and level of aggregation), model specification, estimation technique, and the specific hypothesis being tested.

This paper demonstrates that the effect of interest rate ceilings depends on the restrictions imposed by other financial regulations and visa versa, and that the effect of regulation, in turn, depends on the specifics of the loan transaction. Both interest rate restrictions and a number of other factors affecting borrowing and lending decisions vary systematically by state. First, regulations governing loan contracts differ from state to state. Interest rate ceilings are set by each state and different laws govern the use of garnishment and wage assignment, so that the amount of future income that may serve as collateral also varies. Creditors in different states thus operate under different rules. Second, there are differences in the risk characteristics of borrowers (due to demographic, financial and institutional factors) which affect the supply decisions of lenders. In order to hold these factors constant, this paper analyzes cross-sections of loans made within a state, rather than use a cross-section of states. This approach differs from previous studies in that it allows regression coefficients to vary across states.

II. COLLATERAL AND GOVERNMENT REGULATIONS

Collateral is used as an instrument to enforce loan contracts. It provides an incentive to repay the loan because the borrower loses the collateral in the event of default. Theoretical studies generally suggest that a decrease in collateral will increase the costs to the lender of a default and increase the interest rate on the loan. …