Published on All About Finance

Enlarging the Contracting Space: Collateral Menus, Access to Credit, and Economic Activity

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One of the main obstacles that firms in developing countries face is lack of access to credit. A key factor that restricts access is insufficient collateral. Interestingly, banks in less-developed countries usually lend only against real estate; they rarely lend against other assets such as machinery, equipment, or inventory. The problem is that assets such as machines and equipment often account for most of the capital stock of small and medium-size firms. In this context, these assets become “dead capital”: they lose their debt capacity and only serve as inputs in the firms’ production processes.

While it’s true that machines and equipment are less redeployable than real estate, banks in developed countries do lend against these types of assets. In a recent study with Murillo Campello, we argue that the root of the problem lies in weak collateral laws. The law makes a clear distinction between two types of assets: immovable assets (e.g., real estate) and movable assets (e.g., machinery and equipment). Developing countries have weak collateral laws regarding movable assets, which makes its very difficult to pledge these assets as collateral. This shrinks the contracting space, since the menu of collateral becomes smaller, which limits access to credit. Moreover, since movable assets lose debt capacity, firms under-invest in technologies intensive in movable assets.

In the study, we argue that a law passed in Romania in 1999 showcases what happens when a country improves its collateral framework regarding movable assets. Prior to 1999, Romanian firms could pledge movable assets only by transferring possession of the assets to the bank. As a result, firms could not use these assets in their operations. The new law allowed firms to pledge movable assets without transferring possession. The law also provided for the creation of a modern collateral registry, where banks record the priority of their claims against the collateral. The registry allows creditors to easily verify whether an asset has been pledged before or not. In addition, the law allowed creditors to repossess the secured assets of borrowers in default without court involvement.

Since the law increased the debt capacity of movable assets, it should benefit firms that make extensive use of machinery and equipment. To analyze the effects of the law, we take advantage of the fact that some sectors of the economy naturally demand more machinery and equipment than others (e.g., iron and steel manufacturing versus precious metals manufacturing). We rank sectors in Romania according to movable assets’ intensity, which stems from the nature of firms’ production processes. We then conduct a difference-in-differences test in which we contrast firms operating in sectors with high versus low demand for movable assets, five years before and five years after the passage of the law.

Our analysis shows that the law had important effects on access to credit and economic activity in Romania. First, we find that, following the reform, a firm operating in the top quartile of the movable assets ranking observes an increase in its debt-to-asset ratio by 2.4 percentage points more than its counterpart in the low movables ranking. This is a significant number when one considers that the average leverage of Romanian firms is just 10.5%; that is, a 23% increase relative to the baseline. In addition, we find that the law increased the likelihood that firms would start using debt for the first time, leading to a “democratization of credit.” According to our results, the proportion of zero-leverage firms drops by 16 percentage points more in the high movable assets category after the reform.

Second, we take our analysis one step further and look at the real-side implications of the increased access to credit. We find that after the passage of the law, firms making extensive use of movable assets increase their investment in fixed assets and hire more workers. In addition, these firms become more productive and sell more of their products. From an aggregate perspective, we find that the reform had a profound effect on the industrial structure of the Romanian economy. Sectors that make greater use of movable assets witness a stark increase in their share of the fixed capital stock in the economy: from 37% to 52% between 1999 and 2005. These same sectors witness a significant increase in their share of employment in the economy.

Third, since the law allowed creditors to bypass the courts in order to repossess collateral, we study how the efficiency of local courts shapes our results. Romania has 41 judicial districts and we are able to gather data on court congestion for each of these jurisdictions the year before the law’s passage. We measure court congestion as the backlog of pending commercial cases per judge. We find that our previous results are particularly strong for firms operating in jurisdictions where the backlog of pending commercial cases per judge is above the national median. This means that the Romanian reform reduced legal constraints to credit expansion by making courts less important to contracting.

In summary, our study shows that reforming the collateral framework in order to allow firms to use movable assets as collateral can have significant effects on access to credit and real economic activity. We believe our results are markedly important for policymakers in developing countries, who do not have control over collateral values or their supply in secondary markets, yet can alter collateral menus as a way to enhance financial contractibility.


Mauricio Larrain

Assistant Professor, Columbia Business School

Murillo Campello

Professor, Cornell University

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