Is a Complete Departure from Collateral-based Lending Needed?

UESUGI Iichiro
Fellow, RIETI

"Collateralism," an extreme form of collateral-based lending practice by which corporate borrowers without any collateral or personal guarantee are virtually denied access to bank loans, has been subject to criticism. How serious is this problem of collateralism? Under such a system, companies with otherwise promising futures cannot raise funds necessary for their business simply because they have no real estate collateral to pledge. Indeed, this is exactly why it is necessary to create new flows of money that are not dependant on real estate collateral. In this regard, however, considerable efforts have been made by individual financial institutions and the regulatory authorities. For instance, the size of "business loans" - uncollateralized bank loans to small and medium-size enterprises (SMEs) - has been expanding rapidly; business loans are emerging as an increasingly important method of financing for companies without collateralizable assets. In addition, the launch of the movable property registration system last year has made it easier to obtain bank loans by submitting non-real estate properties as collateral.

Regulators reluctant to recognize the positive role of collateral

Meanwhile, is it necessary to break away from collateral-based lending even with respect to companies that are already obtaining bank loans by pledging real estates as collateral? The Financial Services Agency (FSA) seems to believe that dependence on collateral and personal guarantee should be lowered even in such cases. Its basic stance is reflected in "Action Program Concerning Enhancement of Relationship Banking," a report issued by a subcommittee of the Financial System Council, an advisory panel for the agency. Specifically, the report points to the possibility that Japanese banks have been overly dependent on the presence of collateral and personal guarantees in making lending decisions, failing to efficiently utilize valuable yet hard-to-quantify information that is obtainable only through the intimate relationship with borrowers, such as information concerning individual companies' management conditions and business growth potential. The implication is that the FSA finds the departure from collateralism indispensable to establishing a new system of relationship banking. That is, the role of collateral and personal guarantees should be reduced in order to promote implicit information exchange between creditor banks and borrower companies. It is often pointed out that Japanese banks during the bubble economy era went on a binge of lending against real estate collateral whereby little attention was paid to their relationships with borrowing companies and post-lending monitoring. Given this background, there is a certain logic in considering relationship banking as an alternative to collateral and personal guarantees.

Importance of collateral and personal guarantees: Evidence from firm-level data

However, an analysis based on recent Japanese data has shown that the presence of collateral and/or personal guarantees is complementary to the relationship between creditor banks and borrowing companies, thus, suggesting that it is not categorically correct to be negative on collateral-based lending (note 1). According to the results of an empirical analysis using firm-level data (Ono and Uesugi, 2005), the provision of collateral and/or personal guarantees do not hamper but is complementary to the lender-borrower relationship, as shown in the table provided below:

Relationship between the collateral / personal guarantee use ratio and the number of services provided by the main bank

Services provided by the main bank to its borrower companies are diverse; ranging from opening and managing bank accounts and offering foreign exchange services to introducing business partners and customers. For the purpose of this study, the number of such services is used as an indicator to measure the degree of bank-firm relationship. It is observed that the greater the number of services, i.e. the closer the lender-borrower relationship, the higher the collateral/personal guarantee use ratio. For instance, the column headed "All samples" in the table shows that only 48.6% of the companies receiving only one service from their main creditor provide collateral, whereas the corresponding ratio for those receiving five or more services is 84.9%. This tendency is unchanged even when companies with comparable credit risks are compared and various other factors are taken into account.

Of course, it is not always favorable to have this complementary relationship under which the provision of collateral and/or personal guarantees corresponds to the closer lender-borrower relationship. The higher value of a lender-borrower relationship may increase the bargaining power of the lender bank, thereby prompting the bank to impose stricter conditions - including the provision of more collateral and/or personal guarantees. However, findings from our analysis show that the deepening of the lender-borrower relationship results in lower lending rates, that is, other lending conditions - except for collateral and personal guarantees - are more favorable to borrowing companies. Considering all these, it is fair to say that the presence of collateral and/or personal guarantees plays a positive role in building a lender-borrower relationship that enables closer information exchange.

Future challenges: Lending rates that reflect collateral and personal guarantees

Banks demand collateral and/or personal guarantees in extending loans in order to prevent moral hazard of borrower companies. In addition, it has been found that the provision of collateral and/or personal guarantees is compatible with a closer lender-borrower relationship. It is necessary to redefine the role of collateral and personal guarantees and make efforts to alleviate information asymmetry between lender banks and borrower firms.

Of course, there exist several issues for further improvement. For instance, banks need to give incentives for borrowing companies to proactively provide collateral and personal guarantees; the presence of which reduces the borrowing company's credit risks. Lending rates should be reduced by the provision of collateral and/or personal guarantees. Yet this is not the case with SME lending in Japan. Based on our estimation, lending rates imposed on companies providing collateral and/or personal guarantees are significantly higher (specifically, 0.22% higher for collateral-providing companies and 0.09% for those providing personal guarantees) than those on companies that do not provide them, even when credit risks are controlled for.

Conventional collateral-based lending should not be indiscriminately denied. However, Japanese banks are urged to make further efforts. They can set lending rates at a level that properly reflects the presence of collateral and/or personal guarantees thereby increasing incentives for borrower companies to proactively provide them. In that way they can effectively utilize the collateral and personal guarantees.

*The title of the fellow is as of the date of writing.

June 20, 2006

For details, see Arito Ono and Iichiro Uesugi, "The Role of Collateral and Personal Guarantees in Relationship Lending: Evidence from Japan's Small Business Loan Market," RIETI Discussion Paper Series (05-E-027), November 2005.

June 20, 2006