There is no single official definition or consensus concerning the collateral substitutes used by financial institutions in developing countries. Collateral is an asset pledged by a borrower to a lender until the loan is repaid. In some jurisdictions, banks define loan collateral as a measure a lender takes to protect the money lent against misuse or loss. Collateral is perceived to be an asset that, upon liquidation, is adequate to cover most or all of the lender’s risk exposure. Typically, physical assets such as land, real estate, and chattel mortgages are considered the best collateral. If the borrower defaults, then the lender has the right to seize the collateral and sell it to pay off the loan.
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 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 collateralised. In practice, Financial Institutes (FI) also use to extend ‘clean’ loans or without security loans on the basis of the client-banker relationship and usually at a higher interest rate. The informal financial sector in many other countries, including Bangladesh, successfully run its credit business for centuries. It is guided by customary law and unwritten social norms. Their personalised service and credit management are shining examples of collateral-free credit.
The successful money lending business of Mohajan and Kabuliwala are success stories of collateral-free credits. Their profession is much more challenging as they extend credit to the informal sector, and very difficult to bring them under legal sanction for informality and the availability of sufficient and standard evidence. 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 identify collateral just as one of six enterprise-internal factors, in addition to the legal form, size, sector, and financial management.
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, the amount of equity capital and business conditions. The maximisation 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 occurring due to denial of credit (loan quantity rationing), or collateral can affect loan size rationing when some borrowers are supplied with smaller loans than demanded (loan size rationing). 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.
Recently, BRAC bank has developed a loan product for some small business. The criterion of this loan product is for repayment on a daily basis and close supervision of the business enterprise through a visit by an assigned bank official. The official version of the visit to the borrower to ‘collect’ the daily installment in cash. The experiment is reportedly successful. Other FIs can replicate the loan program developed by BRAC Bank Ltd or the historical loan management methods of Mohajan and Kabuliwala.
The market insider observed that while the majority of formal lenders still rely upon the traditional approach of requiring conventional collateral, several types of collateral substitutes are being used in rural formal financial markets. Semi-formal and informal financial arrangements have found several collateral substitutes to secure loans without relying on conventional collateral, so borrowers rationed out of formal loans are often able to access these sources, and the social, economic and legal environment within which the FIs operate frequently influences the acceptability and value of assets used as collateral.
There is no collateral law in Bangladesh, but it constitutes a coherent body of dispositions. Collateral issue dealt with some collection of dispositions in different legal compartments in private law and in penal law. The law of contract, banking law and negotiable instrument law, plays a crucial role in litigation. The other law is land registration law, the commercial law, the code of civil procedure, bankruptcy law. The litigation attracts some clauses of the penal code. A secured transaction law is in the process of being passed by the Parliament. It should broaden by allowing for substitution of collateral arrangements to the benefit of borrowers with solid investment proposals but without assets, especially for first-time borrowers.
The law should revise the densification of loan contracts by minimising the transaction costs involved for borrowers and lenders in creating, perfecting and enforcing security interest, especially for the situation of borrowers with a certain loan record but still under-collateralised, i.e. small and medium-sized enterprises. It should minimise the high transaction costs in connection with specifying, validating and realising collateral may ration out smaller- and medium-sized borrowers.
The bankers of present days seem not willing to extent loan without collateral and are unable to write off loans in any situation. Bankers should take the experiences of the oldest bankers of the region namely Mohajan and Kabuliwala. Their close selection of borrowers, close supervision and monitoring are the criteria to extend collateral-free credit. The existing local Mohajan follow humanly and liberal policy in discounting of interest and also in certain cases write-off the loan amount due to the sudden death of the borrower or natural disasters. The laws and policies for loan recovery are much harsher than those once branded heartless Mohajons.
Bangladesh should follow the century-old tradition and practice of Mohanjan and Kabliwala to assess the capacity of the borrower and the ability of business management. They also frequently visit the borrower and also keep networking with others for related useful information which may affect the loan repayment capacity of the borrower. FIs should offer collateral-free credit, particularly to SMEs. Bankers should monitor and supervise the loan operation to protect against the misuse or diversion of money from the business.
The writer is the CEO, Bangla Chemical & Legal Economist. E-mail: [email protected]
