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Why are small firms less likely to pledge collateral for formal loans than large firms?

Ha Minh Nguyen's picture

Small firms are commonly believed to have weak access to finance. Previous studies have shown that small firms report larger financing obstacles and use less external finance than large firms do.

It is then a surprise to find in the new research we just published that small firms are significantly less likely to pledge collateral. Using the World Bank Enterprise Survey (WBES) covering 6800 firms across 43 developing countries, we find that all else being equal, the odds of small firms-- those with less than 20 workers-- pledging collateral for formal loans from financial institutions are about 35-37% lower than those of larger firms. Yet when loans are collateralized, the ratio of collateral value to loan value for small firms is not statistically different from that for larger firms. These results are robust across countries, or within a particular country. Given that small firms have weak  access to finance, this is a counter-intuitive, yet interesting finding. 

We also found that small firms are significantly more likely to borrow from nonbank financial institutions, which include microfinance institutions, credit cooperatives, credit unions and finance companies. If loans from nonbanks are less often associated with collateral (which we found to be the case), it makes sense why small firms are less likely to pledge collateral.

There are probably two main reasons for firms not to pledge collateral when they borrow. First, they do not have to, and second, they are unable to. For example, more reputable and less risky firms could potentially borrow without collateral, and a few studies have confirmed this. On the other hand, small and informal firms, especially those in developing countries, are less likely to have collateral assets. As a result, they potentially have to rely on other means, such as the firms’ reputation or the owners’ personal connections, to substitute for formal collateral. Since nonbanks are presumably more locally connected and more flexible than banks, they are more suitable lenders for small firms to borrow from without pledging collateral.

Although our findings indicate that small firms are resilient, this maneuver might not come without costs. After all, we know that small firms report larger financing obstacles and use less external finance than large firms do. This suggests that it is perhaps not easy for small firms to strike loan deals even with less formal lenders. One can think of several potential disadvantages of these loans that small firms have to accept, such as smaller loan values and higher interest rates, not to mention time and monetary costs to cultivate connections with the lenders. Unfortunately, the dataset do not allow us to check our speculations.

What can governments do to help small firms gain better access to finance? One of our findings might suggest a way. We find that loans in countries with better credit information are significantly less likely to require collateral. The quality of credit information index is a part of the World Bank’s Doing Business Report. It measures a country's rules and practices affecting the coverage, scope and accessibility of credit information available through either a public credit registry or a private credit bureau. The index ranges from 0 to 6, with higher values indicating the availability of more credit information to facilitate lending decisions. We find that a one-point increase in the index is associated with about a 19% decline in the odds of loans requiring collateral. The result is intuitive. Better credit information allows banks to track firms’ history of payments and defaults. In this case banks are more likely to tell “good” to “bad” firms, which allow "good" firms to borrow without collateral.

This significant impact of credit information on the likelihood of collateral implies that small firms could benefit from the government gathering and publicizing credit information. That will help alleviate firms’ credit constraints and reduce the cost of financing. Small firms, with all the current disadvantages in access to finance, might benefit the most from better credit information.
 

Comments

There is an argument to make that some small firms can borrow without collateral building on reputation from personal connections or repayments history. But I am wondering whether the data allow one to confirm that it is in fact the firm borrowing the money and not the owner in his/her personal capacity. And when they are able to put up collateral, is it the firm's, or the owner's assets? I have worked a bit with the WB South African data on firms and finance and we found that firms that are financially constrained are more vulnerable to shocks and competition and are weaker contributors to employment creation and growth. These firms are typically small and less established. They hold less inventory, have lower capacity utilisation and are unlikely to be exporters or to introduce new products in response to competition.