Legal Diﬀerence Regarding Inside Collateral:
Tradeoﬀ of Outside Collateral
Yoshinobu Zasu∗

1Introduction

Financial law aﬀects economic performance and corporate external ﬁnance.
It also inﬂuences the activities of entrepreneurs, and the investors who ﬁnance projects. Many authors report diﬀerences in ﬁnancial law between
common and civil law countries. It is well known that weak legal protection
for investors leads to credit rationing, a situation in which entrepreneurs
cannot ﬁnd suﬃcient investment and are therefore unable to set up ﬁrms.
Collateral is a secured asset that is forfeited to investors should a project
fail; thus, investors are more prepared to provide ﬁnance when there is collateral than when there is not. Consequently, collateral is one of the devices
that alleviate credit rationing. The law concerning collateral diﬀers aroundthe world, especially between common and civil law countries.
We examine the legal diﬀerences regarding collateral in common and civil
law, and consider the eﬀect of these on the activities of entrepreneurs andinvestors by using the standard moral hazard model of corporate ﬁnance. In
this context, we focus on the following characteristics of the laws regarding
inside collateral. In civil law, each asset must be individually registered
as collateral; it is not possible to register a group of assets as one item ofcollateral. In order to evaluate the value of the collateral, investors have toevaluate each asset. As a result, the more collateral that is registered and∗Faculty of Economics, Kansai University, zasu@kansai-u.ac.jp

1

is evaluated, the higher the overall cost. Such registration and evaluation
costs are variable, although each one is relatively low. On the other hand, incommon law all the assets of a ﬁrm can be registered as one item of collateral.
When collateral is registered in this way, the registration and evaluation cost
is ﬁxed, but might be high because of the need to estimate the assets’ totalvalue. These diﬀerences between common and civil law regarding collateralaﬀect entrepreneurial and investment decisions, especially inside and outside
collateral, and determine the extent of credit rationing and set-up business.
We incorporate these characteristics into the standard model of corporateﬁnance, and show the following. In order to obtain the loan, the amount ofoutside collateral is larger in civil law tradition than common law tradition;
as a result, the entrepreneurs in civil law countries tend to suﬀer more fromcredit rationing or set-up bussing.

2The model

We adopt a simple model of external ﬁnancing to analyze the eﬀect of legal
diﬀerence on the decisions of the entrepreneur and investors. The most ofresearch seems to be based implicitly on the common law tradition, wherecreditors can acquire all of the value of the project as collection of debt
when bankruptcy. The creditors can relatively easily sell the project as awhole and collect their debt. On the other hand, in the civil law tradition
the creditors cannot describe the whole project as collateral in the contract,
and they can evaluate and register individual asset as collateral.
We ﬁrst analyze the credit rationing model under the common law andcivil law traditions, and then examine the eﬀect of legal diﬀerence.

2.1

The common law traditionFollowing the Tirole’s corporate ﬁnance model1 , let us consider the debt
contract between entrepreneurs and investors with moral hazard. The rep1

See Tirole (2003) and (2006).

2

resentative entrepreneur (borrower) is risk neutral and borrows a ﬁxed loan
L from investors to set up a project. Investors are also risk neutral. The capital market is competitive, and the loan is arranged as long as the investors
break even on average.
The state of the project, which is a success or a failure, is observablefor the investors, but the substance of the project, which is good or bad,is unobservable. A good project brings a higher probability of success thana bad one (p > pb ). A bad project earns private beneﬁt B for the entrepreneur, and this is the source of moral hazard in the model. When aproject becomes success and the borrower pays the repayment of loan R,
and then the borrower gets cash ﬂow of the project ys . This cash ﬂow canbe interpreted to include the expected future cash ﬂow of the project as wellas the present one. However, when a project becomes failure and bring zero
cash ﬂow, in the common law tradition, the creditors can sell or take overthe project and receive the cash ﬂow y2 . In addition to the future value ofthe project, the creditors can collect the borrower’s own assets (including
his house, for example) as outside collateral Co under default. The value ofoutside collateral is assumed to be βCo for the borrower, where β > 1. Thatis, the transfer of the borrower’s asset to the creditors creates social cost or
dead-weight loss (β − 1)Co 2 .
We assume that investors make a take-it-or-leave-it oﬀer to the entrepreneur.

In order to prevent the entrepreneur from choosing a badproject, that is, for the prevention of moral hazard, the contract have tosatisfy the following condition:p(ys − R) + (1 − p)(−βCo ) ≥ pb (ys − R) + (1 − pb )(−βCo ) + B
R ≤ ys + βCo −B,∆P(1)

where ∆P is deﬁned as p − pb . This condition is called as incentive com2

Bestor (1994) assume a similar assumption of outside collateral and the dead-weightloss.

3

patibility (IC) condition. The condition indicates that the repayment hasa ceiling. Hereafter, we suppose that the IC condition is satisﬁed; the entrepreneur chooses a good project which has success with the probabilityp.
In common law tradition, at a stage when the borrower and creditor
draw up a credit contract, they can set a project itself as collateral. Thus,
if the borrower cannot repay the debt, following the contract the creditor
can take over the project as collateral and collect partial of the debt. We
assume that it is costly to evaluate the project as collateral or the future
project value. Investors is assumed to ﬁnd the future value of the project y2
after they evaluate with ﬁxed costs Γ. Given this cost, Investors can lend
the money to the borrower if their expected return of the loan exceeds theopportunity cost of the loan:pR + (1 − p)(y2 + Co ) − Γ ≥ (1 + ρ)L,(2)where ρ is the risk free rate. We assume that the risk free rate is zero forsimplicity, henceforth. We refers this condition individual rationality (IR)condition.
The value of the project is assumed to be perfectly observable for creditors if the creditors evaluate the future project by bearing the evaluation
cost. It is proﬁtable for the investors to evaluate the future project y2 if(1 − p)y2 − Γ ≥ 0.

(3)This condition means that the expected value of collateral must be greaterthan the evaluation cost. To make the evaluation meaningful, both thefuture project value y2 and evaluation cost Γ are satisﬁed the condition (3).
Given the above conditions, we consider the condition of outside collateral Co necessary to provide the loan L. We can rewrite the IR condition4

by using the conditions (1) and (3):(1 − p)Co ≥ −p(ys + βCo −B) + L + Γ − (1 − p)y2 .
∆P(4)The left-hand side means that the expected value of outside collateral forthe creditors, and then we can interpret the right-hand side as the necessary
value of the expected outside collateral. We denote the right-hand side as
C A , which is minimum of the expected outside collateral in order to arrange
the loan. To make this interesting, we assume that the left-hand side has
a positive value, otherwise, outside collateral is not necessary to obtain theloan. Therefore, the entrepreneur with Co < C A /(1 − p) cannot attract thenecessary loan to set up the business, and be suﬀering from credit rationing.

2.2

The civil law tradition

Let us consider the situation under the civil law tradition where in order toregister as collateral each asset of the ﬁrm must be individually registered.
It is not possible to register a group of assets, and the project itself is much
more impossible as collateral. In order to capture the characteristics of civillaw regarding collateral, the investors can observe the value of each asset
after spending the evaluation cost: the value of each asset is deﬁned as vi ,i ∈ {1, . . . , n} and the cost of evaluation about each asset is ci , i ∈ {1, . . . , n}.
In addition, without loss of generality, we assume that v1 = v2 = · · · = vn
and c1 < c2 < · · · < cn , and that there exists an asset k such as (1−p)vk = ck .
This means that at an asset k marginal beneﬁt of evaluation (1−p)vk equals
to marginal cost ck . Therefore, if the expected value of assets investors cancollect when the project fails is greater than the evaluation cost, the investors
have an incentive to evaluate the assets. The following condition is satisﬁed:(1 − p)

k∑

vi −

i=1k∑

ci > 0.

(5)i=1Given the above evaluation process, the break-even condition for in-5

vestors (IR condition) under civil law tradition iskk∑∑pR + (1 − p)(vi + Co ) −ci ≥ L.
i=1(6)

i=1The condition for prevention of the entrepreneur’s moral hazard (ICcondition) is the same as the condition (1). Simple calculation of jointing(1) and (5) with (6) leads to the condition of the expected value of outside
collateral under civil law tradition as well as common law:∑∑B(1 − p)Co ≥ −p(ys + βCo −)+L+ci − (1 − p)
vi .
∆Pkk

i=1i=1(7)The right-hand side indicates the expected value of outside collateral necessary for the entrepreneur to attract credit, and is denoted as C J . We caninterpret this condition as similarly as under the common law tradition;
the entrepreneur who is able to pledge only amount of outside collateral
Co < C J /(1 − p) is suﬀering from credit rationing.

2.3

Eﬀect of legal diﬀerence on outside collateral

Now let us consider the eﬀect of legal diﬀerence on outside collateral andthe decision of the entrepreneur. The minimum (expected) outside collateral
for credit in common and civil law traditions are described as C A and C J ,respectively. The diﬀerence of the amount of the minimum outside collateralisC J − C A = (1 − p)(y2 −k∑i=1vi ) + (k∑ci − Γ).

(8)i=1The ﬁrst term of the right-hand side is the diﬀerence of the expected valueof inside collateral in common law and civil law, and the sign of the ﬁrst∑∑
term is positive because y2 > ni=1 vi > ki=1 vi . The second term is thediﬀerence of evaluation costs, where one is variable type of cost (in civillaw) and the other is ﬁxed type of cost (in common law), and the sign is6uncertain from the assumption in the model.
If the ﬁxed evaluation cost of the project is smaller than the variableevaluation cost of the assets, then the sign of the second term is also positive. On one hand, the aggregate of evaluation cost of each asset seems
to require a lot of time and eﬀort because some of the assets in the ﬁrm
might be special in the business ﬁeld and it requires specialists in the ﬁeld
for evaluation of such assets. On the other hand, evaluation of the projectis also troublesome, but people can evaluate a fair value of it from someaccounting information and the specialist in the ﬁeld can easily evaluate. In
such a manner of consideration, we cannot necessarily say that the evaluation cost of the project Γ is larger than the aggregate of evaluation cost of∑each asset ki=1 ci . After all, the left-hand side of the condition (8) tends
to have a positive value. If so, the required minimum outside collateral in
the civil law tradition is larger than that in the common law tradition. We
summarize as the following result.
Result 1: The entrepreneur in civil law has to provide larger amount ofoutside collateral than in common law as long as the project evaluation costin common law is not enough large.
Now we examine the diﬀerence of payoﬀ of the entrepreneur in eachlegal tradition. We use superscript J and A for civil law and common law,respectively. For example, we denote payoﬀ of the entrepreneur (borrower)
in civil law and in common law as UbJ and UbA , respectively.
By using the IC condition, the payoﬀ of the entrepreneur in the civil law
tradition is as follows:
UbJ = p(ys − R) + (1 − p)(−βCo )∑B+vi ) − βCoJ ,∆Pk≥ p((9)i=1where CoJ is the required outside collateral in civil law which satisfy thecondition (7). Similarly, the payoﬀ of the entrepreneur in the common law

7

tradition is as follows:
UbA = p(ys − R) + (1 − p)(−βCo )≥ p(B+ y2 ) − βCoA ,
∆P

(10)

where CoA is the required outside collateral in civil law which satisfy thecondition (4). After simple calculation of these condition, we can obtain thediﬀerence of the payoﬀs:

UbA − UbJ = p(y2 −k∑vi ) + β(CoJ − CoA )

(11)

i=1

Again, sign of the ﬁrst term is positive by the assumption and that of thesecond term tends to be positive under the above discussion. Therefore, thepayoﬀ of the entrepreneur in the common law tradition is likely to be larger
than than in the civil law tradition. Additionally, If the required outside
collateral is large enough, the payoﬀ of the entrepreneur can have a negativevalue and she would not start up a business. Such situation tends to beoccur in the civil law tradition. The following is the summary
Result 2: the entrepreneur in the civil law traditon is more likely to giveup to start up a business as long as the project evaluation cost in common
law is not enough large.
From the above discussion, we ﬁnd that there is cost and beneﬁt ofoutside collateral: beneﬁt is to provide external ﬁnance In addition to inside collateral, and cost is to prevent the entrepreneur from starting up abusiness.

3Concluding remarks

We examine the eﬀect of legal diﬀerence between the common law and civil
law traditions on the credit contract by using a simple corporate ﬁnancemodel. We ﬁnd that the required amount of outside collateral in civil law

8tends to be larger than that in common law in order to compensate for thevalue of inside collateral. In addition, we suggest that under a reasonablepremise the entrepreneur in civil law who face a larger amount of outside
collateral is giving up to start up a business.

References[1] Bebchuk, Lucian A., and Andrew T. Guzman. An Economic Analysisof Transnational Bankruptcies. Journal of Law and Economics vol. 42:
775–806 (1999).
[2] Bester, Helmut. The Role of Collateral in a Model of Debt Renegotiation.
Journal of Money, Credit and Banking vol.26. no.1: 72–86 (1994).
[3] Tirole, Jean. Ineﬃcient Foreign Borrowing: A Dual- and CommonAgency Perspective. American Economic Review vol. 93, no. 5: 1678–1702(2003).
[4] Tirole, Jean. The Theory of Corporate Finance. Princeton and Oxford:
Princeton University Press (2006).
[5] Wang, Yu-Lin. Does Collateral Cause Ineﬃcient Resource Allocation?
Journal of Economics and Business vol.62: 220-223 (2010)9