The Endowment Effect and Collateralized Loans
Collateral requirements play an important role in credit markets. This paper shows that the endowment effect—the phenomenon where owing a good increases one's valuation of it—inhibits demand for loans which use a borrower's existing assets as collateral. Using a field experiment in Kenya, we show that borrowers instead strongly prefer loans collateralized using the new durable assets being financed by the loans themselves. They are willing to pay 9% per month higher interest for such Same-Asset Collateralized Loans (SACLs) despite the endowed and new assets being randomized, and thus similarly valued before ownership. Our findings imply that assets which are difficult to use as collateral—which cannot be financed by SACLs—will be invested in less, even if the borrower has other collateral. We argue that borrowers' preference for SACLs is driven by naivete: they initially perceive that they have little to lose when offered a SACL, but subsequently come to develop an attachment to the new asset, resulting in high repayment effort. Consistent with this, borrowers underestimate their future attachment to an asset before owning it, and SACLs do not have higher default rates despite having higher demand. We derive the conditions under which offering consumers SACLs increases or conversely decreases borrower welfare.
This project received generous funding from the Weiss Family Program Fund for Research in Development Economics, the Pershing Square Venture Fund for Research on the Foundations of Human Behavior, and an anonymous donor. This document is an output from the research initiative ‘Private Enterprise Development in Low-Income Countries’ (PEDL), a programme funded jointly by the by the Centre for Economic Policy Research (CEPR) and the Department for International Development (DFID), contract reference PEDL-LOA-4768-Rao. The views expressed are not necessarily those of CEPR, DFID or the NBER. We thank numerous colleagues and seminar audiences for helpful suggestions, and James Reisinger and Niharika Singh for excellent research assistance. We received IRB approval from Harvard University (protocol number IRB17-0944) and Maseno University (protocol number MUERC-00430-17. The experiment was pre-registered with a pre-analysis plan on the AEA registry, number AEARCTR-0002448.
Disclosure Statement of Michael Kremer
Co-author of “The Endowment Effect and Collateralized Loans”
1. I am a faculty member at the University of Chicago, where I also direct the Development Innovation Lab and Development Economics Center.
2. I am Counselor to the USAID Administrator on Open Innovation and Scientific Director of USAID’s Development Innovation Ventures.
3. I am an unpaid board member of Precision Development.