From the point of view of acceptance of loan collateral by development banks, securities can be classified into conventional and non-conventional collateral. The former refers to collateral that normally has been accepted by development banks that lend to the rural sector. This type of collateral consists of both personal and real collateral. Non-conventional loan collateral is used basically by informal and semi-formal financial intermediaries (NGOs, Church lending programmes, development projects, etc). The utilization of such collateral enables many institutions to provide access to financial services to sectors that traditionally have been excluded from the formal financial system. Non-conventional collateral can also be personal or real.
Conventional personal collateral
a) Endorsement (Surety-backing).
This type of personal collateral is formalized by the signature of the endorser that is stamped on the loan document. This type of collateral can be constituted easily through the signing of documents in which the borrower or a third party agrees to secure the loan; this means low transaction costs for the borrower. It does, however, introduce additional costs for the lender, for if the endorser has no proper credit record or is not an institution of proven creditworthiness, then his capacity to repay the loan will have to be evaluated. Its major drawback is its dependence on the wealth of the endorser during the contract period; any economic eventuality that reduces the payment capacity of the endorser will negatively affect the possibility of recovering the loan.
In rural loans, development finance institutions that have used third-party surety-backing generally have done so as a means to supplement other types of collateral or have demanded that the security be granted by institutions whose solvency is beyond all risks. The relatively scarce use of surety-backing as collateral by development banks can be attributed to the fact that in the rural sector, above all for small farmers, the possible persons who can act as guarantors are themselves producers, who have the same characteristics as the loan applicants; their income levels are low and uncertain and they do not have a relevant credit record. In this context, surety-backing in its conventional form does not provide a major security to lenders.
b) Third-Party Guarantee.
Through a third-party guarantee, the guarantor obligates himself to comply with a given payment to secure the debt of another party, in case the borrower fails to repay. In other words, one or more persons answer for another one’s debt; they commit themselves with regard to the lender or creditor, to repay in full of in part, in case the principal debtor does not fulfill his obligation. In legal terms, the difference between surety-backing and third-party guarantees resides primarily in the fact that surety-backing (a commercial law instrument) is constituted through the signing of a debt instrument, while the guarantee (a civil law instrument) is constituted by means of a guarantee contract for compliance with the performance of another party’s obligation and it may take the form of either a simple or a joint and several guarantee. As in the case of surety-backing, these guarantees are rapidly established and involve low transaction costs for the borrower, but not for the lender, who must assess the guarantor’s solvency. Like surety-backing, this type of collateral has the disadvantage of depending on the guarantor’s wealth. However, unlike it, the lender can bring suit against the guarantor only after he has exhausted all other legal means of recovering the sum owed by the borrower.
Conventional Real Collateral
Mortgage provides the lender with a real right over a real estate, that the borrower or debtor has furnished as collateral. The lender keeps this right until the debt is paid off, irrespective of who is the owner at that moment, while the borrower maintains the right to the mortgaged property. Mortgage has the advantage of constituting clear and transparent collateral for the lender. Normally, when land is mortgaged, it has the attributes of appropriability, salability, existence over time and creating a great sensation of loss to the borrower, especially since land is generally the main and often only means of production of the small rural producer. In these circumstances, when the borrower mortgages his farm land, he normally does everything in his power to repay the loan; in extreme cases, the lender is able to recover his capital and interest charges without incurring overly high costs. Mortgages generally involve high transaction costs for the borrower and the result of all of this is that mortgage collateral is used mainly for large loan operations that are commensurate with the costs of constituting a mortgage. Farmers, especially smallholders, generally request small loans that do not justify the cost of constituting mortgage. This makes these lending operations impossible. Formal lenders often perceive that the transaction costs of land transfer are very high. It is not unusual, even when property rights are defined, that lenders refrain from accepting land mortgage because they fear that land seizure will create serious social problems that make the transfer impossible or raise its costs and/or because there will be no buyers for the mortgaged land. This results in substantial differences in the valuation of land put up for mortgage between the lender and the borrower; the former tends to undervalue the mortgage which is harmful to borrowers.
b) Pledging of Agricultural Assets.
A pledge constitutes a real right that the lender acquires over tangible movable assets that belong to the borrower. The pledge can involve transfer of the property or not, when the goods remain in the lender’s possession, as in the case of pledging of agricultural assets. This pledge can only be established as security for obligations incurred by the debtor in the normal course of his business related to crop cultivation, livestock raising and agribusiness, in other words, by persons engaged in agricultural activities without necessarily owning the farm plots on which the assets offered as security are located. The use of an agricultural pledge as collateral requires a contract that clearly specifies the asset that is being pledged, the value of the asset, its location as well as personal information on the borrower.
Pledging of agricultural assets has been the most common form of collateral used by development finance institutions in the agricultural sector. The main advantage of agricultural pledges is that almost all rural producers own some asset or crop they can offer as security. Furthermore, almost all assets that can be pledged are salable. Nonetheless, there’s the problem of appropriability and sustainability. The transaction costs related to effectuating the appropriation of the pledged assets are very high, as compared to the relatively small loan sums and in case the borrowers live in geographic locations which have a difficult accessibility. This means that few pledges are executed, thereby exerting a negative impact on the sense of loss. Sustainability is also uncertain, for the pledged assets are subject to multiple risks due to climate, theft, fraud or deterioration, in the case of crops and livestock.
c) Guarantee Funds
These are funds set up by borrowers or third parties (State, NGOs, Church) with the purpose of reducing or eliminating the lenders’ portfolio risks and replacing or supplementing the demand for other real collateral. Guarantee funds are institutions with their own legal status, that have been established by the State and they operate externally to the financial institutions that grant loans to rural producers. It is only recently that guarantee funds have begun to be used as collateral for obtaining rural loans, mainly by development banks, as an alternative or supplement to the use of mortgage or pledging of agricultural assets. Guarantee funds operate like supplementary real collateral and they have the advantage of appropriability, since they give lenders access to liquid cash to cover the risk of loan default. However, when the guarantee funds are created exclusively by the State or third parties, there is a danger that the producers perceive the coverage of their loan defaults from those funds as automatic and at no personal consequence to themselves. If this occurs, the funds operate as security only to a limited extent for two reasons: they are not highly valued by the borrowers and for that reason they do not encourage a compliance with their debt obligation because the execution of the security is not perceived as a personal loss; secondly, by depending on state policies and resources, the continued operation of the guarantee fund is not ensured over time.
When the funds are created by the borrowers themselves, then they fulfill almost all of the ideal requisites of collateral, provided no unfavourable economic events like hyperinflation exist, that erode the value of such funds. However, the sums that small rural producers are able to accumulate as own guarantee funds are small and do not cover a significant proportion of the loans. In short, guarantee funds are an important alternative or supplement to conventional collateral. This is a collateral modality that transcends the rigidity imposed by real security, primarily land mortgage, which in most cases is beyond the possibilities of small rural producers.
d) Agricultural Insurance.
Agricultural insurance is not collateral in itself, since the beneficiary of a catastrophe is the farmer and not the financial institution. Even so, in several of their financing schemes, development banks are using insurance against various types of catastrophes as a requirement for granting of small farm loans. This type of mechanism seeks to supplement or replace the demand for real collateral by banks from the side of the rural producers.
There are several types of insurance. Among these is the insurance of assets that are exposed to major risk. In this way it can be offered as loan collateral by insuring the permanence of the insured assets during the loan contract period. Insurance mechanisms, however, have problems of viability, since rural activities bear high risks. Because of their high costs, it is not very likely that small farmers will be willing to incur these costs. This can well mean that the conditions of sustainability and permanence in the time will not be met. Moreover, if the producer himself does not pay the full cost of the insurance, or part of it, he will not value properly the insurance protection.
Non-conventional Personal Collateral
a) Solidarity Groups
This is a security offered by the members of a pre-established group of borrowers, through which each and all members bind themselves to comply with the unpaid obligations of any one of the group. This form of social collateral, by its very nature, lacks the requisites of appropriability and salability. However, it has been widely used, because it offers several advantages with regard to the other attributes. In the first place, the possibility of repayment is multiplied by the number of the group members, because the entire group guaranties the payment jointly and severally: if one defaults, another, or the whole group of members without distinction, have to pay. Furthermore, as in many cases, the solidarity group with a joint and several liability offers its members the only possibility of obtaining loans on reasonable terms; therefore, group membership is highly valued and the threat of ceasing to belong to such a group is considered a great personal loss. In addition, this mechanism reduces the lender’s transaction costs. Lending small sums of money to very poor people, who have no credit history or can offer no other security, is very expensive and risky. Overseeing several loans simultaneously, the so-called “peer monitoring” and the group members’ joint and several guarantee of loan repayment may reduce the lender’s transaction costs and risks.
From the lenders’ standpoint, it is not that obvious that the granting of loan through groups with joint and several liability is preferred by lenders, as long as they have the possibility of a choice between individual and group loans. However, transaction costs and risks decline for the lender, because these are transferred to a large extent to the group. It is the group that selects and monitors the behavior of its members and takes on the task of loan collection. In many cases, even when these costs are high, group lending is preferred by poor borrowers because they have no other alternative. But as the loan amounts grow, and other alternatives are found, the preference for individual loans grows more pronounced both on the part of the lender and the borrower.
In relation to the requirement of durability or permanence over time, the solidarity group with joint and several liability has some restrictions: there is no guarantee that the group will stay together over the time. The collateral of solidarity groups with joint and several liability functions primarily for small loans; when the loan size grows, other security is demanded, which is preferably real collateral. The groups can also be used for other purposes, like technical assistance, training, etc.
b) The Endorsement by the Organization to Which the Borrowers Belong.
This is collateral offered by a grassroot organization to which the borrowers belong, as a means of providing information on their credit behavior and willingness to pay. The organization can be an association into which producers are grouped to carry out certain tasks (e.g. cooperatives) or communities to which they belong and in which they carry out their social and economic activities. The surety of the organization to which the borrower belongs lacks the attributes of appropriability and salability. Its effectiveness as collateral is based on its valuation and the sensation of loss. For many poor farmers, living in a community gives them a feeling of group identity and of belonging and acts as their social reference space; at the same time, it generates several benefits, from giving members access to public goods such as water for drinking and irrigation, etc to the possibility of obtaining private assets through collective activities like mutual labor, the purchase or sale of collective goods, etc. This makes that honour and prestige within the community highly valued. In granting its endorsement, the organization commits these values (the feeling of belonging to and having access to goods) and for that reason, community surety is quite valued. Failing to pay means discrediting the community and losing one’s own prestige within it. In the worst case, this discrediting can cause the loss of the economic and social reference group, which would be highly damaging. Other advantages of a grassroot organization’s endorsement are that it reduces the transaction costs both for the lender and the borrowers. Surety can be provided by the organization as a whole, or by an authority representing that organization.
This type of social collateral does not operate in places where there are no strong organizations that make successful experiences difficult to replicate. Furthermore, there is always a possibility that disagreements within the organizations will impair their very raison d’etre and that they will not be permanent over time. Collusion can also arise between borrowers and the organization’s leaders or authorities. This organizational surety is supplementary to other types of non-conventional real and personal collateral.
Non-conventional Real Collateral
a) Non-Conventional Pledges
Non-conventional pledges do not vary in definition or attributes from agricultural pledges. The difference lies in the type of asset that is pledged. In this case, rural borrowers pledge livestock or smaller animals (e.g pigs) and household appliances that normally are not accepted as pledges by commercial banks or development finance institutions. This collateral type was first used for loans to urban micro entrepreneurs and normally has taken the form of pawnshops, where the pledge remains in the lender’s possession. The system then evolved into one where the pledge remains in possession of the borrower. The non-conventional pledges have the advantage that most rural producers possess goods that can be used to establish this type of collateral. Furthermore, it does not involve large transaction costs for the borrower, because the pledges do not have to be registered; all that is needed is an ownership document or declaration and a contract, which transfers the pledge to the lender. These goods also represent a sensation of loss for the producers. They have an advantage over the pledging of agricultural property, since they involve assets that already exist at the moment of signing the loan contract. Nonetheless, they share several of the drawbacks of conventional pledges, in the sense that the assets can loose value, by loss or theft; also, the seizure of this collateral generally involves high transaction costs in the rural sector.
b) Common Group Funds
Common funds are a type of collateral that combines the mechanism of solidarity groups with that of guarantee funds. Each one of the members of the group with joint and several liability pays resources (generally money) into a common fund that serves as collateral for loans granted to the group members. This fund is deposited into an account that is made available to the lender so long as the loan contracts is in force and may only be used to cover unpaid loans. This account usually earns the normal interest rate that is paid on savings accounts. The common fund may be shared among the members of a group with a joint and several liability once the loans are repaid, or can be used as a guarantee fund for a future loan. This mechanism assures the lender not only with the social pressure that can be exerted by a solidarity group, but also with real collateral that can be executed rapidly and does not involve large transaction costs. Common funds fulfill the attributes of appropriability, easy execution and create a sense of loss to the borrowers. The common guarantee funds impose some additional transaction costs for the borrowers, for someone within the solidarity group with joint and several liability must take the responsibility for collecting the funds and group members cannot obtain loans until all the members have made their contributions to the common fund. There are also operational problems with the administration of common funds when there are no financial intermediaries available that offer savings facilities in which to deposit the funds. Placing the solidarity funds directly in the hands of lenders entails the risk of their illicit appropriation. Sometimes common funds are constituted through contributions that group members are forced to make in order to obtain loans. In this case, the fund imposes a saving discipline that can serve to promote saving and increase loan resources. Forced savings, however, impose costs on group members, who cannot withdraw their savings to allocate them to other uses and therefore frequently they have to turn to informal moneylenders to obtain resources they need in case of emergencies. Furthermore, the saving process often takes a considerable length of time before loans can be obtained.
c) Blocked Savings.
Blocked savings are savings that the potential borrower gradually but continuously deposits into an account until a certain amount has been accumulated that will serve as collateral for a loan. Once the loan is made, as in the case of the common funds, the savings remain blocked or frozen while earning interest until the loan has been repaid. This surety is usually supplemented by other collateral. Blocked savings offer the advantage of constituting real collateral that can be rapidly executed without transaction costs for the lender. They also promote savings and, through this, contribute to increase the volume of loanable funds. The very process of saving gives the lender also information about the borrower, thereby reducing the problems of imperfect information.
Even so, as in the case of common funds, this mechanism entails relatively large transaction costs for a borrower who intends to obtain a loan through forced savings; he must generally wait a relatively long period of time before he has accumulated enough savings to obtain the loan. When there are no financial institutions where to deposit the savings, then it can be risky to trust the lender with those savings. This mechanism appears to function well when the loans and amounts saved are relatively small, because the payments can be assumed without problem by the borrowers-savers. However, when larger loans are needed, then the savings quotas also have to increase or the saving periods have to be extended.
Other Non-Conventional Collateral
Under this system, the lender allocates a small amount of money in the form of a loan to producers who are first-time credit applicants. Once the borrower makes all his payments at the stipulated times, he is automatically promoted to a higher category, entitling him to a larger loan. This system is applied only up to a certain loan limit. Institutions also take care to ensure that the volume of loans that use this mechanism does not put at risk the performance of the overall loan portfolio. Graduation is based on the valuation given by the borrower to the loans he receives and on his perception that the lender is going to increase the credit line as agreed and that the lender is going to remain in business over time. As a result, losing access to the credit entails a great sense of loss. The major advantage of graduation is that it allows small producers to have access to loans, while the borrower or lender does not incur high transaction costs. If the financial institution manages to increase the volume of its loanable resources from savings or other sources, then this enables it to continue expanding its portfolio since the institution has a captive clientele. This system obliges the lender to transmit to the borrowers a perception that he will remain in business and that he will increase his future lending. Normally, these conditions are difficult to visualize for the lender, especially if the institution is relatively new. Another disadvantage is that the system calls for increasing amounts of loanable funds, as debtors may consider themselves entitled to growing loans and may feel disheartened or betrayed if the loans committed are not forthcoming. Furthermore, it is very risky for the lender to base his entire portfolio on this system; this is the reason why graduation is usually used as a supplement to other types of collateral. Institutions, use graduation very effectively, because it enables these financial institutions to gradually know the borrowing capacity of their clients; these, in turn, progressively build up trust in the institution.
b) Interlinked or Trade Related Credit
Although this collateral system is not used by formal lenders or NGOs that grant loans, it is widely employed by informal lenders. A loan is granted, conditional on another kind of transaction that the lender also effectuates with the borrower. The terms of both the loan and the transactions (such as sharecropping and agricultural input and output marketing arrangements) are set at the same time. Faced by a loan default, the lender will take action in particular with regard to future loans and interlinked transactions. For that reason, it is also called a “tied loan”. For example, a trader makes a loan to a farmer, with the commitment of the latter to sell to the trader at harvesting time his crop; if the farmer defaults, the trader will not give him a new loan and will also retaliate in the marketing of his crop (by not buying it from him or discrediting the farmer with other traders).
An interlinked or trade related credit transaction works, if the borrower views his relationship with the lender, both in terms of the loan and the other transaction, as valuable and permanent. Undertaking other non-financial activities and linking them to credit increases also the risks to the institution, since in addition to the risks inherent to lending, the institution would have to assume the risks of the other activities such as trading. Moreover, the execution of different types of activities creates problems in attaining the specialization needed for managing effectively financial intermediation services.