Social Finance Programme

Working paper No. 26

Collateral, Collateral Law and Collateral Substitutes

(2nd Edition)

B. Balkenhol
H. Schütte

Employment Sector
International Labour Office Geneva
2 Collateral, collateral law and collateral substitutes

Table of contents

Acknowledgements iii

Acronyms v

Executive summary vii

Introduction 3

1. Is lack of collateral a constraint? 5

1.1 A constraint for whom? 5
1.2 Causes for the collateral constraint 6

2. Collateral, collateral law and collateral substitutes 9

2.1 Collateral 9
2.2 The functions of collateral 10
2.2.1 From the lender’s point of view 10
2.2.2 From the borrower’s point of view 12
2.3 Collateral substitute 13
2.4 Collateral law 15

3. Collateral law and collateral substitution: Limitations and scope

from the point of view of small borrowers 19
3.1 Does collateral law work? 19
3.1.1 Does collateral law influence substitution? 19
3.1.2 Does collateral law exacerbate credit rationing? 20
3.2 How do collateral substitutes perform? 21
3.2.1 How widely are collateral substitutes being used? 22
3.2.2 Peer pressure 25
3.2.3 Probation 29
3.2.4 Interlinked contracts 30
3.2.5 Co-maker arrangements without intended enforcement 31

4. Findings 33

5. Conclusions 37
Is Collateral a Constraint? 3

Glossary 43

Bibliography 47

Annex: Survey responses by members of the Donors’ Working Group 57

4 Collateral, collateral law and collateral substitutes
Introduction

The collateralization of loan contracts is at the intersection of several fields: in financial sector
development, the possession of collateral largely determines whether certain categories of economic
agents obtain access to the financial market and whether financial contracts are efficiently concluded,
i.e. with least losses. Collateral issues are also relevant in targeted promotion strategies, like small
enterprise and private sector promotion, respecting poverty alleviation. Some successful major
micro-finance programmes have developed original approaches to collateral. 1 Collateral issues
attract therefore the interest of a broad range of agencies in the development community.

The purpose of this report is to tie together ongoing conceptual and field work on collateral
law and substitution, to identify the outstanding issues, especially those relevant for policy-making
and institutional learning and to formulate recommendations for donor agencies interested in the
financial sector in developing countries and transition economies. The ultimate goal of this report is to
influence policies, the regulatory framework and institutional behaviour with a view to innovative and
effective collateral substitution. This would contribute to removing what is considered to be an
important obstacle in the access of the poor to financial services.

The report is organised in 5 sections: the first part explores the extent and nature of the
collateral constraint. The second section seeks to throw light on what is meant by collateral,
collateral law and collateral substitutes and their respective functions. The third section reviews the
available empirical evidence on the effects of the legal and regulatory framework and on the
performance of substitutes. The fourth part summarizes findings. The report concludes with policy
issues and points for discussion.

There has been some controversy over the incidence of collateral on the access to financial
services, especially of small and micro businesses. This debate would seem to justify a brief review
of the functions of collateral in loan contracts. The notion "collateral substitute" has been around for
some time in the donor community, a "catch-all" notion to describe a variety of techniques to resolve
a shortfall in real, tangible assets to secure a loan. Therefore, a more rigorous examination of the
notion "substitution" seemed to be called for. Another concern of this report is the statutory
environment of collateralization; the very notion "collateral law" signals that the difficulties are closely
related to the legal and regulatory framework within which loan contracts − secured or unsecured −
are concluded.

1
To the point that some donor agencies like USAID require "additional evidence from a financial
institution . . . that it is actually reaching poor customers . . . (if) it does not rely on collateral substitutes."
6 Collateral, collateral law and collateral substitutes

The practical interest of this report is embodied in two assumptions:

− a simplification of the formal rules to create, perfect and enforce security interests and a
greater transparency in registers will reduce overall transaction costs in loan securization and
thus lead to an increased flow of finance to investment-seeking (small) borrowers; and

− if banks were better informed about the merits of collateral substitutes, they would
increasingly secure loan contracts in this way thus stimulating a flow of investable resources
to market participants that would otherwise have gone without them.

If these assumptions are valid, then in the first instance public authorities would be called
upon to alter the conditions under which loan contracts are secured (collateral law); in the second
instance, banks and other financial institutions would be invited to learn how to adjust their lending
technology (collateral substitutes).
1. Is lack of collateral a constraint?

Collateral is an asset pledged by a borrower to a lender until a loan is paid back. If the
borrower defaults, then the lender has the right to seize the collateral and sell it to pay off the loan.

Lack of collateral is said to explain the mismatch between supply and demand in the small-
scale financial market.2 The risk perception by banks of small enterprise lending − whether justified
or not3 − and the absence of risk guarantee institutions seem to have contributed to the segmentation
of financial markets in many developing countries (J. Levitsky, 1993, pp. 9-10 and W. Schneider-
Barthold, p. 51). "The provision of collateral by the target group has posed a significant problem to
those projects involving banks" (USAID).4 "Lack of collateral satisfactory to banks has almost
always been a constraint on disbursement of World Bank SME lines of credit" (Steel).

1.1 A constraint for whom?

It is plausible to think that the lack of collateral is primarily a constraint for the borrower, i.e.
in terms of market access limitations: "this reliance on real estate as collateral means that one quarter
of Argentine farmers that own no land will have no access to formal credit" (Fleisig, 1994, p. 3).
However, not all undercollateralized borrowers are necessarily constrained in their access to
financial services, only those that seek formal bank credit, for example SME targeted by credit lines
operated through the banking system. For borrowers outside of the formal banking sector,
"particularly micro enterprises this is much less of a constraint" (USAID), or in connection with
"revolving funds and income-generating credit schemes as part of social funds and welfare-oriented
projects . . ." (Steel).

Also, undercollateralization is not exclusively a problem for the borrower. A bank could also
conceive as constraining the lack of collateral, namely when a borrower's credit application meets all
other criteria except the bank's collateral requirement. In this case, the bank would be obliged either
to take the risk of uncollateralized exposure or accept a less preferred form of collateral implying
possibly higher costs in establishing and enforcing security interests. Sometimes a bank can
compensate for these increased risks and costs by charging correspondingly higher interest rates;
sometimes it cannot do so because of interest rate ceilings, in which case the bank is doubly
constrained by a lack of collateral and interest rate policy.

2
The notion "small-scale financial market" is to encompass SMEs, micro-enterprises, small farmers.
3
That the risk perception is often not supported by statistics is borne out by comparing overall default
rates with SME portfolio default rates within the same banks (Koch, annex A-52, table).
4
Quotations without reference relate to a survey response. For complete text refer to the annex.
8 Collateral, collateral law and collateral substitutes

If, because of a lack of collateral, a large number of loan contracts are not concluded, then
Central Banks and other authorities responsible for the efficiency and security of transactions in the
financial market and for a broad-based participation of the largest possible number of households
and enterprises have a reason to be concerned, as well. The social costs of collateral-related
problems in terms of higher interest payments, a reduced volume of investment and lower output
levels (Fleisig, 1994, p. 3) does therefore call for the attention of public authorities.5

1.2 Causes for the collateral constraint

Four explanations have been advanced:

− Suboptimal asset distribution

The first explanation is to say that the asset distribution is suboptimal; if more Argentine farmers
owned more than 100 hectares, then they would have obtained more loans, more investments would
have been made, etc. According to this view, assets would need to be redistributed more equitably;
land reform would make the search for collateral substitutes redundant;

− Inappropriate legal and regulatory framework

According to the second view, there is nothing fundamentally wrong with asset distribution, but with
the legal and regulatory framework governing financial contracts and especially their collateralization;
Fleisig and USAID, for example, argue that if one removed legal restrictions on the use of moveable
property for collateral purposes or if one made real estate and commercial registries more
transparent, up-to-date and accessible, then more "security interests" would be established at no
supplementary risk to banks, hence more loan contracts would be concluded and more output
produced;

− Repressive monetary and especially interest rate policies

Another way to look at the collateral constraint is to say: the legal and regulatory framework itself is
not a constraint, but certain monetary and credit policies by the Central Bank, especially interest rate
ceilings that make it impossible for banks to charge the extra risk premium to undercollateralized
clients. However, this view presupposes that banks have the "right" risk perception;

− Uninformed banks
The fourth position questions the risk perception by banks. They are basically poorly informed.
Banks exaggerate the likelihood of default of particular classes of borrowers, hence impose
unrealistically high collateral requirements, which results in credit-rationing (Stiglitz/Weiss, 1992, p.
718).

5
World Bank (1994, p. III) in fact estimates that collateral problems cost the Bolivian economy 3-4% of
Is lack of collateral a constraint? 9

Whatever the precise cause, it has also generally been argued that the collateral constraint is
a false problem in the sense that banks use it as a pretext not to have to deal with SMEs. By hiding
behind the collateral issue, they deflect the criticism that they are "not doing enough for small
businesses", while in reality the transaction costs involved or other problems are the real constraints.
Indeed, collateral is not the only constraint. Sprenger (pp. 15-16), for example, in a systematic
overview of the factors determining the financing situation of small enterprises identifies collateral just
as one of six enterprise-internal factors (in addition to the legal form, size, sector, financial
management). Koch's survey of commercial bank appraisal criteria in Ecuador, Colombia and Peru
(pp. 318-323) found that 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. Whether lack of collateral is indeed a false problem for banks is difficult to say; but
that it is perceived to be a problem by borrowers is without any doubt and justifies further
investigations.

A diametrically opposite view is to say that collateral should only be used to offset some
weakness evident in the other four "C's". This view tends to place more emphasis on character and
cash flow analysis, and sees collateral as a means of recouping losses only if all else fails. The
fixation on 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 preoccupation with collateral leads
thus to a suboptimal allocation of funds. While there may be a grain of plausibility to this argument, it
is a fact that banks are obliged to protect the assets of their depositors, creditors, owners, which
does not leave much room for experiments with unsecured portfolios.

Collateral-free practices are generally associated with the informal financial sector, in fact the
absence of collateral is considered to be one of the outstanding features of the informal financial
sector6 (Timberg/Aiyar, p. 49). This is plausible because of the greater proximity between lender
and borrower and the facilities to obtain reliable information on default risk quickly and cheaply. The
absence of collateral could also partly explain the high interest rates on informal sector loans which
may contain an important risk premium (Christen, p. 20; Ghate, p. 5; Rahman, p. 153). On the other
hand, not all informal financial contracts are collateral-free and not all formal financial contracts are
collateralized: a survey of 248 households in two villages in Tamil Nadu in 1985 found that between
14% and 38% of formal credit contracts were issued without any collateral; it was also observed
that in informal loan contracts a wider range of assets was used for collateral (gold, jewellery,
household goods, labour, etc.) (Swaminathan, pp. 165-166).

GDP.
6
Reflected in the title of Frits Bouman's book: Small, short and unsecured − Informal rural finance in
India, Oxford University Press 1989; inversely Swaminathan identifies as one of the two constituent features of
formality the type of collateral accepted.
10 Collateral, collateral law and collateral substitutes

Collateralisation in formal and informal contracts: evidence

from two villages in Tamil Nadu

100%

80% no collateral
promissory notes
60% mortgages
movable assets other than gold
gold
40%
immovable assets

20%

0%
formal informal formal informal
Konur Gokilapuram
Source: Swaminathan, pp. 165-166
Error! Switch argument not specified.
The empirical evidence is mixed: several studies find indeed a strong predominance of
collateral-free practices (Schrieder/Cuevas on ROSCAs in Cameroon, p. 52; N. Fernando on
informal financial market in PNG, p. 122; and A. Bottomley on moneylenders in Ecuador, India and
Nigeria, p. 247); others, like Sanderative on Sri Lankan moneylenders and Bouman/Moll on
Indonesian moneylenders in urban areas (pp. 93 and 217 respectively), observed that informal loan
contracts were indeed secured, even formally, through a promissory note, post-dated checks,
chattel mortgage (Timberg/Aiyar, pp. 53-54). In other instances, borrowers "in the informal markets
provide . . . real guarantees for their loans (physical collateral) often up to 200% of the amount
borrowed" (Bailey, p. 3).

Without going here into the determining factors of collateralization in informal finance
(whether the moneylender is a specialized full-time professional or not, where the client is located,
how large the loan is, etc.), it is obvious that the available evidence is not compelling with regard to
the importance of collateral as a constraint in the informal financial sector, and that informal finance is
therefore only of limited value to guide and inspire collateralization by banks.
2. Collateral, collateral law and collateral substitutes

2.1 Collateral

Collateral is an asset pledged by a borrower to a lender until a loan is paid back. If the
borrower defaults, then the lender has the right to seize the collateral and sell it to pay off the loan.

A closer look at this standard definition reveals why collateralization tends to pose access
problems for small and new borrowers, why collateral is intrinsically linked to the legal system:

− An asset
There has to be an asset, a marketable property, start-up businesses or rapidly growing businesses
may not have such assets, or at least not of sufficient market value; also there has to be a market for
seized assets, whether narrowly defined as physical assets (Binswanger), or more broadly to include
also financial assets and even off-balance sheet assets like personal guarantees. "Asset" also implies
a certain specificity; after all, the loan against which the asset is pledged is also defined. Borrower
and lender must be perfectly clear about what they mean by the asset pledged: contract law usually
provides guidance in this respect, at least in the formal financial sector. In the informal financial
sector, it is customary law and unwritten social norms. The specification of assets may be fairly
straightforward with most forms of real and financial assets, but some moveable properties escape a
precise definition in quantity and quality: stored merchandise, perishable goods; in these cases, it is
not the asset as such that becomes the object of the pledge, but the storage room with its contents
(Büschgen, p. 719; Fleisig, 1994, p. 9).

− A pledge
Secondly, there has to be a pledge by the borrower to the lender, i.e. a more or less formal,
contractual obligation in exchange of an advance of money. Again, the norms governing the validity
of a pledge are either formally legal (in the formal financial sector) or informally binding; differences
of views about who has pledged what asset to whom are obviously inextrically interwoven with
norms surrounding individual contracts. The complications get worse if an asset is not physically
transferred into a lender's possession, but remains at the borrower's disposal, so that the question of
property, ownership and appropriability can effectively only be resolved by recourse to the law. This
pledge can imply the physical transfer of an asset into the possession by the lender where that is
possible (i.e. moveable assets), but more often the pledge concerns only the appropriability of an
asset by the lender, not its effective possession (chattel mortgage in contrast to pledging). The
borrower also retains the right to the returns accruing from the use of the asset pledged (land,
machines and tools).
12 Collateral, collateral law and collateral substitutes

While all forms of collateral have in common the focus on a marketable asset and a link
between a money transfer and a conditional cession of some asset, there are distinctions between
them with regard to the object pledged as an asset (for example personal vs. real) and to the
possession of the asset pledged (attached vs. perfected security interests), as the diagram below
shows:

Conventional collateral instruments

Collateral

Pledging or Chattel
Personal Assignment pawning mortgage
guarantees for security (perfected (attached
security security
interests) interest)

of claims and of movable

of real estate
rights property

Error!
Switch argument not specified.

The difference between a large-scale and a small-scale borrower is that the small borrower
will only have a very limited range of assets to offer, while the large-scale borrower is more likely to
dispose of a full range of assets, and probably also more easily disposed to let some assets go into
the possession by a lender.

2.2 The functions of collateral

2.2.1 From the lender's point of view

The lender has the right to demand collateral: basically, collateral serves the lenders'
interests.

− Protection against risk

Collateral must limit a lender's losses (Besley, p. 4) by giving the lender a protection against the
partial or total loss of resources (in addition to the intrinsic capacity of the financed activity to
generate a surplus).
Collateral, collateral law and collateral substitutes 13

− Screening
Collateral is also a screening device (next to a number of other screening devices built into a loan
contract, for example the interest rate). The pledge in a collateral arrangement means that the
borrower could lose part of his property if he does not pay back; the borrower has an interest in
paying back. The hesitation of a borrower to provide collateral could signal to the bank that the
borrower is fully aware of the implications of making this pledge, and if he does provide collateral,
then he is likely to do everything to avoid the loss of the pledged asset.7

In addition to these primary functions, collateral also serves to put the lender into a
privileged position vis-à-vis other creditors, should the borrower become insolvent; to obtain this
effect, the lender must effectively acquire information on prior claims to the same asset. Another, less
frequently observed motive for taking collateral is to reduce transaction costs; this is the case with
high-quality collateral, for example financial papers held by the bank, the value of which is stable for
the duration of the loan and easier to establish than the inherent creditworthiness (Büschgen, p.
716).8 By taking collateral, the bank can "save" the transaction costs of having to review a loan
application.

While all forms of collateral are expected to perform these functions, lenders prefer some
forms of collateral more than others and these preferences vary from country to country, from bank
to bank and over time. Even within one and the same bank, the preference for, say, real estate may
give place to another form of collateral, sometimes as a result of changed procedural dispositions in
the execution of mortgages. Basically, one can distinguish the following criteria:

− marketability;
− appropriability and access to the asset in comparison to other lenders (World Bank, 1994,
p. 16);
− transaction costs involved in verifying ownership of assets, valuating them, enforcing security
interests, etc.

According to a survey of Austrian banks involved in SME lending, life insurances, financial
assets, mortgages and personal guarantees were considered preferable, while chattel mortgage,
pawned moveable personal assets and assignment of claims against third parties were less preferred
because of costs, limited marketability and appropriability (Schmoll, p. 179). Especially with regard
to the transaction cost criterium, it is plausible that loan size determines whether and what form of

7
It has been argued that 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. In other words: is a borrower the more trustworthy, the more collateral he
can mobilize? (Stiglitz/Weiss, 1995, p. 695). To some extent lenders can hedge against this by using the
interplay/trade-off between price mechanisms (i.e. the interest rate charged on a loan) and non-price mechanisms
(such as the use of collateral).
8
This clashes somewhat with the banking orthodoxy according to which collateral is only the "second
defence line".
14 Collateral, collateral law and collateral substitutes

collateral is taken: it makes little sense to demand a mortgage for a US$5,000 loan. With increasing
loan size, collateralized lending becomes more widespread, but also costlier in absolute terms,
illustrated in a review of Indonesian microfinance institution (Pearson/Garland, p. 7):

Loan size and collateral

Loan size (Rp ,000) Collateral

10 - 100 No
No, but seek local character
101 - 500
reference
501 - 2,000 Inquire about asset ownership
Ask to see and sometimes hold
2,001 - 10,000 documentation providing asset
ownership
Secure and hold asset
10,001 - 25,000
ownership documentation
Legally attach to secured
financial and fixed assets, and
25,001 +
register a pledge of assets from
the client

Source: Pearson/Garland, p. 7
Error!
Switch argument not specified.

2.2.2 From the borrower's point of view

For the borrower, on the other hand, while collateral requirements are a constraint, not all
forms of collateral are equally constraining: chattel mortgage is a matter of a certified transfer of the
document testifying ownership to a machine; land titles and mortgages are more time-consuming to
establish. Personal guarantees may be fairly easy to obtain, but whether they are accepted by the
bank is another matter; there is always the reciprocal obligation in a personal guarantee, which may
not always be pleasant. Tools and equipment can be easily pledged under a chattel mortgage, but if
they are seized, then business activities could be severely disrupted. Some of the most obvious
borrower criteria of preferability of different types of collateral are:

− transaction costs;
− impact on current household and enterprise affairs;
− social exposure.

However, in real life and especially in the real life of small businesses, it often occurs that:
Collateral, collateral law and collateral substitutes 15

− the borrower simply does not dispose of enough assets to satisfy the borrower's securization
needs; or

− the pledged asset is not easily or no longer marketable, nor to an extent to cover the loan
amount fully, with interest and collection cost (Esguerra/Meyer, p. 2); or

− the lender may feel that costs of liquidating the collateral may justify some extra protection.

In these instances, the loan contract could still be concluded with the help of a "substitute".

2.3 Collateral substitute

"Collateral substitute" is an evasive notion. Sometimes, it is simply meant to describe a form

of securing a loan that is to cover a shortfall in "solid" collateral: for example, in the case of the
borrower who wishes to contract a US$100,000 loan but disposes only of real assets assessed at
US$80,000; the bank in question − for whatever reasons − would prefer real assets but is prepared
to accept exceptionally also, say, a personal guarantee from a third party; in this view the personal
guarantee is a substitute.

Sometimes substitution is more strictly interpreted to describe cases of a complete

replacement of preferred forms of collateral by less preferred, but still accepted forms: in the above
example, the substitute would be a US$100,000 personal guarantee or life insurance, etc.

Sometimes, substitution is a term used to describe a situation where a bank accepts an

unusual form of a guarantee although the loan is already fully covered by conventional means: in our
example, this would occur once the bank takes household goods assessed at US$20,000 on top of
a US$100,000 mortgage for a US$100,000 loan.

The different meanings attached to "collateral substitutes" and "substitution" emphasize either
a pledged asset's:

− unusual occurrence, innovative nature or

− its para-legal character of enforcement or
− its limited marketability.9

9
Confusingly, the literature labels "collateral substitutes" items that have a market value and that can be
repossessed, like inventories, savings deposits, accounts receivable, co-maker arrangements, guarantee fund
commitments (see, for example, Najarajan/Meyer, p. 2). Sometimes, joint liability is presented as a particular form
of a personal guarantee and interlinked contracts as a specific application of assignment of income and blocked
savings as a form of assignment for security (Hartig, pp. 191-202), although their enforceability through courts is
doubtful.
16 Collateral, collateral law and collateral substitutes

Is leasing a collateral substitute?

Leasing is a form of debt financing, but in contrast to loan contracts, leasing does not require collateral.
The lease-giver retains full ownership of the machinery; there are no costs involved in verifying property rights
of the lease-taker and if the lease-taker is negligent in lease payments, enforcement and repossession are
automatic and do not require court action.

Moreover, there is a lively market for leased equipment, including among specialized leasing companies.

Purely in terms of facilities to get around a collateral constraint and disregarding other aspects (impact
on the cash flow of the lease-taker, fiscal drawbacks) a leasing contract would seem to be an attractive alternative
to a loan contract. (Point make by van Rijn, Steel, SDC.)

Enforceability of loan contracts and marketability of seized assets signal the borderline of the
formal financial sector; if a major objective in financial sector development is to push out further the
sector's frontiers so as to broaden the access of the poor to the market, then it is interesting to
explore ways to enforce creditor claims that do not involve the formal judicial process. In most
developing countries, the law and its administration do not reach the poor; and even if they did, then
the poor would not be able to afford legal recourse. Any effective extra-legal mechanism is therefore
relevant for financial sector broadening.

The same applies to marketability; while the majority of the population has no or very limited
real and financial assets that can be pledged as collateral, they do have some personal or family
belongings to which they are attached; if such "assets" perform comparable risk protection and
screening functions and are accepted by a bank, then this could have far-reaching implications for
financial sector broadening.

In contrast to a "collateral", a "substitute" is characterized by two criteria:

1. it is not enforceable through courts (or even if it is, it will not be enforced through courts in
which case the threat of enforcing a claim − by whatever para-legal or social means − is the security
interest (e.g. Grameen Bank));

2. it has no or little market value (example: household goods, promissory notes signed by the
borrower).
Collateral, collateral law and collateral substitutes 17

2.4 Collateral law

There is no collateral law in the sense that it constitutes a coherent body of dispositions,10
collateral law is rather a collection of dispositions in different legal compartments in private law and
in penal law:

Private law
− contract law (especially the general dispositions of the Code of Obligations of some
countries governing standard form contracts used by major banking groups)11
− property law (especially the dispositions of security rights over movables)
− commercial law (especially concerning registers with information on ownership of company
assets
− judicial process law
− general code of civil procedure
− bankruptcy code (prior claims to pledged assets)
− special laws concerning foreclosure (judicial execution), sale by court order and
sequestration
− decrees governing land registers and other registers

Penal law
− usury prohibition (which does not explicitly deal with collateral, but indirectly limits the scope
to compensate for insufficient collateral by charging higher interest rates).

The various dispositions affect how the parties of a loan contract go about the:

− selection of assets for collateral ("creating security interests");

− verification of ownership ("perfecting security interests");
− realization of pledged assets/titles through foreclosure and other means ("enforcing
security interests" (Fleisig)).

10
This does not preclude the possibility to modify the dispositions in disparate legal fields simultaneously
and in a coherent fashion so as to produce something close to a "collateral law" (illustrated in USAID's project
title "Collateral Law Reform Project" in Bulgaria).
11
The standard form contracts (AGB), the small print of loan contracts, govern rights and obligations
between a bank and a borrower. The borrower submits to these conditions upon signing the loan contract. The 3
major banking groups in Germany, for example, have their own set of standard form contracts, and the
securisztion of bank claims against the client figure prominently: right of the bank to demand collateral; extent
and limitation of security interest; exceptions; right of the bank to choose between forms of collateral in
execution; conditions for realization and execution; right to claim supplementary collateral because of changes in
risk; obligation of the bank to release collateral if its value exceeds not just temporarily the value of all claims; etc.
,etc.
Generally, from the point of view of internal rules, cooperative banks do not treat their customers
differently than commercial banks with regard to securization of loans, while the stipulations of savings banks are
less extensive and in some respects even more customer-friendly (for example, the rules governing the release of
part of security).
18 Collateral, collateral law and collateral substitutes

Collateral law:
dispositions in different legal compartments

Collateral
Law

Private
Penal law
law

judicial usury
contract property commerci
process prohibitio
law law al law
law ns

civil degrees
bankrupt- special
procedure governing
cy code laws
code registers
0

The rules governing the "creation of security interest", in other words the specification of the
asset pledged as collateral, differ from one legal system to another. In Uruguay, for example, the law
requires that property be in all cases enumerated, which can pose a problem with cattle or
merchandise-based contracts (World Bank, 1994 and Fleisig, 1995a, p. 2). Other legal systems
allow for floating pledges where the generic contents of a specific warehouse are pledged
(Büschgen, p. 719).

Once an asset is specified the lender wants to know whether the borrower is really the
owner of the asset. This is a question of documenting property rights reflected, for example, in land
registers. The verification of ownership titles can pose problems if registers are outdated,
incomplete, inaccessible, not transparent, costly to consult. Fleisig quotes the cases of Bolivia and
Uruguay where it is "extremely difficult to search the records for prior claims against collateral"
(1995a, p. 2). In fact, USAID's Collateral Law Reform project in Eastern Europe has singled out as
one of its three objectives the need to develop registries that help "determine whether another lender
has a prior claim to the collateral".

The law of judicial process becomes relevant after a loan contract has been concluded and
collateralized and once the borrower's non-repayment gives rise to the lender's decision to seize
collateral. The law of judicial process determines the terms and conditions of enforceability of claims
based on collateral by way of:12

12
It is one of the intriguing features of commercial banks to insist on land titles, although they are fully
aware of limitations to the social and practical enforceability of claims based on such titles.
Collateral, collateral law and collateral substitutes 19

− lengthy (and hence costly) judicial procedures;

− requirements limiting or excluding direct action by the lender against the borrower (court
orders);
− a limitation in the access to accelerated court orders;
− exemptions of parts of property from repossession (homestead clauses).

In contrast to these extensive civil law dispositions, the public law is rather mute on collateral
as a specific issue. Germany's law governing credit activities of banks, for example, does not refer to
the securization of loan transactions at all. Neither the principle nor the forms of collateral are
explicitly prescribed. Neither the Federal Office for Banking Supervision nor the Bundesbank set
limits to or allow exceptions for the extent and nature of collateralization, whether in individual loan
transactions or in the entire loan portfolio of banks. It is the responsibility of primary banks to look
after the security of their portfolios.

However, to the extent that Central Banks oblige banks to differentiate between assets
secured by different degrees of repossession and registration facilities and declare as high-risk those
loans secured by collateral substitutes, Central Banks regulations indirectly affect collateral-taking as
well, because banks would be compelled to increase their capital base to meet the minimum capital
adequacy requirements of the Basel Accords (V. White, USAID).

Collateral and the German Law on banks and financial institutions (KWG)

The Swiss Banking Law (8.11.1934) stipulates in article 4 that a bank's exposure in terms of loans and
advances has to be in proportion to its equity. This is further detailed in the Banking Decree of 1972. Article 12
defines which assets have to be weighted by what % age to allow the calculation of the equity requirement (of
8%). This classification gives an implicit ranking of different forms of collateral: for example, the borrower's
financial assets held by the same bank are not at all discounted for risk, in other words they represent the most
preferable form of guarantee (12a, 1.4-1.5); while options and futures are discounted at 25% for the purposes of
calculation of equity requirement, mortgages at 50%, receivables from banks outside of OECD countries at 100%,
etc. While this grading/ranking reflects the supervisory organs' (Bank Commission) perception of the ease of
execution, enforcement and liquidation of different forms of assets, it does not have a normative, binding effect
on the way banks take particular types of collateral or exclude the use of other types.

Collateral and the Swiss Banking Law

Paragraph 18 of the KWG stipulates that under certain conditions banks may be entitled to forego the
presentation of detailed and complete financial statements from their potential clients, namely when and if it
would be unfounded to do so in view of the quality of collateral provided. The decree of application explains
further that certain forms of collateral can generally be considered for this possibility, namely: mortgage papers,
financial assets (shares, bonds, participations, sight and term deposits, life insurances): however, always with a
certain discount varying between 25 and 40% of the nominal value of the assets. Other forms of collateral can
also be considered for this exemption provided their realization covers principal and interest "under all imaginable
circumstances". Chattel mortgage and assignment for security, however, can only in exceptional cases be
considered a valid justification for not requiring financial statements.
20 Collateral, collateral law and collateral substitutes
3. Collateral law and collateral substitution: Limitations and scope
from the point of view of small borrowers

3.1 Does collateral law work?

A "good" collateral law should:

− encourage the conclusion of many financial contracts (density);

− broaden the financial sector by making it more accessible (access);

− and at the same time maintain or even raise the general level of financial contract security
reflected in a fairly low default rate and limited default losses across the financial sector
(quality).

Collateral law can contribute to financial sector broadening by allowing for substitution
arrangements to the benefit of borrowers with solid investment proposals but without assets
(basically the situation of first-time borrowers); collateral law can secondly enhance the densification
of loan contracts by minimizing the transaction costs involved for borrowers and lenders in creating,
perfecting and enforcing security interests (basically the situation of borrowers with a certain loan
record but still undercollateralized, i.e. small and medium-sized enterprises).

3.1.1 Does collateral law influence substitution?

The banks and financial NGOs in Malaysia, Indonesia and the Philippines interviewed in the
framework of an ILO/APRACA survey declared that they did not consider themselves really
constrained by legal or regulatory dispositions in experiments with collateral innovations. Institutions
in Indonesia, however, added that they felt encouraged by the Financial Sector Reform in the late
1980s (see box on Bank Indonesia/GTZ) which allowed them some flexibility in dealing with NGOs
as subcontractors or wholesale agents. The sort of encouragement that they would like to get from
public authorities was in terms of guarantee funds and other risk-sharing arrangements, i.e. had little
to do with the law.
22 Collateral, collateral law and collateral substitutes

Linking banks and self-help groups in Indonesia

The Project Linking Banks and Self-Help Groups (PHBK) aims to improve the availability of financial
services in rural areas by promoting and supporting linkages between banks and self-help groups (SHG). The
project is being implemented by Bank Indonesia with German technical assistance since 1988.

Indonesian Bank Regulations (UU7/1992) require banks to assess borrower creditworthiness,

independently of the kind of collateral offered. Collateral substitution within the framework of this project and in
Indonesia generally, has benefited from the legal and regulatory environment: for example, since 1992, projects
with credit secured by collateral substitutes have received the same valuation by Central Bank authorities as
those with traditional securities. Also the norms for the registration of financial self-help groups, the legal
procedures for the registration of SHGs, and the establishment of rural banks (BPR) in villages have been
simplified.

Backed by the new Indonesian banking law, PHBK supplements traditional physical collateral with
alternative collateral like joint liability and peer pressure.

The key lesson is that collateral substitutes can be highly successful in a linkage approach - provided
the legal and regulatory environment incentive-oriented.

Source: GTZ

3.1.2 Does collateral law exacerbate credit rationing?

High transaction costs in connection with specifying, validating and realizing collateral may
ration out smaller- and medium-sized borrowers. This is not at all unlikely, considering the way the
law in many countries is administered. Often the institutions for the enforcement of claims do not
exist (bailiff, courts) or, if they exist, they function too slowly. Rational lenders will require only
collateral that can be liquidated without court orders, i.e. financial assets in the possession of the
lender. This could have a rationing effect on small businesses to the extent that they do not have
financial assets to pledge (except savings deposits).

In most countries, the legal execution of claims into moveable property requires the
intervention of a bailiff; the bank as creditor has to have already a writ of execution (for example a
court judgement) or a title deed (i.e. a document with an immediate executory effect, signed and
recognized by the debtors) in order to obtain satisfaction by the bailiff. Again, to the extent that
smaller clients do not have such titles, one could say that the law reinforces an existing rationing-out
effect.

Furthermore, not all moveable property can be seized: paragraph 811 of the German Code
of Civil Procedure, for example, explicitly exempts from seizure tools, equipment and stocks of raw
Collateral law and collateral substitution: limitations & scope 23

materials essential for the continued operation of the debtors, in other words the assets that the
banks may have helped to finance and to which a lien may have been established. This will make
banks think twice about taking chattel mortgage in small enterprises, particularly if the courts tend to
interpret the homestead clause fairly broadly.

Not all receivables can be seized by virtue of a court order: claims against pension funds,
reimbursements of staff for costs incurred, paid annual leave of employees, untransferable claims are
exempted. These restrictions are not necessarily known to the bank. This could have a discriminating
effect on those borrowers that have primarily moveable intangible assets to pledge (receivables,
financial papers).

The legal execution into mortgaged property can be in the form of a bankruptcy sale or
sequestration (i.e. the administration of a house or a piece of land by the creditor allowing the
extraction of revenue out of the continued use of the asset). Both forms presuppose that the debtor
is clearly indicated in the land register and that the register is complete and up-to-date with regard to
prior claims to the same asset: again, the inefficient administration of registers may penalize smaller
businesses, because banks may refuse to proceed with verification while a larger-scale client may
get more attention if endowed with other, non-registered assets.

To sum up, the legal framework could conceivably hamper financial transactions when
lenders want to ascertain property rights and enforce claims, but are discouraged from concluding
the contract because of exorbitant, collateral-related transaction costs. There may be gains in
modernizing registers and simplifying enforcement procedures in situations where lenders, and
especially banks, would consider verifying the ownership of assets, provided the transaction costs
can be brought down to a level compatible with the size of the envisaged transaction.

However, not much is known empirically about the actual transaction costs related to
collateralization, neither in the formal nor the informal financial sector. Also, unexplored are the
relative effects on financial contracts of measures like introducing new laws (shortened stays in
court) or more efficient law administration (for example computerized registers).

3.2 How do collateral substitutes perform?

Genuine collateral substitutes (i.e. not marketable assets and para-legal or social
enforcement) are, for example:13

− peer pressure (group-based forms of collateral like joint liability);

24 Collateral, collateral law and collateral substitutes

− probation or credit-scoring (i.e. the threat of loss of access to future loans);

− interlinked contracts;

− co-maker arrangement without intended enforcement.

Since the primary function of collateral is to screen out and to protect against default risks,
then the repayment rate would be the first performance indicator of a collateral substitute. However,
repayment in isolation is not a meaningful indicator: clearly, lenders want to maximize repayment of
appraisal, monitoring and collection effort, all of which entail transaction costs. It makes sense to
take costs as a second criterion for measuring the performance of collateral substitutes, i.e. the
transaction costs for borrower and lender in selecting an asset, in using it and in realizing it, if
necessary, in case of default. Since the interest is to explore the conditions for bank-institutional
learning with regard to credit technologies, it seems plausible to take as third performance criterion
the extent to which collateral substitution has become a bank-internal habit, i.e. the extent to which it
has been mainstreamed, within a bank and perhaps even across the financial sector.

3.2.1 How widely are collateral substitutes being used?

Before looking at the performance of collateral substitutes, it may be useful to recall a few
facts that show that this is not a marginal or ephemerous phenomenon. In 1994/95, an
ILO/APRACA/SDC survey reviewed several hundred sample accounts in several banks and
financial NGOs in Indonesia, Malaysia and the Philippines to determine the extent of the use of
collateral substitutes and its effects. The types of collateral substitutes examined were: joint liability,
co-making arrangements and cession of professional licences or car papers. The
institutions/organizations participating in this exercise were primarily government-owned rural banks
(BPM in Malaysia, LANDBANK in the Philippines), cooperatively-organized rural banks (CRB
Laguna in the Philippines), private for profit rural banks (CR Calamba in the Philippines, BPR Shinta
Daya in Indonesia) and financial NGOs (TSPI in the Philippines and BINA SWADAYA and BPR
Jatiarta in Indonesia), all of which target credit at "small borrowers", defined in terms of loan size,
asset value, occupation, gender or a combination of these criteria.

With the exception of the Philippine TSPI programme, collateral substitutes are rarely used
in isolation, but always in combination with traditional collateral (or with what is considered to be a
substitute, but is in actual fact a traditional collateral, i.e. blocked group or individual savings).
Collateral substitutes are being used both within special schemes and in "mainstream" operations; it is
not clear whether the use of collateral substitutes in mainstream operations is the result of

13
In the real world, these forms are often intertwined: the group exerts pressure on the defaulting member
precisely because the sanction is to be cut off from a future supply of credit, not because the bank executes and
repossesses into other group members.
Collateral law and collateral substitution: limitations & scope 25

experiences made in special schemes. The institutions put partly own resources at risk. The survey
found consistently a strong correlation between loan size and use of collateral: the larger the loan, the
more likely a traditional collateral requirement (Haryadi and Ramli, p. 18; Casuga/Hernandez, p.
26). Assuming that new entrants to the financial market are more likely to demand comparatively
smaller loan amounts, then this correlation could signal that collateral substitution provides a bridge
for first-time, small-scale borrowers.

Collateralisation related to loan size

ILO/APRACA

collateral substitutes collateral

140
120
100
80
60
40
20
0
0 20 40 60 80 100 120 140
Number of accounts Loan size (in thousands Philippine Pesos)

0
Group guarantees based on peer monitoring are the collateral substitute most widely used,
particularly in several Asian countries. Evidence from Thailand and India shows that the majority of
titled farmers have provided land as collateral while untitled farmers offered group guarantees to
obtain bank loans (Huppi/Feder). Thailand's Bank for Agriculture and Agricultural Cooperatives
(BAAC) is well known for its extensive use of joint liability groups. "In 1984-85 a total of 628,194
clients made 773,233 loan contracts based on joint liability security. These clients represent 13% of
all farmers in Thailand, 48% of all farmers registered as direct clients of the bank and 80% of all the
direct clients who borrowed during that year. . .; joint liability loans disbursed were US$280 million,
i.e. 44% of all BAAC's disbursements" (Tohtong, p. 5). Grameen Bank's "general loans" are entirely
secured by joint liability groups (Khandker, pp. 8 and 22): they made up 81.6% of its total portfolio
in 1992.

Outside of these well-known examples, collateral substitution is also pervasive in the

informal and semi-formal financial institutions: the review of sources of credit for the rural poor in the
Gambia (Zeller et al., pp. 176-177) found evidence of collateral substitution (social pressure) in
credit unions, NGOs and the informal financial sector, interlinked contracts in credit unions, while
26 Collateral, collateral law and collateral substitutes

commercial banks accepted only real estate titles. The USAID/AITEC supported ACCION
affiliates are also entirely built on the solidarity group concept: "no one in the group can have access
to a new loan until the whole group has repaid the previous one" (Otero, p. 6).14 USAID's analysis
of 11 of its own microfinance programs suggests that experiments with collateral, including its
genuine substitution, are typical of a successful micro-finance lending methodology, be it complete
substitution with peer pressure as in the solidarity group and village banking approaches or partial
substitution as in the individual lending approach (Christen/Rhyne/Vogel, p. 17).

Caja de Ahorro y Prestamo Los Andes S.A.: Concept to solve the collateral security problem in the urban
informal sector in Bolivia

Urban micro-enterprises in Bolivia are practically excluded from access to credit in the formal financial
sector because of the lack of conventional collateral and inadequate legal remedies. Since 1991, the Caja de
Ahorro y Prestamo Los Andes (until 1995: NGO Procredito) has been implementing, supported by German
bilateral technical assistance, a credit technology adapted to the situation of small-scale enterprises in the
informal sector to solve the collateral problem. The Caja has been administering a credit volume, at the end of
1995, of some US$6 million, consisting of about 16,000 single credits. With an average loan amount of less than
US$500, the Caja is serving mostly the poorer groups of micro-enterprises.

In contrast to the traditional collateral usually requested by commercial banks, such as mortgages, the
demand for collateral under this programme is limited to anything of value that can easily be given by the
borrower. Assets of the enterpris e to be financed (including working capital and merchandise) and household
goods (e.g. TV, HiFi, sewing machines, jewels) are accepted as collateral. Of crucial importance is that these
goods have a certain (replacement) value for the customer, be it material or even non-material, and that the threat
of repossession is serious should the borrower fail to repay the loan. It is of secondary importance whether in
case of default all claims by the creditor are fully secured.

The sanction mechanism is occasionally also combined with a probation approach: initially, relatively
small loans are provided below the customer's borrowing ability. If the willingness to repay has been
demonstrated by means of timely repayments the borrower can be given access to more substantial credits. At
the end of 1995, the share of credit repayments outstanding for more than 30 days amounted to only 0.5% of the
portfolio. Every credit analyst handles a portfolio of 266 clients; the administrative cost represent 23.9% of the
credit volume. The Caja has been operating on a cost-recovery basis since 1994.

Source: GTZ

14
In both cases, however, the notion of joint liability does not mean that the bank would actually threaten
to execute into any group member's moveable or unmoveable property, whether he is the defaulting member or
not; the sanction is rather the prospect of no longer having access to credit. This diluted form of joint liability is
actually a mix of social pressure and probation.
Collateral law and collateral substitution: limitations & scope 27

3.2.2 Peer pressure

3.2.2.1 In terms of repayment 15

The ILO/APRACA/SDC survey found that, in terms of collection and past due ratios,
collateral substitutes produce equivalent (and in the case of the BPM in Malaysia, even superior)
results compared to collateralized loans. A review of 15 group lending schemes applying the peer
pressure technique (Huppi/Feder) found that the repayment enforcement mechanism was effective; it
worked particularly well if the lender is perceived to be able to provide such services over a longer
period of time. Other factors of success were: small group-size, homogeneous, self-selecting groups,
common bonds, mandatory savings, regular repayment schedules with fairly small investments. The
main finding is that while "experience does not clearly indicate whether lending to individuals or
lending to groups as a whole yields better results, . . . practice has shown that joint liability has
positive effects on repayments if certain conditions are met" (Huppi/Feder, p. 22).

Joint liability loans represent the largest share in the entire portfolio of Thailand's BAAC
from 1987 onwards, reaching in 1993 a level of close to US$1 million in loans outstanding. The
repayment rate increased from 77% in 1987 to 90% in 1992 and was generally superior to the
repayment performance of all other BAAC loan types (cooperatives, mortgage, special projects),
except paddy pledging (BAAC, p. 15).

In 18 ACCION affiliates operating with the solidarity group principle, "the average level of
arrearage was about 12%" (M. Otero, p. 12), with a range from 0% to 26%. Grameen Bank
reported recovery rates of 95% in 1991 (Khandker, p. 23).16 The Grameen Trust reports for 29
Grameen Replication projects repayment rates between 59% (ASKI, Philippines) and 100% as of
November 1995. In 8 minimalist NGO programmes in Kenya, also employing the joint liability
model, the repayment rate varied between 78% and 100% (Kesterton, p. 17).

BRI Unit Desa and BKK are two well-known micro-finance institutions in Indonesia. Both
operate in rural areas of Central Java, the former catering to better off clients who can pledge land

15
Strictly significant would only be a comparison between a batch of loan portfolio that is conventionally
secured and another part that is secured with a collateral substitute. However, with a few exceptions, this intra-
bank comparison is not documented; and even if such data were available, the usual multi-variate limitations
would apply.
16
Yaron (Successful Rural Finance Institutions, 1991) points out that Grameen Bank uses a fairly broad-
minded definition of arrears, namely one year past due, which makes the recovery rate look better. According to a
KfW evaluation of 1994, Grameen Bank treats as "arrears" those amounts that are not repaid after even two years
past due! (point made by W. Neuhauss, KfW).
28 Collateral, collateral law and collateral substitutes

and comparable assets, while the latter's loans are unsecured. In terms of long-term loss ratio, they
compare as follows (December 1987): BRI Unit Desa: 1.35%; BKKs: 1.98% (Patten/Rosengard,
p. 96). More recently (1990, Yaron, Successful RFIs, p. 30) BRI Unit Desa and BKK had annual
loan collection rates of 95% and 80% respectively. From 1992 to 1994, BRI's Division of Village
Units registered past due ratios of 9.1%, 6.4% and 4.4% respectively (Indonesia report of
ILO/APRACA project, p. XX).

Eleven micro-finance programmes, using the solidarity group approach or the individual
lending technique compare in terms of loan delinquency rates (defined as outstanding balances of
loans with payments late over 90 days) as follows (Christen/Rhyne/ Vogel):

Loan delinquency rates of solidarity group approach and

individual lending technique

Individual lending
Joint liability
without collateral

Grameen 0.0% BKD (Indonesia) 10.3%

K-REP 0.0% LPD (Indonesia) 3.9%

ADOPEM 4.0% BRD (Indonesia) 20.0%

FINCA 1.7% BRI 6.5%

CORPOSOL 1.3% ACEP 3.0%

BANKOSOL 0.0%

Source: Christen/Rhyne/Vogel

0
The Small Farmer Development Programme (SFDP) and the Production Credit for Rural
Women (PCRW), both in Nepal, are also using almost exclusively joint liability as a credit delivery
technique, but much less successfully. Here the repayment performance is less impressive: SFDP
reported 33% of "estimated bad debt losses of principal incurred on each year's disbursement"
(Bennett, p. 16), while PCRW failed even to disclose its performance.

More recently, the longer-term solidity of peer monitoring as a screening and sanctioning
mechanism has been put into question. Over time, successful joint liability schemes appear to lead
inevitably to internal power rifts, thus eroding internal social control while attracting alternative
sources of credit supply in the local financial market, thus undermining the effectiveness of scarcity as
an incentive (Yaqub, p. 10).
Collateral law and collateral substitution: limitations & scope 29

3.2.2.2 In terms of transaction cost

Transaction costs matter in the entire loan cycle, but in particular with regard to
collateralization, this applies to both lender and borrower transaction costs. A review of the
administrative costs incurred by different types of financial institutions in the Philippines showed that
lender costs related to loan recovery amount to about half of total lending costs (including
advertising, promotion, planning, loan processing, monitoring) (Llanto/Chua), independent of the
type of supplier (commercial banks, rural banks, cooperative rural banks, multipurpose
cooperatives). This suggests that the selection of the collateral instrument has considerable cost
implications for the lender, particularly with regard to enforcement and recovery. Even in the
informal financial sector, "screening and enforcement costs are about 14% of marginal costs of
lending operations" (Hoff/Stiglitz, p. 244). The question is, therefore, at what cost good repayment
performance?

Some collateral substitutes, like "joint liability", come with cost advantages, namely by
reducing lender transaction costs through externalization to a group of prospective borrowers.17
Rather than selecting the credit risk itself, the bank relies on the self-selection mechanism in joint
liability groups. Llanto/Chua found that the involvement of NGOs in group formation and training
increased transaction costs by approximately 20%. This cost advantage to a bank can be further
enhanced when − as in the Grameen Bank − the collateral instrument is actually just the threat of
calling on the joint and several liability, but not execution, repossession and seizure into the property
of group members, all of which obviously would be fairly cost-intensive.

Of course, joint liability does not eliminate all lender transaction costs (somebody in the
bank has to check on the previous repayment performance, the group still has to be notified of
arrears and default by correspondence or visits, group-internal differences might require the
mediation by the loan officer, etc.), all of which still entail some administrative costs to the bank. Yet,
on the whole, a bank is probably better off with a delivery mechanism that externalizes costs (and,
even better, risks). The review of group-lending schemes by Huppi/Feder finds evidence of scale
economies provided "lenders are not required to carry group formation costs" (p. 25).

Whether borrower transaction costs in joint liability exceed those required by more
conventional forms of collateral is an open question. A financial NGO in the Dominican Republic
that operated group-based lending and individual lending at the same time observed that "group
members lost less total work time and . . . less on travel expenses than individual borrowers. The
opportunity cost of time taken . . . amounted to only RD$75 for the group, while the same costs for
the 10 individual loans totalled almost RD$400." (Adams/Romero, p. 10). This would seem

17
This is not to be confused with the argument that "group lending" reduces a lender's transaction costs
in terms of lower per unit costs (Feder/Huppi, 1989); what is meant here is the comparison between transaction
costs involved in establishing conventional security interests and those involved in establishing substitute
security interests.
30 Collateral, collateral law and collateral substitutes

plausible because of "savings in fees for collateral registration, expenses on certificates needed for a
loan application and on time and transportation costs of visiting lenders" (Huppi/Feder, p. 26). This
would suggest that from a cost perspective, a borrower could be better off with joint liability.

On the other hand, the comparisons of group vs. individual lending should also take into
consideration the costs of default of another group member and the longer term opportunity and
transaction costs if a member or a group is definitely deprived from the access to credit as a result of
default. To become a member of a joint liability group makes sense for a rational microentrepreneur
if the return to the investment financed by a loan exceeds the transaction costs involved in getting the
loan and if there is no alternative available to obtain the loan at lower cost. The stability of joint
liability groups would positively signal such a utility.18 However, not much reliable data is available to
say with certainty whether borrower transaction costs in joint liability schemes are lower or higher
than in other collateralization modes (if at all available!).

3.2.2.3 In terms of building up durable bank-client relations

and in terms of mainstreaming

If the underlying idea of collateral substitution is to facilitate access to the formal financial
sector or at least to a regular flow of credit, then the longevity and institution-internal mainstreaming
of such arrangements are also indicators of whether collateral substitution works. The question is
whether, based on fairly satisfactory results in terms of repayment and transaction costs, a bank
continues to accept a substitute, thus making it over time into a perfectly normal screening, incentive
and enforcement device.

Bank Pertanian Malaysia, for example, uses joint liability as a risk protection device over 25
years. Other financial institutions in the Philippines and Indonesia surveyed in the ILO/APRACA
project, use joint liability more or less extensively since years:

18
Notwithstanding the observation made in Thailand where people form joint liability groups although
they do not even need credit nor intend to apply for it (Steinwand, p. 43).
Collateral law and collateral substitution: limitations & scope 31

Philippines
Land Bank 4 years
Cooperative Rural Bank Laguna 17 years
LBP Batangas 4 years
Rural Bank Calamba 18 years
Indonesia
BPR Shinta Daya 6 years
Bina Swadaya 28 years
BPR Jatiarta 2 years

Grameen Bank, the ACCION affiliates, K-REP, etc. also have been operating with joint
liability over a sufficiently long period of time to be evidence of at least limited institution-internal
acceptance. It is true, none of the above institutions are "normal" banks: either they are government-
owned rural banks, or NGOs transformed into banks or NGOs/self-help organizations/cooperatives
with financial functions.

3.2.3 Probation

Peer monitoring works as a screening and risk protection device, provided groups have
reasons to be concerned about a future supply of credit and if alternative sources of credit supply on
comparable terms and conditions are not available. The "security interest" here is the repayment
performance of every group member in the present. Such a security interest based on rational
expectations does not necessarily have to be group-based, it can also work in the transaction with
an individual borrower. Provided the lender has the capacity to increase loan sizes continuously and
in relation to the absorption capacity of the borrower, there are a number of incentives that have a
similar screening and risk protection effect as peer pressure. The lender can offer to the borrower
prospective incentives in subsequent loan transactions, like:

− continued access to the same flow of financial services;

− a rebate on future interest payments;
− progressively larger loan amounts;
− a more flexible repayment schedule;
− or a combination of the above.

Probation can also be considered as a genuine substitute because the pledge that secures a
loan is simply a promise, there is no asset of any commercial value. The borrower does not pledge
anything other than his/her good will to pay back the loan in time.19

19
Of course, as Hoff/Stiglitz (p. 240) have pointed out, this has only an incentive effect if the borrower can
expect to get a surplus out of a debt contract; which in turn requires that the interest rate cannot be too high.
32 Collateral, collateral law and collateral substitutes

Compared to "peer pressure", in joint liability arrangements there is much less information on
how "probation" performs as a device to ensure repayment, what the transactions costs are for
lender and borrower and whether it has become a major loan securization technique in any regular
bank. Among the few documented micro-finance programme using the probation approach is
PROCREDITO in Bolivia (see box on p. 25). Several micro-finance programmes in Indonesia
(BKK, P4K, LDKP, BPR Sempoerna) and the Philippines (KMBI, BASIDECO) also operate
with probation of individual borrowers, BRI/Kupedes is perhaps the best known example. BRI's
policy is to demand collateral whenever this is realistic,20 but otherwise it allocates unsecured
individual loans in very small amounts (starting from US$ 100) that are renewed with progressively
larger amounts if the repayment performance in the preceding period was satisfactory. In 1993, BRI
registered an overall loan delinquency rate (volume of outstanding balances payments late over 90
days) of 6.5% (Christen/Rhyne/Vogel, p. 3); available data does not allow to segregate the BRI
portfolio by type of collaterization to see whether the unsecured portion performed better than the
collaterized portion. BKKs and KURKs in Central and East Java also operate with a probation
technique based on interest rebates and progressively increasing loan size. In 1992, they reported
arrears rates of 2.1% and 9.7% respectively (Mosley, pp. 5-7).

In terms of transaction costs, probation would seem to be fairly attractive for the borrower
since collateral transaction costs are limited to direct dealings with the bank: there are no group
sessions to attend. For the lender, on the other hand, probation with its short loan cycles involves
intensive performance monitoring and hence probably some administrative costs. It would seem
plausible that they even exceed the costs incurred by the lender when dealing with joint-liability
groups. Why then would a bank like BRI use this collateral substitute? One reason could be that
probation lending concerns only a marginal portion of its portfolio which means that losses can be
easily cross-subsidized. Another consideration could be that risk exposure of unsecured lending is
bound by the small amounts of debt exposed and by the fact that short loan cycles signal
underperforming assets fairly early. It would be interesting to explore this further in view of the scope
for institutional learning and the increasing popularity of credit scoring for consumer loans in
developed financial markets.

3.2.4 Interlinked contracts

Another collateral substitute are interlinked contracts. They are quite common in the informal
financial sector of many countries, including in industrialised countries (dei Ottati, pp. 534-543).
They are based on the principle that "lenders who are landlords or merchants may use the
contractual terms in these other exchanges to affect the probability of default" (Hoff/Stiglitz, p. 240).
Interlinked contracts can be considered a genuine substitute since the incentive (reduced input price)
Collateral law and collateral substitution: limitations & scope 33

or the sanction (longer working hours, reduced wages) has, to the bank, no cash value: this incentive
respecting sanction cannot be negotiated and liquidated in the market nor enforced in courts.

Practically, however, interlinked contracts do not play a major role as collateral substitutes;
banks tend not to intervene in the local labour, input or produce markets. The closest that special
banks like Grameen or financial NGOs come to "interlinking contracts" is the exclusion of a
defaulting borrower from participation in training, advisory or other non-financial services that are
occasionally provided along with credit; even these services are not provided on the basis of
contracts, strictly speaking. Also, in order to function as an incentive and enforcement device, the
borrower must believe to derive considerable benefits from training and other non-financial services,
so that the ejection from the credit circuit is effectively perceived as a deprivation. The only type of
institution that has internalized inter-linked contracts to some extent are multi-purpose cooperatives,
which can ensure repayment by sanctioning the defaulting member in non-financial transactions.

In many instances, the reference to interlinked contracts in the context of bank operations is
loose language. What is often meant is "assignment of future income" to the bank, i.e. a perfectly
normal collateral instrument.

Again, not much is known about the performance of interlinked contracts seen as pure
repayment enforcement device, nor about total transaction costs involved nor about cases where
some specialized financial institution would have systematically resorted to such an arrangement. This
is probably due to the fact that interlinked contracts are a complex socio-economic arrangement to
secure labour supply, maximize rents and respond to input fluctuations. It is difficult to isolate the
collateral function within this complex socio-economic context. Another reason for the obscurity
surrounding inter-linked contracts may be the exploitation that is hidden behind such a contract.
Land owners, traders, moneylenders, but also the indebted labourers will be reluctant to disclose the
nature of the contractual arrangement.

Be that as it may, the subject merits further investigation from an equity point of view, even if
a full-fledged replication by specialized financial intermediaries does not seem feasible.

3.2.5 Co-maker arrangements without intended enforcement

The last collateral substitute reviewed here is an arrangement similar to a personal guarantee.
In contrast to a regular personal guarantee, the creditor has in this arrangement from the beginning
no serious intention to execute into the guarantor’s property. The guarantor's signature has only an
enforcement effect on the debtor; it obliges the borrower to pay back a loan, otherwise the good
reputation would be affected.

20
According to W. Steel, BRI (Kupedes) "requires fixed property (farm land) as collateral", but not
necessarily for the full amount of the loan.
34 Collateral, collateral law and collateral substitutes

Illustrations of this type of collateral substitute can be found in the BPD programmes in
Indonesia, of which the Badan Kredit Kecamatan (BKK) in Central Java is the best-known. It
requires that a borrower obtains the signature of the village head and of a co-signer (Rhyne, p. 7).21
The co-signer in the BKK programme can even be co-opted into the system by a "performance
bonus" dependent on the profitability of the local BKK unit (Mosley, p. 28). Co-signing, often in
combination with probation, is a feature also in the SEWA, UNO, PRODEM, ADMIC, and other
programmes (Dessing, pp. 56-58).

Again, while anecdotal evidence seems to suggest that the system works well (GTZ), the
information about the actual performance (by whatever standard) of this collateral substitute is
unsystematic or dated. It would be of interest to probe further into the stability of arrangements
involving local hierarchies with increasing mobility of the rural population.

21
A different view is put forward by Pearson/Garland (p. 5), according to whom "signatures . . . from
village officials are insufficient in vouching for a person's character . . .; village leaders have capitalized on the
feeling of indebtedness that comes with the approval for a loan" which has brought to the programmes
borrowers with questionable character”.
4. Findings

While the report failed to find a magic formula in the collateralization of small-scale financial
contracts, it has identified the parameters under which lender and borrowers make decisions about
the extent and modalities of loan securization. It was found that transaction costs play a major role
for both contracting parties. Not much is known about those collateral-related transaction costs. The
report has also identified some obstacles to the replication of collateral substitutes normally
associated with the informal sector and non-banks. The review of the performance of collateral
substitutes concluded with a list of items that need to be further investigated.

The most important specific findings were:

1. Collateral deficiencies are an important constraint for very small-, small- and medium-sized
enterprises, but in different ways: while the absence of assets that can be pledged is a major
constraint for micro-enterprises, it is the transaction costs for both borrower and lender in
establishing and especially enforcing security interests of available forms of collateral that represent
an important obstacle for small- and medium-sized enterprises.

2. Lack of collateral can be a constraint also for the lender, namely in a situation when a loan
would have been processed, had it not been for high transaction costs associated with the form of
collateral offered by the prospective borrower, that cannot be absorbed or otherwise externalized.

3. The informal financial sector is not an island of collateral-free lending. Whether or not
collateral is taken in the informal sector depends on the professionalization of the lender, location,
the loan size and the familiarity of the contracting parties: at any rate, collateral is taken. For this and
other reasons, it is not clear whether informal lending practices are always a reliable guide for the
introduction of uncollateralized lending in the formal financial sector. Collateral-free lending in the
informal financial market is accompanied by a fairly high level of interest rates, which may be
impossible to charge by banks and other supervised financial institutions.

4. Adverse selection problems could very well exist also in connection with collateral-taking: is
it the most serious and trustworthy borrower who provides the most compact collateral protection?

5. Collateralization is closely linked to loan size: the larger the loan, the more likely is a
collateral requirement; however, the cost of establishing and enforcing security interest is not
necessarily related to loan size, but contingent on borrower characteristics and the legal and
regulatory framework.
36 Collateral, collateral law and collateral substitutes

6. The anticipation by the lender of major transaction costs in connection with cumbersome
judicial process to liquidate certain types of collateral may have the side effect of further rationing out
loan transactions with SMEs.

7. The entire range of collateral instruments is available only for few borrowers; among those
instruments available, borrowers prefer those with minimum transaction costs, nuisance, incidence on
business and social exposure shame. Lenders prefer collateral instruments that are easily marketable,
rapidly appropriable and entail hardly any transaction costs.

8. There is a wide range of views of what "collateral substitutes" means: some emphasise the
extent of replacement of a conventional form of collateral; others focus on the method of
enforcement (legal, para-legal); yet others the marketability of the pledged asset. Some propose to
use the combination of these features as qualities of a genuine substitute. In view of their incidence
on small and micro-businesses' access to credit, two criteria are retained for the purposes of this
report, namely enforceability by extra-legal means and zero marketability.

9. Some collateral substitutes like joint liability, probation and informal co-maker arrangements
seem to provide access to the financial market for first-time borrowers; group formation and other
intermediary functions taken over by an NGO or self-selection mechanisms help reduce and
externalize lender transaction costs.

10. Bank acceptance of collateral substitute is enhanced by two factors: scope for externalising
transaction costs (self-selection or group formation by a NGO) and the freedom to compensate for
the supplementary risk by a premium on top of the interest rate.

11. Government-owned banks, NGOs that have transformed into banks and financial NGOs
have been found to use collateral substitutes, but usually not commercial, private banks.

12. Collateral substitutes seem to perform equally well − if not better − than conventional
collateral in protecting lenders against default. This applies particularly to peer monitoring which is a
substitute that has been successfully used in a number of financial institutions, primarily in Asia, over
a considerable span of time: this applies to special schemes with external refinancing resources and −
more significantly − to mainstream operations on own resources.

13. Collateral is governed by different legal fields: there is no collateral law as such; civil law (or
rather the way the law is administered in contract law, property law, bankruptcy law, law of judicial
process). Public law and Central Bank regulations are surprisingly unspecific about collateral issues.
Findings 37

14. Collateral law influences the choice of collateral instruments by contracting parties via the
way judicial process, registers and other dispositions are administered, entailing projection and
anticipations of more or less substantial transaction costs for both borrower and lender. In some
cases, Central Bank decrees have been found to play a role in disseminating information about
extra-legal enforcement mechanisms, thus indirectly encouraging financial institutions to deal with
first-time borrowers.
5. Conclusions

1. Not all forms of collateral are equally accepted by banks: their preference is determined by
present and anticipated transaction costs in establishing and enforcing property rights, the ease of
liquidation and the position vis-à-vis other creditors in case of insolvency. Because of differences in
legal systems and local markets, there are considerable variations within and among countries.

2. Lack of collateral is a major constraint for small- and micro-enterprises, and especially new
entrants to the financial market; it is also a constraint for banks to the extent that it prevents the
financing of (probably) safe small-scale investments. Lack of collateral is also a concern for public
authorities supervising the financial sector in the sense that it may lead to a suboptimal flow of bank
credit to certain sectors of the economy.

3. In principle, there is a close link between loan size and the extent and quality of
collateralization: the larger a loan, the more the bank will be inclined to require a form of collateral
that retains its value over time and and that can be easily sold, taking into account the respective
transaction costs involved.

4. Transaction costs in connection with collateralization can be considerable. Banks try to

externalize some of these transaction costs to the borrower or to an intermediary; banks also seek to
compensate for insufficiently attractive collateral by charging higher interest rates, wherever that is
possible.

5. Confronted with the lack of collateral, several intermediaries have tried to come up with
"substitutes". The definitions of what constitutes a "collateral substitute" differ. For the purposes of
this report, a genuine collateral substitute has two characteristics: it is not enforceable through the
formal judicial process and it cannot be sold in a market.

6. The best-known examples of collateral substitutes are peer pressure, probation (credit
scoring), interlinked contracts and co-maker arrangements without intended enforcement. For some
institutions, collateral substitutes have become the major loan securing technique, and this over a
fairly long period. Whether they are effective or not is a question of repayment performance by
borrowers, transaction costs and bank-internal acceptance ("mainstreaming").

7. Peer pressure and probation (credit-scoring) are fairly well documented substitutes: peer
pressure (joint liability arrangements) is widely used by financial NGOs, government-owned banks
and rural banks. Its performance in terms of ensuring adequate repayment is not inferior to more
conventional instruments. Probation mechanisms (credit-scoring) for individual borrowers are less
40 Collateral, collateral law and collateral substitutes

widespread, but appear to function equally well. Little is known about the transaction costs involved
in the four substitutes reviewed.

8. Further work is required on collateral-related transaction costs, the stability of joint-liability

groups and the actual extent of collateral-free credit-scoring. Such work should cover both bank-
internal cost functions and external factors like judicial process in connection with repossession and
registers. Donors can play a key role in integrating collateral issues in financial sector reform and
liberalization programmes. The dialogue on collateral issues should involve banks, public authorities
(including Central Banks), support NGOs and representative organizations of micro and SMEs.

Open issues

− Can efforts to reduce transaction costs due to judicial process be efficiently combined with
the identification and wider use of collateral substitutes?

− Do modifications of collateral in the legal and regulatory environment also affect micro-
finance outside the formal financial sector?

− Is there a link between the degree of targeting and the use and effectiveness of collateral
substitutes? And if so, what are the implications for governments and aid agencies that
impose or suggest targeting?

− If banks could charge any interest rates to compensate for the risk of undercollateralized
lending, would that make a difference to the volume of small-scale businesses (K. Hoff, p.
238; World Bank)?

− Would efforts to mobilize savings make collateral substitutes redundant? Or policies to help
the shift from real to financial savings (van Rijn)?

− Why is it that leasing, hire purchase arrangements, franchising are not more extensively used
as "collateral substitutes" (van Rijn, Steel)?

− Accepting that there is a (social) benefit to increased market access of undercollateralized

MSE, what kind of incentives are most effective for banks that come up with innovative
approaches to collateral or that subcontract NGOs which themselves operate with collateral
substitutes?
Conclusion 41

Recommendations

Central Banks

− Collateral substitutes are for first-time borrowers a bridge to the financial market; in view of
the scope of collateral substitution for financial sector broadening, public authorities and
especially Central Banks may wish to collect data about ongoing experiments and open a
dialogue with commercial banks.

− In particular, Central Banks may wish to set up observatories to study longer term changes
in the competitiveness of rural financial markets with the accompanying impact on joint
liability groups stability.

− Central Banks may wish to explore evidence of cost-reducing measures in connection with
collateral, for example staff incentive schemes, subcontracting to non-banks and
decentralization of approval authority, etc., and then inform the banking sector about the
results.

− Credit referral systems − if adjusted to small-size transactions − can play a major role in
accompanying collateral substitution; Central Banks could review the costs and benefits of
such systems and encourage their adoption within banking groups and across the financial
sector.

− It is not clear to what extent credit scoring is a genuine collateral substitute; in many banks,
especially in developed markets, it is a way to simplify and standardize transactions of a
repetitive nature, thus reducing transaction costs without, however, completely doing away
with the need to establish collateral; Central Banks could collect information on the
effectiveness of credit-scoring as a technique to minimize default risk and encourage banks
to learn more about it.

− Examine − together with banker associations and others − the effectiveness of (limited)
interest rate liberalization as a means to increase bank spread to compensate for special
risks.

Representative organizations of SMEs and microenterprises

To the extent that such organizations have members already with bank contacts − even if
these are precarious − their concern will be that banks accept available forms of collateral. As this
acceptance is largely determined by bank transaction costs, the interests of these organizations will
42 Collateral, collateral law and collateral substitutes

largely coincide with those of public authorities, i.e. provide banks with as much information as
possible about what works as collateral instrument at what costs. Vis-à-vis their members such
organizations should take a lead and disseminate accessible information about comparative costs
and benefits of collateral instruments.

Banks

− may not be well informed about the actual transaction costs and effectiveness of collateral
instruments (including collateral substitutes); they may wish to assess their transaction costs
with regard to specific collateral instruments, identify the scope for cost reductions and
implement them;

− should voice their concern to public authorities concerning unduly long judicial process in
connection with repossession and with the state of registers;

− in the light of experiences made within certain bank groups and by non-banks (NGOs),
banker associations could issue to their members leaflets on collateral substitutions (case
studies);

− may wish to examine the feasibility of expanding credit referral systems to smaller-loan
transactions;

− review the possibility of collateral-free credit-scoring.

Government (Ministries of Justice, Finance, Economy)

− should ensure that collateral law reform takes transaction costs aspects into consideration;

− should − in the framework of law reform − systematically review the scope for simplifying
existing procedures for establishing security interests, but also study para-legal instruments
used in connection with collateral substitutes (accelerated court orders, updated registers);

Policy and practical issues for donors

− Donor agencies may wish to become better and regularly informed of the significance of
collateral constraints for targeted micro-finance programs, especially the costs attributable to
the enforcement by judicial process of different forms of collateral.
Conclusion 43

− Beyond integrating collateral substitution into their financial sector development policies,
donors could initiate a dialogue with partner Governments on the need for specific collateral
policies (including law reform, administrative reform, creation of specialized intermediaries)
or the accommodation of collateral issues into the framework of other policies affecting the
financial sector, for example savings mobilization and interest rate measures.

− Donors and partner Governments aloke may have an interest to integrate collateral
substitution especially into financial sector reform measures, in the light of its impact on the
access of new entrants to the financial market.

The following grey areas that lend themselves for immediate further investigations have been
identified:

− borrower transaction costs in connection with different forms of collateral;

− factors that explain the reluctance of commercial banks to adopt more readily innovative
loan securization techniques (lacking competition, interest rate regulations);

− the effectiveness of the individual probation approach in terms of repayment rate, transaction
costs and borrower graduation;

− the mechanisms of interlinked contracts in multi-purpose cooperatives;

− mainstreaming of collateral innovations within and between banks;

− the effects of group drop-outs;

− collateral law with regard to the introduction of substitution and transaction costs.

After consultation of the members of the Donors' Working Group, the following priorities for
further work have been set:

1. Lender transaction costs of different forms of collateral substitutes.

2. Idem, but for collateral in general.

3. Borrower transaction costs in connection with collateral substitutes.

44 Collateral, collateral law and collateral substitutes

4. Effectiveness of collateral substitutes (other than peer pressure) like probation/credit

scoring/interlinked contracts/co-maker arrangements.

5. Effectiveness of peer pressure over time (group drop-outs).

 45

Glossary

Account: A detailed statement of the mutual demands in the nature of debit and credit
between parties, arising out of contracts or some fiduciary relation.

Assignment: The act of transferring to another all or part of one's property, interest, or
rights.

Bailiff: One to whom some authority, care, guardianship, or jurisdiction is delivered,

committed, or intrusted.

Chattel mortgage: A transfer of some legal or equitable right in personal property or

creation of a lien thereon as security for payment of money or performance of some other
act, subject to defeasance on performance of the conditions.

Collateral: Property which is pledged as security for the satisfaction of a debt. Collateral is
additional security for performance of principal obligation.

Collateral law: Largely civil law dispositions that affect the creation, perfection and
enforcement of collateral (security interests).

Collateral substitute: A pledged good, right or title that is neither marketable nor legally
enforceable, but works as an incentive, screening and sanction mechanism to ensure
repayment of a debt.

Conveyance: In its most common usage, transfer of title to land from one person, or class of
persons, to another by deed.

Co-signer: Person who signs a document or instrument along with another, often assuming
obligations and providing credit support to be shared with other obligor(s).

Deed: A written instrument, signed, and delivered, by which one person conveys land,
tenements, or hereditament to another.

Foreclosure: To shut out, to bar, to destroy an equity of redemption.

46 Collateral, collateral law and collateral substitutes

Guarantee: An agreement in which the guarantor agrees to satisfy the debt of another (the
debtor), only if and when the debtor fails to repay (secondarily liable).

Homestead clause/exempt property laws: Laws passed in most states allowing a

householder or head of a family to designate a house and land as his homestead, and
exempting the same homestead from execution by creditors for his general debts.

Interlinked contract: A system by which a creditor can ensure repayment by modifications in

the terms of labour, input supply, produce marketing and other contracts that provide links
to the same debtor.

Joint liability: Liability that is owed to a third party by two or more other parties together.

Loan delinquency rate: Outstanding balances of loans with payments late over 90 days.

Pawn: A pledge; a deposit of personal property made to a pawnbroker as security for a loan.

Pledge: A bailment, pawn, or deposit of personal property to a creditor as security for some
debt or engagement.

Post-dated check: A check issued before the stated date of the instrument. One delivered
prior to its date, generally payable at sight or on presentation on or after day of its date.

Promissory note: An unconditional written promise, signed by the maker, to pay absolutely
and at all events a sum certain in money, either to the bearer or to a person therein designed
or his order, at a time specified therein, or at a time which must certainly arrive.

Redemption: The right of a debtor, and sometimes of a debtor's other creditors, to

repurchase from a buyer at a forced sale property of the debtor that was seized and sold in
satisfaction of a judgement or other claim against the debtor, which right usually is limited to
forced sales of real property.

Risk premium: Extra interest paid to a lender, over amounts usually considered normal, in
return for their undertaking to engage in activities more risky than normal.
Glossary 47

Security: An obligation, pledge, mortgage, deposit, lien, etc., given by a debtor in order to
assure the payment or performance of his debt, by furnishing the creditor with a resource to
be used in case of failure in the principal obligation.

Security agreement: An agreement which creates or provides for a security interest between
the debtor and the secured party.

Security interest: Interest in property obtained pursuant to security agreement.

Surety: One who at the request of another, and for the purpose of securing to him a benefit,
becomes responsible for the performance by the latter of some act in favour of a third person,
or hypothecates property as security therefore.

Title deeds: Deeds which constitute or are the evidence of title to lands.

Writ of execution: Formal, written command of a court directing a sheriff or other official to
enforce a judgement through process of execution.

Taken from: Black's Law Dictionary (St. Paul, 1990)

48 Collateral, collateral law and collateral substitutes
 47

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54 Collateral, collateral law and collateral substitutes

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 47
Annex: Survey responses by members of the Donors’ Working Group

List of Respondents:

Canadian International Development Agency (CIDA), Quebec, Canada: G. Lessard

Danish Ministry of Foreign Affairs, Copenhagen, Denmark: T. Lindqvist

Dutch Ministry of Foreign Affairs, Den Haag, the Netherlands: Fr. van Rijn

European Commission, Brussels, Europe: P. Logli

Giordano Dell’Amore Foundation, Milan, Italy: F. Tambussi

Gesellschaft für Technische Zusammenarbeit (GTZ), Eschborn, Germany: A. Hannig

International Development Law Institute (IDLI), Rome, Italy: M. E. Footer

Kreditanstalt für Wiederaufbau (KfW): Mr. W. Neuhauss

Norwegian Royal Ministry of Foreign Affairs, Oslo, Norway: A. Eidhammer

Swedish International Development Cooperation Agency (Sida), Stockholm, Sweden: J. Runnquist

Swiss Agency for Development and Co-operation (SDC): R. Avanthay (India), R. Brugger
(Bolivia), B. Girardin (Pakistan)

United Nations Development Programme (UNDP): H. Jackelen

U.S. Agency for International Development (USAID): V. White

Women's World Banking: R. Goodwin

World Bank: W. Steel, J. Yaron

62 Collateral, collateral law and collateral substitutes

Answers:22

1. Please, rank the importance of the collateral issue in the light of your experiences
with SE promotion and other targeted programmes:

Importance of collateral issue

very important
41.2%

not very important

important 17.6%
41.2%

USAID: “Because differences in lending practices and legal and regulatory frameworks exist
both between and across geographical regions, it would be difficult if not misleading to try to
broadly categorise the “collateral issue”. In general, however, the “collateral issue” defined
within the framework of collateral law and collateral substitutes, offers an important
explanation to the reluctance by many developing countries’ formal banks to lend to small
farms and businesses. In Latin America, in particular, the tight link between access to credit
and ownership of real estate, largely due to deficiencies in laws concerning collateralization,
precludes many micro and small scale entrepreneurs from securing bank loans. Such legal
deficiencies, however, do not pose significant problems in most of Asia. Instead, the high
cost associated with collecting pledged collateral relative to the size of the micro loans is
often cited by banks as a principal deterrent to pursuing SE lending. Within the larger
context of SE promotion, the growth of informal sector lending programs, which typically
rely on collateral substitutes as a means of targeting the poor, has greatly improved access to
credit for many micro and small-scale businesses throughout the developing world. These

22
Fifteen member agencies responded, sending in a total of eigtheen answers, of which one could not be
included in the analysis due to a different format. The visualization of the results is meant to serve as an
illustration. The citations are to show the broad spectrum of views by members of the Donors' Working Group on
Financial Sector Development related to the collateral issue.
Annex: Survey 63

lenders typically have stronger relationships with the borrowers and are able to exercise
more control over the borrowers’ activities. They are also willing to accept a much wider
range of collateral to support their loans than banks are. As such, while the collateral issue
may limit access to formal bank credit, it presents much less of a constraint to borrowers
operating outside the formal banking sector, particular microenterprises.”

2. The following is a preliminary list of collateral instruments, some of which are used
more often than others in small-scale lending. Some are conventional, others quite
unusual, at least in formal financial contracts. Seen in the context of small-scale
finance in general, does your agency have experiences with any particular of the
above-mentioned collateral instruments? Which?

Experience with collateral instruments

collateral instruments

land title
building
chattel/lien on assets
blocked savings
other financial assets
assignment of future income
pawning
personal guarantees
joint liability
group lending
cash-flow-based lending
cession of licence
interlinked contracts

0 2 4 6 8 10 12 14
mention

World Bank (Steel): “Targeted credit programs have tended to be at two extremes: SME
credits through banking systems rely on banks’ standard collateral requirement, usually legal
title to land or building. I don’t think we impose a requirement on them, but since they bear
at least some of the risk, their normal requirements come into play. On the other extreme,
“revolving funds” and income-generating credit schemes as part of social funds and welfare-
oriented projects tend not to have any collateral requirements, except perhaps personal or
group guarantees.”
64 Collateral, collateral law and collateral substitutes

3. In the light of these experiences, does your agency have a preference for particular
types of collateral? Or collateral substitutes? If so, please explain and illustrate.

Preference of responding agency for collateral type

collateral instruments

land title
building
chattel/lien on assets
blocked savings
other financial assets
assignment of future income
pawning
personal guarantees
joint liability
group lending
character based lending
cash-flow based lending
cession of license
interlinked contracts
guarantee funds
leasing

0 1 2 3 4 5 6
mention

Danish Ministry of Foreign Affairs: “Land titles have very limited applicability as security.
Purchased assets in combination with joint liability may offer perspectives.”

Dutch Ministry of Foreign Affairs: “here are no particular types of collateral excluded
except for the use of homestead. As these are hard to realize and if realized have a strong
adverse social effect, it is better not to include them in the list of acceptable collateral.”

USAID: “With regard to microenterprise lending, USAID’s Microenterprise Development

Guide states: ‘Serious issues exist about the relative merits or these different approaches,
and this guidance imposes no preference for one over the other. However, reliance upon
some form of collateral substitute provides an important means for MFIs to ensure that the
poor have access to their services. As a result, a mission considering providing assistance to
a financial institution that does not rely upon a collateral substitute should seek additional
evidence that the institution is actually reaching poor customers’”.

World Bank (Steel): “Neither type of experience has proven very satisfactory in terms of
recovery rates. Banks rarely attempt to recover fixed property as collateral, at least in most
African countries, where the legal system is not well designed for business law, costly, slow,
uncertain, and subject to manipulation. (South Africa seems to be an exception; contract
enforcement is quite effective. Reportedly, even informal moneylenders can use the legal
Annex: Survey 65

system to enforce written contracts to repay a given sum of money - even though the
implicit, but not written down, interest rate might be technically in violation of the Usury
Act.) There has been growing interest in leasing as a way to avoid these collateral problems
for SMEs. This enables them to substitute a leasing contract (with the equipment itself as
collateral) and avoid having to borrow to purchase the asset (in which case they have to put
up property as collateral). Repayment rates in micro credit components of social loans have
not been very satisfactory. The Bank is now emphasizing that such components should be
designed in accordance with best practices in macro finance, as embodied in the Guiding
Principles of the two donor committees, including methodologies such as blocked savings
accounts and use of solidarity group guarantees as collateral substitutes.”

4. In those projects implemented by your agency that involved banks, was the provision
of collateral by the target group always a constraint? If so, please explain and
illustrate.

Collateral as a constraint

yes
64.7%

no answer
5.9%

no
29.4%

Dutch Ministry of Foreign Affairs: “In the case of individualized loan facilities through
banks there has always been the feeling of being restricted by a lack of 'quality' collateral. In
particular for customers without relatives who live in urban areas and own developed plots,
and customers who live in areas where land titles or long term leases have not been issued
the lack of availability of a prime collateral such as land is felt.”

GTZ: “No, but an excuse for rejection of loans (social distance of formal bankers, small,
unattractive and cost-intensive loans).”
66 Collateral, collateral law and collateral substitutes

KfW: “We received few complaints, if any in this respect. We have a feeling that banks took
what they got, but there is always the problem of turning assets in cash.”

Norwegian Royal Ministry of Foreign Affairs: “No. For good projects with well qualified
management, security is a lesser problem than for more risky projects.”

Swiss Agency for Development and Co-operation (Avanthay): “Yes it was. When
micro-entrepreneurs can not include their credit request in a ‘bulk request’ channelled by a
SHG or an NGO to the bank, in most cases the lack of collateral will prevent them from
having access to credit.”

USAID: “In general, the provision of collateral by the target group has posed a significant
problem to those projects involving banks. Given the reluctance by formal banking
institutions to accept collateral substitutes, the provision of collateral typically remains a
constraint to poor borrowers. To mobilize credit through the formal financial sector for these
poorer borrowers, USAID has traditionally established loan guarantee programs. Recently,
however, in Eastern Europe, USAID has attempted to directly address the legal and
regulatory framework governing collateral.”

World Bank (Steel): “Lack of collateral satisfactory to banks has almost always been a
constraint on disbursement of World Bank SME lines of credit. It lies behind the typical
situation in which the participating banks say that ‘there is not enough bankable demand’,
even though our assessments indicate an excess demand for finance by viable, dynamic
SMEs. But this is not always the case. For example, we have had very successful SME
finance programs in Sri Lanka and Ecuador. I am not sure offhand about the collateral
requirements of the participating banks. But I believe that in Sri Lanka they gave a high
degree of responsibility and authority to local branch managers, and this may well have
included substituting first-hand personal knowledge of the business for formal collateral
requirements. (For this to work, branch managers have to be directly rewarded or penalised
depending on the performance of their SME portfolio.) Another successful Bank-supported
small credit project has been the KUPEDES (Unit Desa) program of Bank Rakyat
Indonesia. They do require fixed property (farm land) as collateral, but I am not sure that
this has to cover the full amount of the loan; in any case, personal knowledge of the client by
the bank staff is at least as important as formal collateral. These staff share in the profits of
their unit bank, so have a strong incentive to make good loans and collect them.”

5. How was the collateral constraint resolved?

Annex: Survey 67

Approaches to resolve collateral constraint

collateral instruments

blocked savings
chattel/lien on assets
pawning
personal guarantees
joint liability
group lending
cash-flow-based lending
interlinked contracts
guarantee funds
funds in trust arrangement
forced lending
institution building
policy reform

0 2 4 6 8 10 12
mention

USAID: “The following two examples are representative of USAID`s approach to the
collateral issue within the formal banking sector: (1) Loan Guarantee Program in South
Africa (. . .); (2) Policy Reform in Eastern Europe: The purpose of the USAID funded IRIS-
Central Europe project is to create a positive commercial law institutional framework for the
development of the financial sector in Poland, Lithuania, Macedonia, Bulgaria, Croatia and
Albania. This purpose is being accomplished by assisting these countries to reform their
collateral and bankruptcy laws. In Bulgaria, for example, the Collateral Law Reform Project
has recently been launched to address two fundamental problems: the transfer of possession
rule, which states that movable property can only be used as collateral for a loan if the
debtor transfers possession of the property to the creditor, and the absence of a registry to
record the use of movable property as collateral, which makes it impossible to determine
whether another lender has a prior claim to the collateral. To address these issues, the IRIS
project has targeted four objectives: (1) help Bulgarian experts draft a modern collateral
law, (2) help develop a collateral registry, (3) help train people to use the new law and
registry, and (4) help people understand why commercial law reform is important.”

World Bank (Steel): “Collateral constraints have sometimes been dealt with by raising the
ceiling on loan size, which dilutes the objective of reaching smaller clients (but recognizes
that this may not be achievable without a change in banking methodology to find good
collateral substitutes). The solution that banks tend to propose is a Guarantee Scheme. (. . .)
The World Bank generally opposes guarantee schemes as a solution. If the guarantee is too
high (above 50-60%), moral hazard problems arise, diluting the bank`s incentive to screen
68 Collateral, collateral law and collateral substitutes

loans adequately or pursue defaulters and reducing borrowers’ incentive to repay. In such
cases, guarantee schemes tend to decapitalize and be unsustainable. If the guarantee is low,
bureaucratically cumbersome, inadequately funded, etc., it may have little impact on
behaviour.”

6. Have you seen banks adopt innovative collateral instruments? If so, with what
results? Could you provide details?

Adoption of innovative collateral instruments by banks...

yes
41.2%

no answer
no
17.6%
41.2%

... these were mentioned by respondents replying with ‘yes’

collateral instruments

assets not converted into cash

mortgage
personal guarantees
joint liability
social rights, kinship
religious obligation
cash-flow-based lending
guarantee funds
post-dated checks

0 1 2
mention
Annex: Survey 69

GTZ: “In general good results, much better than results of operation based on traditional
collateral forms (land, house, etc.).” (In reference to “Mortgage with/without possession;
social rights inside village communities, kinship; religious obligation formula”.)

Swiss Agency for Development and Co-operation (Avanthy): “Self-help-groups with a

100% recovery but with the support of apex-banks supporting at concessional rates NGOs
which in their turn on-lend to SHGs”.

USAID: “The solidarity group methodology acts as a key screening mechanism and is a
substitute for collateral at such banks as BancoSol and the Grameen Bank. As has been well
documented, this type of collateral substitute has proved during the last few years to be
effective in reconciling the competing pressures of serving the very poor and operating in a
self-sustaining manner. The general reluctance by banks to accept collateral substitutes,
however, is not solely due to a lack of innovation among the banks themselves. Instead, the
lack of reform of the regulatory and legal environment has prevented banks from accepting
most forms of movable property as collateral. For example, restrictions on or imperfections
in pledging movable property as collateral, inadequate registration of collateral and lien
rights, difficulties in and costs of ascertaining title of goods, and the slowness and
underdevelopment of enforcement and regulatory mechanisms all increase, instead of reduce
the risks associated with lending against non-traditional collateral. In addition, the
supervisory treatment of traditional collateral versus collateral substitutes has a negative
impact on bank lending to the micro and small business sectors, because collateral
substitutes are difficult to register and repossess, the loans against which they are pledged
are typically classified by banks examiners as high risk assets. As a result, banks are forced
to increase their capital base when making such loans in order to maintain minimum capital
adequacy requirements.”

Women’s World Banking: “Most innovative is cash-flow-based lending - they are learning.”

7. Do you think the collateral problem can be resolved by modifications in the legal and
regulatory environment?
70 Collateral, collateral law and collateral substitutes

Desirability of modifications in the legal and regulatory

environment
yes
41.2%

no
11.8%

ok, but not sufficient

47.1%

Danish Ministry of Foreign Affairs: “Such modifications are usually a necessity, but not a
sufficient condition. Behavioural changes in financial institutions will still need to be induced.”

Dutch Ministry of Foreign Affairs: “Relaxation or modifications of the legal and regulatory
environment will often not be the solution. Stricter rules protect the banking sector against
accepting too high a risk. In that respect relaxing the rules would pose the danger of running
the risk of bankruptcy which will make the other banker even more risk evasive and will
reduce the client's willingness to save with the banks. As banks often go for a higher than
100% security cover, relaxation of the rules and regulations will not solve the problem
anyway. Efforts to expand the volume of investable funds (savings mobilization, redirecting
credit from the public to the private sector, monetarization of savings, etc.) will be necessary
in conjunction with reviewing individual conditions that are felt to be too harsh.”

Giordano Dell’Amore Foundation: “We do not think that this issue could be solved by
degree because the problem is closely related to how the banks approach the customers.”

GTZ: “If customary right applied, no! Legal and regulatory reforms are important, but only
in connection with the introduction of innovative financial technologies.”

KfW: “Yes, in cases where the law 'over'protects the borrower.”

Norwegian Royal Ministry of Foreign Affairs: “In some cases it will help, if the banks can
more easily realise the collateral.”
Annex: Survey 71

Swiss Agency for Development and Co-operation (Avanthy): “Yes. The regulatory
environment should be reformed in such a way that more importance is given to joint liability
(micro level) or business potential (small level).”

USAID: “Appropriate modifications in both the legal and regulatory environment can have a
significant impact on improving, though not necessarily resolving, the collateral problem, as
banks will still have to seek alternatives to collateral or collateral substitutes in order to reach
those without marketable assets. Legal and regulatory constraints include the following:
barriers to using registry systems, usury laws which discourage lenders from making small
loans, and cumbersome restrictions to repossessing pledged collateral. In Bolivia, for
example, homestead and exempt property provisions make the land and equipment held by
poor families unacceptable as collateral. In addition, as mentioned above, traditional asset
review procedures used by bank superintendents need to be re-examined in light of both the
increases role these institutions are beginning to play outside the formal banking system and
the growth in collateral substitutes among microfinance institutions.”

Women's World Banking: “Not the most important factor. Banks can be more flexible (. .
.), if they want to be. The key is understanding that the clients are a good credit risk.”

World Bank (Steel): “Assets are weighted by riskiness in determining key ratios for
supervising bank performance, and loans that are not secured by titled property generally
are counted in a higher risk category than those that are ‘properly’ secured. So bank
restructuring programs that strengthen the regulatory environment can have the consequence
of making banks pay even stricter attention to collateral. The preceding may explain the
apparent anomaly that banks require titled property as collateral even though they complain
that it is virtually unenforceable in a given country's legal environment (or social, where it
would be unacceptable to evict people from their family home). Certainly, it is critical for
private sector development generally (not just collateral) to improve the legal and regulatory
environment for enforcement of contracts. But that is a slow process, so really should be
seen as long-term solution. A more promising short-to-medium term approach may be in
hire-purchase and leasing laws, to make it easy to recover movable asset if payment are not
made (without having to get a seperate court order or warrant).”

8. Does the collateral problem call for policy interventions, e.g. (fiscal) advantages to
induce banks to adopt collateral substitutions?
72 Collateral, collateral law and collateral substitutes

Policy interventions required?

yes
47.1%

maybe no answer
11.8% 5.9%

no
35.3%

Danish Ministry of Foreign Affairs: “What about the creation of guarantee funds?”

Dutch Ministry of Foreign Affairs: “When and where banks would feel that reform of
collateral law or the incentive system would make financing less collateralized smaller
enterprises more worthwhile (and without getting exposed to high risks), policy interventions
may be useful. Policy changes only increase the bank's flexibility on the collateral issue which
would not be useful if the financial risk involved would not be reduced at the same time.”

Norwegian Royal Ministry of Foreign Affairs: “Banks cannot be expected to increase

risk of not screening the loans. The depositors’ interests must be safeguarded.”

Sida: “Yes, until they see for themselves that it is possible to work without collateral.”

Swiss Agency for Development and Co-operation: “Yes, besides banking regulations to
prohibit vinculated loans" (Brugger); "Possibly for a certain period (2-5 years) so that
bankers would realize that supporting promising businesses is more important than refrain
from doing it because of the lack of collateral” (Avanthay).

USAID: “As discussed above, one of the principal reasons banks are not accepting
collateral substitutes is the country's legal and regulatory framework. Collateral substitutes
are often time-consuming and costly to collect, in the event a debtor fails to service a debt.
In addition, most developing countries do not maintain centralized public registries,
facilitating fraudulent pledging activity. Given these legal realities, banks have tended to treat
Annex: Survey 73

such loans as unsecured. As such, they have either compensated for this predetermined risk
by charging higher interest rates, or have chosen to avoid such collateral substitutes
altogether. While offering fiscal advantages to banks may provide some short-term incentive
to banks, such a policy does not address the root of the problem as explained above, nor
does it address longer-term institutional changes which may be needed. In addition, such
‘fiscal advantages’ often serve only as green lights to approve loans which hold significant
risk.”

World Bank (Steel): “I am somewhat sceptical about fiscal incentives for banks to waive
collateral. If banking regulations are the fundamental issue, this won't help much. If banks
really aren't interested in SME loans, then measures such as guarantee funds may have to be
too large to be sustainable or may encourage imprudent behaviour.”

9. What do you think are the implications of the collateral problem for donors interested
in the development of the financial sector in developing countries?

CIDA: “More resources for training and for capacity development (lenders with experience
in the private / productive sectors).”

Danish Ministry of Foreign Affairs: “Needed: Constant pressure for innovative

approaches, increased importance of better risk management techniques.”

Dutch Ministry of Foreign Affairs: “Donors should pay more attention to interventions
directed at reducing transaction costs and improving the environment in which banks have to
operate such as the enforcement of contracts. In such situations one would not need to look
for over-securing loans and would be more flexible in accepting shared collateral.”

European Commission: “We need a dialogue with other donors.”

Giordano Dell’Amore Foundation: “It is not easy to distinguish between development

objective and charity objective.”

GTZ: “No export of ready-made solutions from industrialized countries, identify local
solutions, customary rights-based approaches and existing practices.”

KfW: “I believe, that the problem of collateral cannot be seen as a separate one from the
whole lending technology used by the bank. The better it manages character or cash-flow-
based lending, the more it will reduce attention paid to collateral.”
74 Collateral, collateral law and collateral substitutes

Norwegian Royal Ministry of Foreign Affairs: “Collateral is not the problem. Pushing
credit is a problem. Lack of savings is a problem. Lack of good projects also. Banks must
recover the loans given out, because the money belongs to the depositors or the banks’
other creditors.”

SIDA: “Collateral should be restricted to large loans. Donors should stress better measures
for screening, peer pressure, etc.”

Swiss Agency for Development and Co-operation: “(a) Reach a critical mass of
successful SHGs to have a demonstration effect; (b) support human and institutional
development of banks to train their staff in credit appraisal, understanding of clients/potential
clients needs, marketing of credit; (c) diversify the offer of financial services including
guarantees, cash credit, credit cards; (d) support innovative private banks and/or no (. . .)”
(Avanthay); “(a) Action at the level of central banks; (b) support to alternative financial
institutions; (c) conscientization of borrowers through NGOs” (Brugger); “Uneasy to
comment at that stage; possibly: extension of guarantee schemes” (Girardin).

UNDP: “Not the fundamental issue.”

USAID: “A two-pronged approach is recommended: support policy changes in the formal

banking system (collateral law reform, registry development, etc.) and encourage a wider
use of collateral substitutes (leasing, group guarantees, etc.). Guarantee mechanisms or
subsidies should not be relied on to address the collateral problem. Both of the proposed
approaches need to include greater best practices research and information dissemination,
as well as increases support for efforts aimed at forming linkages between the formal
banking sector and microfinance institutions. Because of weak linkages and a lack of
coordination between intermediary financial institutions and formal financial institutions and
among the microfinance NGOs themselves, the different components of the financial system
tend to operate in isolation of each other. By encourage bank-microfinance linkages, donors
can support the realization of such benefits as information networks, credit referencing and
the increased recognition of successful collateral substitutes.”

World Bank (Steel): “Rather, I think the solution is an encouraging development of

innovative (no-bank) intermediaries that use methodologies that do not depend on fixed
property as collateral. This works best at the micro finance level - methods such as solidarity
groups and accumulating savings accounts to hold on reserve against loans. In some country
contexts, personal guarantees may work - e.g., the LPDs in Bali, where the village head has
Annex: Survey 75

to guarantee each loan, and is also on board or loan committee of the community bank (and
has sufficient authority to induce to the family of a defaulter to make good on the debt). The
growing number of NGOs that are transforming into some type of banking institution in
order to expand their operations (and take savings deposits) is a positive development that
should be encouraged. This means revising banking laws and regulations to permit different
types of banking and no-bank institutions that are subject to different minimum capital
requirements and regulatory requirements from commercial banks. This doesn’t mean less
stringent requirements, but rather recognition that their methods -- such as collateral
requirements -- may be different, so performance standards should be designed accordingly.
Donors should therefore support: (a) micro-finance institutions, based on their performance
in terms of sustainability and outreach, particularly in transforming into full-fledged financial
intermediaries; (b) rethinking of banking laws and regulations to accommodate a wider range
of institutions, with different methodologies, and appropriate levels of regulations (or
exemption from regulation, for small informal or 'common bond' activities).”

World Bank (Yaron): “To initiate research program that would eventually redesign legal
systems in countries where collateral issues impede financial intermediation.”