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VOL 18 NO -168 REGD NO DA 1589 | Dhaka, Wednesday April 27 2011

Collateral substitutes for SMEs

M S Siddiqui

There is a consensus on development of small and medium enterprises (SMEs) among


policy makers and very often policy makers and financial institutions (FI) assure of all
out support to SMEs, particularly about providing collateral-free loan. The first
generation entrepreneurs, especially the new entrants to the financial market in our
country, lack collateral, which is a major constraint in the starting and expansion of
business.

The FIs have many well-designed and well-printed brochures offering lucrative
collateral-free loan but in practice there is no facility available to really deserving
entrepreneurs. FIs very politely ask for collaterals and in case of female entrepreneurs,
additionally ask for personal guarantee from father or husband.

Collateral issues attract the interest of common people and economists. 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 small scale investments. Bankers reportedly use collateral to screen potential
borrowers.

Collateral may be defined as property that secures a loan or other debt, so that the
property may be seized by the lender, if the borrower fails to make proper payments
against loan. Lenders demand collateral for a secured loan, they are seeking to minimize
the risks of extending credit. There are some well-accepted collateral -- real estate
including deeds, mortgages, leases, and other rights in real estate, inventory, account
receivable from government entity and some reputed corporation, plant and machinery
and security and bonds. There are some more collaterals like forward dated cheque,
hypothecation (warehouse with valuable and marketable products), and trust receipts etc.

Collateral is an asset pledged to a lender, until the borrower pays back the debt. In case of
default the lender has the right to seize the collateral and sell it. Collateral serves to
protect the lender against risk. 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 that can be
easily sold, taking into account the respective transaction costs involved.

In business, the lender is relying upon the creditworthiness and reputation of the borrower
to repay the obligation. They virtually rely on security of investment through collateral.
An alternate is unsecured loan for a promise to pay a debt. A mere promise does not serve
the creditors' interest or right in any specific property unlike a secured loan. Some of the
consumers' loan like credit card and small purchase for consumers are examples of
unsecured loan. Sometime, the bank managers use to extend short-term loans to credit-
worthy borrowers with a very high margin to meet their short-term financing needs.

The remarkable and globally acclaimed unsecured loan is micro-credit which is offered
and transacted in the informal financial sector by the NGOs. These financial transactions
have some criteria like small loan size, location as preferably rural area, use of loan for
small family business with personal or informal relation between borrower and lender,
and specialization of lenders.

These micro-credits are called microfinance as these are linked with transfer of
technology, supply of raw materials and assured marketing support etc. Bangladesh is the
birthplace of microfinance and which has been replicated in other developed and
developing countries. On the other hand, our SMEs are struggling for finance. Some of
the donors (ADB and others) offered special funds for SMEs, but those are lying in the
banks as they are 'unable' invest due to lack of collateral of borrowers.

It is now imperative to find alternatives to collateral to bridge the gap between lenders
and borrowers. Confronted with the lack of collateral, several intermediaries have tried to
come up as substitutes. The best known examples of collateral substitutes are joint
liability of community members for peer pressure and supervision. The credit rating is a
new idea in Bangladesh and has no impact on lending decision.

The substitutes of collaterals are popular in the financial sector, as they solve the disputes
out of court or legal process, since the lender usually can safeguard their interest through
negotiations with the partners. SMEs are not prepared to get involved in the legal course
due to financial and organisational limitation.

Joint liability and credit rating are fairly well documented substitutes. A joint liability
arrangement is widely used by financial NGOs and private money lenders. The joint
liability has provision that no one in the group can have access to a new loan until the
whole group has repaid the previous one. Its performance in terms of ensuring adequate
repayment is widely acclaimed methods of NGOs. It is most widely used, particularly in
several Asian countries.

The costs are another criterion for measuring the performance of collateral substitutes.
The transaction costs for borrower and lender in selecting an asset, on the other hand, the
recovery of loan in case of default is another costly process to follow through acquiring
and dispose of the collateral.

The peer monitoring works as a screening and risk protection device, since groups have
reasons to be concerned about a future supply of credit. This may develop a working
environment and confidence between lenders and borrowers. The long term relationship
may increase the capacity of borrower to utilize more finance and re-payment capacity.
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.

The long term relationship is also another genuine substitute because the pledge that
secures a loan is simply a promise. The borrower does not pledge anything other than his
good will to pay back the loan in time. This goodwill is the real collateral other than any
other tangible assets. This hardly exists in Bangladesh due to regulation of Central Bank
and also FIs own lending policy. The is another dilemma of strict rule of collateral
declared in lending policy and so called collateral free loan for SME.

Another collateral substitute is interlinked contracts. They are based on the principle that
lenders use to involve in backward and forward linkage through supply of raw materials
and sell of finished products. Grameen Bank and other NGOs have active participation in
those transactions. Grameen check is global brand and Aarong is a popular retail outlet in
Bangladesh as shining example of forward linkage with borrowers. They also link the
training, advisory service and other services like health, insurance and education etc with
repayment of loans.

These are quite common in the informal financial sector of many countries, including in
industrialized countries. Interlinked contracts can be considered a genuine substitute.

Another collateral substitute is a personal guarantee, in contrast to a regular personal


guarantee from third party. The guarantor's signature has only an enforcement effect on
the debtor and it obliges the borrower to pay back a loan, otherwise the good reputation
would be affected.

FIs can find substitute to collaterals since the present recovery is not satisfactory, and
they have a role to play in the production of goods and services as well as generation of
employment. They may also consider other substitutes in informal and semi-formal
finance use of collateral substitutes: moveable property (non-traditional assets),
reputation and credit rating, value of long-term relationship and goodwill, inter-linking of
financing, peer monitoring in solidarity groups and credit guarantee systems from
socially reputed and credit worthy persons. The process can be a means of reaching
marginal clients. The enforcement of credit process and repayment is low cost for
borrowers and lenders

Also, under-collateralisation 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 uncollateralised exposure or accept a
less preferred form of collateral. Sometimes a bank can compensate for these increased
risks and costs by charging correspondingly higher interest rates.

The substitute of collateral is essential for growth of SME by helping improve their
access to finance through a supportive financial infrastructure, financial products
development and strengthening of financial institutions, and providing quality business
services towards strengthening value chains. Bangladesh needs strong policy support for
implementation, capacity building as well as confidence building of financial institutions.

The NGOs have now started financing enterprise credit in Bangladesh. There may be
partnership among the FIs and NGOs for expansion of SME loan sharing the experience
of NGOs. The Central Bank and all other FIs should change credit and collateral policy
before publicising about collateral free loan.

The writer is a PhD student in Open University, Malaysia, and can be reached at E-mail:
shah@banglachemical.com