Collateral, Collateral Law and Collateral Substitutes

The report states that collateral substitutes seem to perform equally well if not better than conventional collateral in protecting lenders against default. It ties together ongoing conceptual and field work on collateral law and substitution, identifies the outstanding issues, especially those relevant for policy-making and institutional learning and formulates recommendations for governments, NGOs and donor agencies interested in the financial sector in developing countries and transition economies.

• Explores the extent and nature of the collateral constraint;
• Throws light on the concepts of collateral, collateral law and collateral substitutes and their respective functions;
• Reviews available empirical evidence on the effects of the legal and regulatory framework and on the performance of substitutes.

The paper finds that lack of collateral:

• Is a major constraint for small- and micro-enterprises;
• Is also a constraint for banks to the extent that it prevents the financing of (probably) safe small-scale investments;
• Is 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;
• Has spurred several intermediaries have tried to come up with substitutes such as peer pressure, probation (credit scoring), interlinked contracts and co-maker arrangements without intended enforcement.

The paper concludes that:

• 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.