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CHAPTER 4. TACKLING THE ISSUES OF COLLATERAL AND HIGH INTEREST RATES


As discussed previously, a common difficulty confronting many potential entrepreneurs seeking a loan to develop a commercial aquaculture venture in sub-Saharan Africa is the lack of the adequate collateral required by the banks. If a loan is offered, the interest rates demanded are prohibitively high. This chapter reviews some of the commonly used strategies to tackle these problems.

4.1 Alleviating the lack of collateral

Borrowers’ failure to meet banks’ collateral requirement may be because they simply do not have any asset that they could offer as collateral; it can also arise when borrowers have assets that have a value but which the bank would have difficulty accepting as collateral. In both cases banks have tended to reject loan applications that are not accompanied by the offer of collateral acceptable to them. Approaches of alleviating the issue change accordingly. They vary from “no-collateral” strategies to government interventions.

4.1.1 “No-collateral” approaches: promotion of group lending

Recent decades have witnessed a rethinking of conventional banking practice in particular circumstances where it has become evident that there was market failure. The formal banking sector has long held to the assumption that loan risk is inversely related to asset ownership. The experience of the last three decades, however, suggests that lack of asset ownership does not necessarily mean that there exists a high risk of default on loans. The following experiences in group lending as a strategy of tackling the problem of lack of collateral illustrates this assertion.

4.1.1.1 Group lending: the Asian experience with Grameen Bank

The Grameen Bank, established in the mid-1970s in Bangladesh, is widely cited as an example of innovative thinking about banking services for the poor people without assets. By 1998, micro credit banks modelled on the Grameen Bank had spread to 58 countries (The Times, 1998). Since its inception, the Bank’s mission has been to provide loans to the poorest of the poor in rural Bangladesh, to borrowers without collateral. In 2001, the Bank had grown into an important financial institution with 11 457 employees, 1 170 branches and 2.38 million borrowers (Grameen, 2001a) to whom it lends $31 million a week in very small loans (Grameen, 2001b). For most of its history, the Bank has had a loan repayment rate of 98-100 percent although in 2001 it had dropped to 90 percent[17]. The method used to ensure repayment relies on group lending[18]. This approach utilizes peer pressure, small weekly repayments, and personal contact with borrowers. Interest rates are set to raise revenues that will cover costs, making the Grameen Bank a sustainable, commercial financial institution servicing the rural poor (Grameen, 2001a). The Grameen Bank has since established the Grameen Trust Fund for the purpose of providing loans primarily to ventures that are “risky, technology-oriented and otherwise deprived of financing from existing formal lending institutions” (Grameen, 2001d). This Fund, operating on the same lending principles as the Bank, was covering all costs by 1999 (Grameen, 2001e).

Although this example does not deal with the loan needs of potential commercial aquaculture ventures, it does establish that it is possible, through developing innovative approaches, to grant loans to borrowers who are unable to provide collateral.

4.1.1.2 Group lending: some African experiences

Examples of initiatives similar to the Green Bank experience can be found in sub-Saharan Africa. In Benin, state-owned commercial banks were liquidated in 1990, making way for the emergence of a strong network of private banks serving urban areas, and the re-emergence of the Rural Savings and Loan Project, providing loans in rural areas. An adaptation of the Grameen model was developed for the project. Of Benin’s 5.4 million people, some 65 percent live in rural areas; most of them are poor and had difficulty making savings and accessing loan services (Mosele, 2001). Loans are only granted to members who have had a savings account for a minimum of six months; loans cannot be more than double the amount deposited. Loan recovery rates had risen to 98 percent by 1995. The pre-requisite of a saving account encourages the mobilization of rural savings, which are utilized for loans. Decentralized decision-making helps reduce the screening, monitoring and enforcement costs of lending, and empowers members to both take decisions and help ensure repayment (Mosele, 2001).

In Burkina Faso, the “Projet de Promotion du Petit Credit Rural (PPPCR)” was established in 1988; it was also modelled on the Grameen Bank. However, a significant modification was necessary because of the particular context of the country, especially the much lower population density. The PPPCR groups are formed in each village and group members carry joint responsibility for repayment of the loans. In addition, no group in a village can receive new loans if another group has defaulted (Paxton, 2001). Thus, peer pressure plays a significant role in loan repayment. The arrears rate on loans was 2.3 percent in 1995. Although loan repayment rates are high, the project had not yet achieved self-sustainability because of the high costs of providing loans to a widely dispersed, very poor population (Paxton, 2001).

The Kenya Rural Enterprise Program (KREP) was established in 1984 as an intermediary NGO providing loans to other NGOs which supplied rural loans. KREP later established a direct lending program for people who would otherwise find it extremely difficult to access loans from commercial banks. It adopted the group lending methodology used by the Grameen Bank and facilitated the forming of groups of five to seven members. The groups, in turn, are federated to form larger groups (Charitoneko, Fruman and Pederson, 1998). These larger groups are administrative and legal entities through which loan transactions to individuals are carried out. Savings from individual members are collected at group meetings, recorded and banked in the group savings accounts to which KREP is a signatory. The interest earned on savings belongs to the group. A 0.5 percent insurance levy covers the loan amount in the event of death, incapacitation or prolonged illness of the borrower. When each loan is repaid, the borrower gains access to a larger loan. The group’s savings serve as collateral for the loans and each member agrees to forfeit his/her savings in the event of default by a group member (Charitoneko, Fruman and Pederson, 1998). This places considerable peer pressure on the borrower to repay the loan.

Grants on which KREP were initially dependent were being phased out. By 1996 operating income excluding grants covered 98 percent of operating expenses, thus approaching a position of being self-sustaining. It was anticipated that by 1998 Financial Services Division of KREP would become a formally chartered bank (Charitoneko, Fruman and Pederson, 1998).

The Land Bank of South Africa has launched financial services for more ambitious commercial ventures. It has launched a “silver range” of financial products, targeting farmers who have proven agricultural abilities and experience but lack collateral (Anonymous, 1998), and a “bronze range” of products targeting people who have no track record or venture capital at all. The latter will be required to pay an additional “risk-fund” levy in return for intensive after-loan support services (Anonymous, 1998). The performance of these services remains to be assessed.

4.1.1.3 Village banks and solidarity groups

Village banks and solidarity groups are the two other popular modes used to tackle the problem of collateral. In the village banking approach, an institution goes into a village and organizeses a group of 20 to 50 members which then functions as a bank. Group members select a management committee, which is trained to run the bank. One loan is made to the village bank after the passage of some time. The bank must repay the whole loan with interest at the end of the term before it can receive a subsequent loan. In effect all members of the group are fully accountable for the loan.

4.1.2 Extension of the possibilities for securing loans

4.1.2.1 Use of non-moveable assets as collateral: land

The incapacity to offer collateral acceptable to a bank as security for a loan, may arise when the applicant for the loan has assets which have a value but which are in a form that makes it difficult, if not impossible, for a bank to accept them as collateral. This may arise in instances where the legal and regulative environment is inadequate to enable the use of certain assets as collateral. The most commonly unused and yet available asset for use as collateral is land.

a. Titling of government and common land

Among countries in sub-Saharan Africa there is a large variation in the legal and regulatory regimes relating to land. However, in general, most countries in the region have a mix of land for which there is some form of firm title, and common land where legally enforceable rights are undefined or do not exist.

If a farmer wishing to establish a commercial aquaculture venture holds full title to the land, and that title is transferable, then the farmer may offer the land as collateral. However, if the land is government owned or common land, to which no individual or group of individuals holds title, then, although the land has a value, it cannot be used as collateral for raising a loan. An option that could be considered is the titling of land. Nevertheless, such developments can be politically and socially sensitive as the change is likely to involve conflicts of interest, transaction costs and friction (Platteau, 1992).

Apart from enabling the land to be used as collateral, titling of common land can also affect the incentive to use the land sustainably as the gains from land improvement can be assured for the investing family. Common land, when used for cultivation, is almost always farmed individually with private use rights (IFAD, 2001). In such instances the granting of title may be the next logical step.

b. Establishment of clear and defensible common property rights

If land is held in common, and secure, clearly defined and defensible common property rights are established, then the group lending concept could theoretically be used with the commonly held land, or a portion thereof, offered as collateral. Thus, there would need to be a common interest in raising capital, with each having the opportunity to use the land in this way. The group would need to trust each other and be confident that the project will be successfully implemented and there would need to be a readiness to forfeit land in case of default.

4.1.2.2 Use of moveable assets as collateral

Using moveable property as collateral is an additional option of lessening the problem of collateral. However, the ability to do so depends much on the legal and regulatory environment in each country. When a bank accepts an asset as collateral for a loan, it gains a “security interest” in the asset (Fleisig, 1995).

An asset must meet three requirements in order to be acceptable as collateral by a bank. It must be possible to create a security interest in the asset; it must be possible to perfect the security interest created; it must be possible to enforce the security interest created.

Creation of a security interest means that it should not be too difficult or costly to define what the asset is in accordance with legal requirements. Assuming a farmer wishing to raise a loan for an aquaculture venture owns cattle, and the law requires that specific cattle must be individually identified in order for it to be used as collateral, then it would be difficult to create a security interest in that particular asset. If, however, a binding agreement can be written using a “floating security interest” by referring, for example, to $10 000 in cattle, it becomes feasible to create a security interest. In the event of sale of the cattle, it must be possible to attach the proceeds from the sale whether they are in a bank account or some other asset (Fleisig, 1995).

Perfection of a security interest implies that it must be possible to establish a confidence that no superior claims to the asset exists. Superior claims to the asset would exist, for example, in case the asset had already been offered as collateral for another outstanding loan (Fleisig, 1995). A compulsory entry into a publicly accessible and easily searched register of all assets offered as collateral would avoid superior claims and ensure perfection of a security interest.

Enforcement of a security interest suggests that the legal requirements for the seizure and sale of the collateral must be simple and able to be done without too much delay or expense. If it is too costly or takes an excessive period of time to enforce the claim on the collateral, enforcement becomes a costly problem for the lender, diminishing or even negating its value as collateral.

4.1.3 Government loan guarantees

Another policy that can be used to alleviate the problem of lack of collateral in commercial aquaculture is the use of government loan guarantees. Government loan guarantees were used to encourage the establishment of commercial aquaculture in several OECD countries (Ridler and Hishamunda, 2001). They work as a substitute for collateral, as the risk of the borrower defaulting is shifted to the government and, thus, to the taxpayer.

However, a note of caution is necessary. If a government is to be able to sustain such guarantees, then it must minimize the extent to which it is asked to honour its guarantees. This means that the government would face the same trouble ensuring that loans are repaid as the banks would have collecting them. If it does not do so, the payments of guarantees to the banks become a drain on the public purse and subject to possible political attack. The existence of loan guarantees can undermine the determination of the borrower to repay the loan (Fleisig, 1995).

4.2 Lessening the problem of high interest rates

4.2.1 Addressing factors influencing interest rates

The principal area of focus for reducing interest rates is to ensure that the factors influencing them are constructively addressed. As discussed in Chapter 2, these factors include perceived high risks of the venture being financed and lack of collateral, lack of a properly functioning market in financial services, high rates of default on loans, inefficient means of outreach resulting in high transaction costs, and high inflation rates.

Ways to address the problem of perceived high risks of aquaculture ventures for which loans are sought were discussed in Chapter 3. This section focuses on the other driving forces behind high interest rates charged to loan seekers for commercial aquaculture development.

4.2.1.1 Lack of collateral

The problems of a lack of collateral and high interest rates are inter-linked. Both relate to the degree of risk perceived by the bank in making the loan. On the one hand, if there is adequate collateral to cover the full extent of the loan, then much of the risk that the bank might otherwise have to carry is shifted to the borrower. As the risk to the lender of making the loan is smaller, lower interest rates are possible. On the other hand, if the borrower offers inadequate or no collateral, much or all the burden of risk of default weighs on the lender, which incites the lender to charge a high interest rate in the event the loan is granted.

The lowest interest rates are generally associated with being able to offer assets as collateral in which the lender is able to establish the best security interests (Fleisig, 1995). This is the case of fixed assets offered as collateral will often be associated with lower interest rates. However, as discussed previously, other assets can be used as collateral as well. The better governments ensure that the legal and regulatory environments enable lenders to establish good security interests over a wide variety of assets offered as collateral, the lower interest rates are likely to be. Strategies which were discussed as capable of alleviating the problem of collateral can be used to lessen the problem of high interest rates charged to farmers.

4.2.1.2 Lack of a properly functioning market in financial services

In much of rural sub-Saharan Africa, the market has failed to provide adequate financial services. Banking facilities tend to be urban based where transaction costs are lower and outreach into rural areas is minimal or non-existent. In instances where banking facilities exist, there is little or no competition allowing for inefficiency to creep in or for higher profits to be earned through prohibitive interest rates. There is a need for policies to set up more and adequate financial services in much of sub-Saharan Africa.

4.2.1.3 High default rates on loans

Loans not recovered by the bank are default costs to the lender; they become part of the overall operational costs of the bank. When a bank sets interest rates so as to raise sufficient revenues to cover its costs, the higher the default rate on loans, the higher the interest rate needs to be (Gautam, 1995). Thus, it is essential to design banking services that achieve a high rate of loan recovery in order to keep default costs low. This again emphasizes the need for innovative thinking in tackling the problem of providing adequate banking services to rural communities in sub-Saharan Africa.

4.2.1.4 Inefficiency of outreach

In the examples of micro-credit institutions discussed under the section of tackling the issue of collateral, a common problem has been to ensure that the delivery of financial services is done cost-effectively. Small loans made to a large number of people physically spread over a wider area than in urban areas, means upward pressure on transaction costs. These institutions have designed systems that have kept the cost of outreach relatively low, to a greater or lesser extent.

The higher the cost of providing these services, the higher will need to be the interest rates to generate the revenues to cover costs. This again emphasizes the need for innovative thinking in designing financial services for rural sub-Saharan Africa.

4.2.1.5 High default

Where inflation is high, nominal interest rates will be high. Even if real interest rates are relatively low, high nominal rates are a disincentive to borrowing. Inflation rates need to be managed through appropriate macro-economic policies, some of which have been discussed in Volume 1 of this study.

4.2.2 Some other options

There are other alternative options to lessening the problem of high interest rates. Of these, interest rate subsidies and loans guarantees are the most commonly cited.

4.2.2.1 Interest rate subsidies

As noted in Volume 1 of this study, interest rates subsidies have been used in other parts of the world to reduce the cost of borrowing for aquaculture production (Ridler and Hishamunda, 2001), thus promoting its development. As financial markets in some parts of sub-Saharan Africa are characterized by very high rates of interest, this option could be considered.

It is noteworthy that, while subsidized interest rates could be used to stimulate development of aquaculture in the region, any policy of this nature should be approached with caution. In the first instance, there are few governments in the region who can afford interest rate subsidies in the face of fiscal retrenchment. Interest rate subsidies may create supply-demand imbalances and as well as opportunities for rent[19] collection. Subsidized interest rates may also have a disincentive effect on banks to seek deposits as the subsidy facilitates cost recovery while raising funds for on-lending from the financial markets (Gautam, 1995). By lowering the cost of capital, they may also induce more capital intensive technologies than would otherwise be selected. This could be an important cost to society as production technologies with higher capital-labour ratios mean less employment. Nevertheless, interest rate subsidies are options employed by governments to alleviate the burden of borrowing and to stimulate economic growth.

4.2.2.2 Government loan guarantees

Because government loan guarantees can substitute for the borrower’s collateral by shifting the risk of the borrower defaulting to the government (taxpayers), they could result in banks charging lower interest rates to borrowers. Several developed countries such as Canada, Holland and Spain have used government loan guarantees to encourage commercial aquaculture (OECD, 1989).

Summary and conclusions

This chapter examined some strategies of alleviating the problem faced by bank loan seekers in general, and in sub-Saharan Africa in particular, when they do not have adequate collateral. It also examined the implications of lack of collateral for interest rates.

There are lessons to be learnt from the discussion covered in this chapter. The review of different experiences and options available to tackle these problems provides evidence that innovative ideas, such as forming financially self-sustaining initiatives, can be successfully used to overcome the lack of collateral. They further show that it is possible to advance loans to borrowers who have few or no assets and recover them successfully. It ought to be possible to initiate programmes that extend these services to entrepreneurs wanting to launch more ambitious commercial projects and who have greater financial needs. In some instances, an adaptation of some form of group lending, through a greater mobilization of small savings for use as collateral, might be possible to support the development of commercial aquaculture in sub-Saharan Africa.

It should be noted that in the case of the Grameen Bank, its operations were initially subsidized with donor funds. It took five years before the Bank became self-sufficient. There is a strong case for subsidising the establishment of rural banking services in sub-Saharan Africa. The infant industry argument could be presented in favour of this policy which has the potential of enabling the banking sector to design efficient services and build up the number of clients needed for the sector to sustain self-sufficient operations. Innovative thinking is needed to create banking services honed in each instance to the particular characteristics of the countries and communities they are created to serve.

Governments need to ensure that it is possible, within the legal and regulatory environments of each country, to use a wide variety of assets as collateral. The better governments ensure that the legal and regulatory environments enable lenders to establish good security interests over a wide variety of assets offered as collateral, the lower interest rates are likely to be and the wider the possibilities for securing loans for commercial aquaculture development.

With market failure of the magnitude experienced in the supply of financial services to rural enterprises in sub-Saharan Africa, it is necessary for governments to very carefully study the question and consider what ways might be most appropriate for overcoming these difficulties. A cautionary note has been struck in the discussion of interest rate subsidies and government loan guarantees. With such evident market failure in relation to financial services provision, and because it takes some years for the volume of savings and loans to grow sufficiently to break even (Khandker, 1995), subsidizing financial service provision in sub-Saharan Africa may appear an attractive policy. However, it looks unrealistic in the context of fiscal austerity in most countries of the region.


[17] In the 1998 floods in Bangladesh, half of the Grameen Banks clients lost all assets; their loans had to be rescheduled (Times, 1998). This could be expected to have a considerable impact of the loan recovery rate in the short to medium term.
[18] Loans are made available for income-generating production operations selected by the borrower. Small informal groups coming from the same background and trusting each other are formed. Loans to members of the group are dependent on repayment of loans by other members. Savings are a prerequisite for loans, providing a solid base for loan funds. Borrowers are closely monitored.
[19] Return or profit from differential advantage of production.

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