Collateral free loans can attract entrepreneurs

Collateral is perceived to be an asset that upon liquidation is adequate to cover most or all of the lender's risk exposure including principal, accrued interest and collection costs. Typically, physical assets such as land, real estates and chattel mortgages are considered as best collateral. There are a number of collaterals and substitutes such as land, chattel assets, third party guarantees, group guarantees, warehouse receipts, savings funds, reputation, guarantee funds, insurance etc. If the borrower defaults, then the lender has the right to seize the collateral and sell it to pay off the loan.

In many countries for SME lending, collateral may be life insurances, financial assets, mortgages and personal guarantees are preferred, while chattel mortgage, pawned moveable personal assets and assignment of claims against third parties were less preferred because of costs, limited marketability and appropriability.

Collateral free micro and small credit organized by NGOs in Bangladesh is shining example for bankers. After the years of experiments and success of microfinance programs was possible due to acceptance of equitable mortgage and goodwill supported by group guarantee. The supervision and monitoring of the borrowers is another criterion for success of micro and small credit.

Collateral-free credit is generally associated with the informal financial sector. The absence of collateral is considered to be one of the outstanding features of the informal financial sector. Collateral issues attract therefore the interest of a broad range of agencies in the development community mostly non-government agencies. On the other hand, not all informal financial contracts are collateral-free and not all formal financial contracts are collateralized. In practice, Financial Institutes (FI) also use to extend ‘clean’ loan or without security loan on the basis of client-banker relationship and usually at a higher interest rate.

The informal financial sector in many other countries including Bangladesh is successfully run their credit business for centuries. It is guided by customary law and unwritten social norms. Their personalize service and credit management is a shining example of collateral free credit. The informal credit market shows that collateral is not compelling issue for lender.

The successful money lending business of informal moneyleders in this part of South Asia are success stories of collateral free credits. Their profession is much more challenging as they extend credit to informal sector and very difficult to bring them under legal sanction for informality and availability of sufficient and standard evidences. The high interest rate and close supervision and personal relationship play an important role is those successful transactions.

The availability of collateral was not the most important criterion, and that the track record, the transparency of financial management and the borrower's position in the market ranked higher. Many studies of the factors determining the financing situation of SMEs identifies collateral just as one of six enterprise-internal factors in addition to the legal form, size, sector, financial management. Avoid identical works all formalities of process of loan both for all small and big borrowers.

The security of credit against collateral shifts the attention of banks from what they really are supposed to do, namely appraise a borrower's character, a project's capacity to produce a net return to service principal and interest, amount of equity capital and business conditions. The maximization of collateral conditions does not necessarily yield optimal results; to the contrary, there may be an adverse selection problem, similar to the optimum interest rate to differentiate good from bad borrowers.

Collateral is believed to have an adverse selection effect because higher collateral requirements will deter good borrowers from entering credit markets. This occurs since increases in collateral requirements will result in less risky borrowers dropping out of the credit market. For a given project, an increase in collateral increases costs and decreases profits, thereby reducing the project's expected profits for the borrower. Some projects that are initially profitable may become non-feasible due to higher collateral requirements. Collateral is only one of the factors that affects loan quantity rationing. It may lead to credit rationing occurs due to denial of credit (loan quantity rationing) or Collateral can affect loan size rationing when some borrowers are supplied with smaller sized loans than demanded (loan size rationing).

Collateral can also affect the interest rates charged. Both formal and informal lenders ranked immovable assets and gold as having high collateral values while assets such as promissory notes and movable assets were ranked low. The highest rates of interest in informal markets were charged for loans secured by movable assets.

Collateral is widely used to place moral pressure on the borrower rather than to actually force loan repayment. While formal lenders generally require tradeable assets as collateral, informal lenders often grant loans with no explicit collateral or accept tradeable and non-tradeable collateral/ collateral substitutes. In addition, informal lenders design loan contracts in such a way that other terms and conditions substitute for the conventional collateral.

In general, the collateral and collateral substitutes used in informal markets range from the widely acceptable collateral such as land on the one extreme to less marketable assets such as reputation, long-term relationships (business and social), the threat of loss of future loans and social ostracism on the other extreme. The lenders based on their specializations choose the most appropriate collateral/collateral substitute to consummate transactions. Therefore, borrowers rationed out of formal markets often are able to access informal loans.

The writer is a legal economist