Business owners everywhere know that a blockbuster idea for growth can be hamstrung without the capital needed to implement it. But in much of the world, securing a bank loan is difficult, if not impossible, even for a healthy company.
Why is that, exactly? To get at the answer, José Liberti, a clinical professor of finance at the Kellogg School, looked at how lending decisions are influenced by the type of collateral that companies offer to secure a loan.
To a bank, collateral is a kind of insurance—an asset that the bank can seize and resell if the borrower defaults on the loan. There are two main categories of collateral. Banks can accept either an “immovable asset,” such as real estate, which will not wander off if a borrower defaults, or a “movable asset,” such as pending revenue or equipment, which could in theory vanish or lose its value over time.
Across the world, at least from a bank’s perspective, immovable real estate is king. Many of the reasons are obvious: it holds its value, it is relatively simple to liquidate, and the borrower cannot just skip town with it in the event of a default.
But Liberti and colleagues find another related factor at play in emerging markets like Southeast Asia, South America, and Eastern Europe. Local laws in many of these countries compound the difficulty that banks have in seizing movable assets in the event of a default.
As a result, banks are reluctant to extend favorable terms on loans backed by movable collateral—if they even make the loans at all. This is a particularly big problem for service sector firms.
“Think of an advertising company,” Liberti says. Even if the business is healthy, “it doesn’t have many tangible assets. It’s basically just a group of talented people working on computers.”
This lending behavior restricts businesses’ access to credit, which makes it difficult for them to grow and operate as efficiently as they otherwise might. And this can hinder an economy’s overall growth.
The Impact of Weak Collateral Laws
In developing economies, the laws and rights around collateral that are intended to protect lenders are, in Liberti’s words, “weak.” For example, in the U.S., “if you don’t pay your mortgage, you’re in foreclosure the next day,” he explains. “But in Argentina or Brazil, the lender and borrower have to go to court and a judge has to grant the lender permission to seize the asset. The trouble is, that takes ages.” During that time, movable assets may depreciate—or in the case of buses or trucks, “run away,” Liberti says; real estate won’t. That makes it the safest asset to lend against in a country with weak collateral laws.
Banks are reluctant to extend favorable terms on loans backed by movable collateral—if they even make the loans at all.
Liberti, along with Charles W. Calomiris at Columbia University and NBER, Mauricio Larrain at Columbia University, and Jason Sturgess at DePaul University, sought to quantify the impact of these laws. They obtained unusual access to a proprietary dataset from a major global bank that included quarterly liquidation values for movable and immovable collateral in 12 countries in Europe and Asia.
Liquidation values are generated by appraisers that banks hire to predict how much assets can be sold for in the event of a default. “It’s usually very hard to find liquidation values, because it’s basically a proprietary forecast for the banks,” Liberti explains.
The dataset also included loan-to-value (LTV) ratios for business loans, which serve as a signal for how much confidence the bank had in the collateral backing each loan. Low LTV ratios mean the bank had lower confidence in the collateral and sought to minimize its potential exposure to default by lending less money against the asset’s value. For example, a bank making a loan to a delivery firm might set the liquidation value of the collateral of, say, a fleet of trucks at $100,000, but only lend the firm $65,000, resulting in a 65% LTV. Conversely, a higher LTV ratio means that the bank has more confidence in the asset.
The research confirmed the authors’ hypothesis: LTV ratios for loans with moveable-asset collateral were in fact higher in countries with strong collateral laws and lower in countries with weak ones. This makes sense: if a bank feels that its legal rights to seize movable assets in the event of a default are robustly protected, it is willing to put more confidence in the collateral backing the loan, even if the collateral is not real estate.
The researchers also discovered another layer of economic distortion.
Not only do weak collateral laws hinder the ability of otherwise-healthy firms in the service sector to grow, but the laws also lead banks to over-allocate capital to firms that do have access to real estate to put up as collateral—even if these real-estate-rich firms are not doing as well.
“Imagine you’re a bank,” Liberti says. “You’re going to start giving even more money or resources to industries that are more real-estate dependent. Then the companies that have real estate to put up as collateral are more easily capitalized, which makes them more efficient in their economic activity than, say, companies in creative services or IT. Which means that those companies are less able to positively contribute to the output of the overall economy.”
Making Moveable Assets More Reliable
The researchers next looked at the effect of collateral laws within a single country. The ultimate guinea pig would be a country that started with weak collateral laws and then beefed them up.
Slovakia offered exactly that. The country changed its collateral laws in the early 2000s.
“The main characteristic of Slovakian reform was that if you are the bank, you can repossess the asset immediately, without going to a judge,” Liberti explains. Even within the tiny timespan that Liberti’s data covered—about three years—the effect of legal reform was significant: the LTV ratios for loans backed by movable assets improved by 20 percentage points compared with the pre-reform ratios.
So why don’t all countries implement Slovakian-style reforms? Liberti speculates that it may have something to do with the difference between common law and civil law systems. Common law, which is used primarily in former British colonies, puts more weight on judicial precedent than civil law, which most countries in the world use and which privileges written statutes. Under civil law, statutes may be unambiguous, but they are also inflexible and difficult to modify. In any democracy, rewriting laws is a lengthy political process involving legislators, lobbyists, and constituents. Striking down a statute in common law system, however, can be accomplished by adjudicating a single case.
“I always make the joke to my students that being a lawyer in civil-law countries is very boring,” Liberti says. “Why? Because there’s no interpretation of the law. You just apply whatever the legal code says. It may be more difficult to introduce changes to the collateral laws in civil-law countries, because you have to change the code—and it’s not like you can just do that every other year whenever you want.”
As the global economy continues its shift toward service and technology industries that do not have access to real estate, Liberti believes more and more countries will start strengthening their collateral laws. For example, India shifted to a service-driven economy in the 1990s; in the 2015–16 financial year, service businesses contributed nearly two-thirds of India’s GDP. And two years ago, India underwent a policy change in collateral laws similar to Slovakia’s.
More access to data, he says, could also speed the transition in collateral laws—and Liberti hopes his findings will encourage more banks to pull back the veil to make further analysis possible.