Collateral is an asset pledged to a lender until the borrower pays back the debt. The most common forms are personal guarantees, assignment for security, pledging/pawning, chattel mortgage. Lack of such collateral is considered a major constraint for small businesses and new entrants to the financial market; it is also a constraint for banks as it excludes the financing of small‑scale investments. This situation is a concern for public authorities because it results in a suboptimal level of private investment in smaller firms. The causes are complex: market imperfection, inadequate regulations, counterproductive monetary policies (especially interest rate ceilings), poorly developed institutional infrastructure.

It is in the area of collateral that microfinance has made a real breakthrough, demonstrating that loans can also be secured with joint liability, jewellery, household appliances and other collateral substitutes.

In partnership with the Governments of Germany, the Netherlands and Switzerland and on behalf of the Donors’ Working Group of Financial Sector Development, the Social Finance Programme explored a key aspect of the lack of collateral, namely the substantial transaction costs for both borrower and lender in identifying, seizing and realizing collateral.. The empirical work covered Bolivia,  India and Tanzania. Collateralisation comes at a cost: the collateral has to be identified, controlled and, in case of default by the borrower, repossessed. Collateral substitutes allow banks to externalise part of the cost to the borrower or borrower groups. The use of collateral-free lending and of collateral substitutes is not necessarily incompatible with Central Bank provisions.

Collateral, collateral law and collateral substitutes, B. Balkenhol and H. Schütte

Securing small loans: The transaction costs of taking collateral, final report.

In follow-up to the findings aof a workshop organized jointly by the Employment Federation of India and the ILO in December 2001 in Bombay, the Social Finance Programme identified a set of concrete steps to accelerate and simplify judicial procedures, make property registries more accessible, user-friendly and comprehensive and enhance the understanding of risk by bank loan officers.

For more information, please contact Bernd Balkenhol.