Why collateral matters

• Pages: 1-10

Contenidos

• Borrowers typically face requirements for collateral.
• Loans secured by collateral have better terms.
• Most enterprises have productive assets-but can't use them as collateral.

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For those concerned with increasing the private sector's access to finance in low-and middle-income countries, collateral matters. It matters because of three essential features of formal credit markets:

* Borrowers face requirements for collateral in the formal financial sector of most countries, regardless of the size of the economy.

* Loans secured by collateral have more favorable terms than unsecured loans do, for any given borrower or size of loan. A borrower able to offer collateral can obtain a larger loan relative to the borrower's income, with a longer repayment period and a lower interest rate. This holds true regardless of the economy and of the other characteristics of the borrower. Conversely, a borrower who cannot provide the type of assets lenders require as collateral often gets worse loan terms than an otherwise similar borrower who can do so-or gets no loan at all.

* In most low-and middle-income countries most firms receive none of the benefits of collateral despite having a wide array of productive assets-because their assets cannot serve as collateral. This limitation arises entirely from the legal framework for secured transactions.

Borrowers typically face requirements for collateral

Secured loans are the most common loans in the formal financial sector. In low-and middle-income countries between 70 percent and 80 percent of firms applying for a loan are required to pledge some form of collateral (figure 1.1). In high-income countries the story is similar: in the United States, for example, 45 percent of all commercial and industrial loans from banks-and nearly 90 percent of those under $100,000-are secured by collateral.¹

Why do lenders put such weight on collateral? The answer lies in the central question that private lenders confront: How can I ensure that I will be repaid? When lenders can obtain collateral from a borrower, it makes lending a less risky business. When they cannot, lenders must find other ways to reduce risk. That usually means less favorable terms for borrowers.

To reduce the risk of nonpayment, lenders try to gather a great deal of information about their borrowers. But information about borrowers tends Page 2

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to be difficult to get. In low-and middle-income countries credit reporting systems-if they exist-often contain only limited information, may rely only on data from banks, and may be available only to banks.² Moreover, typical borrowers lack audited financial statements; company records consist instead of checkbooks and canceled checks.³ In many countries firms keep two sets of books-one for the tax collector and another for the accountant-a practice that undermines confidence in information from borrowers' balance sheets and income statements.

Ultimately only the borrowers know what they are going to do and what their true conditions are, while the lenders have to guess-a problem economists call asymmetric information. Lenders respond to this problem by doing business only with borrowers whom they have known and observed over many years.

Credit bureaus (where they exist) and records of prior performance can weed out those who failed to pay in the past. Identifying those who will not pay in the future is a bigger challenge. Careful analysis of borrowers, recognizing that those who will be in the market for a larger loan in the future are less likely to default on today's loan, helps spot good borrowing prospects.⁴ But all lenders know that the facts in these analyses can change: good luck can turn Page 3 bad; formerly conservative borrowers can be tempted by a high-risk, high-return project; healthy business operators or members of their family can get sick; and apparently honest business operators can turn out to be crooks. Even borrowers who have consistently repaid loans in the past may fail to repay a larger loan in the future. Lenders respond to this risk by increasing loan sizes very slowly.

Lenders also face uninsurable risks, risks that neither they nor the borrower can insure against: acts of war, natural disasters, even the death or illness of key employees of the borrower. The biggest causes of bankruptcy in the United States are death or illness of the borrower and natural or human-caused calamity. Lenders respond to this risk by diversifying their portfolios, limiting loans to any one borrower.

Together, these responses by lenders to the risks of lending create the credit market characteristics common in...