INVESTIGATION INTO COLLATERAL OPTIONS FOR LENDING TO MICRO AND SMALL ENTERPRISES

Transcription

1 INVESTIGATION INTO COLLATERAL OPTIONS FOR LENDING TO MICRO AND SMALL ENTERPRISES September 2009 Vulindlela Development Finance Consultants, South Africa (Pty) Limited, and Kunene, Ramapala, Botha, KRB Law Firm

2 Table of Contents I EXECUTIVE SUMMARY AND RECOMMENDATIONS 2 II INTRODUCTION 12 III COLLATERAL FUNDAMENTALS 16 IV COLLATERAL SUBSTITUTES 20 V MARKET SIZE AND CHARACTERISTICS IN S.A. 23 VI SUPPLIERS OF MSE LOANS IN SA 26 VII SA ENVIRONMENTAL FACTORS 33 VIII BILLS OF EXCHANGE 40 IX SURETIES AND GUARANTEES 42 X MOVABLE ASSETS 44 XI LEASING AND INSTALMENT SALE 52 XII IMMOVABLE ASSETS 58 XIII CESSIONS 62 BIBLIOGRAPHY 67 INSTITUTIONS AND INDIVIDUALS INTERVIEWED FOR THE STUDY 2008/ ANNEX A NEW BUSINESS FINANCE CASE STUDY 70 ANNEX B SCHEDULE OF LENDER FRIENDLY LEGISLATION 74 ANNEX C PERUVIAN LEGISLATION 77 LIST OF ACRONYMS 83 Acknowledgements The authors would like to thank the large number of individuals and institutions who participated in this study, through sharing of experiences with the taking of collateral for micro and small business loans. We would like to extend a particular thanks to Mr. Graham Erasmus and his small business colleagues at Nedbank, Mr. Manu Muthusamy and Mr. Andre Tredoux, for sitting through multiple meetings, helping us to better understand the legislative constraints, and providing comments on the draft recommendations. A special thanks goes to Mr. George Watson and his team at New Business Finance, for allowing us to interrupt them over a three day period to prepare the case study provided as Annex A. We also appreciated the time taken by Mr. Roger Herbert of the Banking Association to explain the world of factoring and the new Invoice Clearing Bureau initiative in South Africa. Sharing experiences of microfinance beyond South Africa s borders, a special thanks goes to the team at ACCION International, and particularly to Ricardo Calvo who provided details of the Peruvian Legislation for a Global and Variable Security. We would also like to thank Finmark Trust for believing that collateral for micro and small business lending is a subject worthy of study and reform and for providing the financial support to take this forward. This investigation required a comparison of the law on paper with the law in practice. Seemingly inconsistent experiences had to be untangled and interpreted. The authors welcome feedback including corrections, criticism, or additions. Please send any comments to Barbara Calvin at bcalvin@vulindlelasa.com; or

3 List of Tables 1 Market Segments by Business Sophistication Measure (BSM) 3 2 Summary of Security Instruments 7 3 Qualifying MSEs per Province 24 4 Demographic Profile of the Micro and Small Business Segments 24 5 Business Profile of the Micro and Small Business Segments 25 6 Stability and Sophistication of the Micro and Small Business Segments 25 7 Illustrative Examples of Costs of Collections 37 8 Sector-by-Sector Potential for Asset Financing 55 9 Growth of Factoring 1998 to List of Boxes A Government References to the Collateral Policy Environment for MSE Lending 13 B Reasons Provided by Bankers for not Lending to MSEs 13 C NSIC Small Scale Business Rating System 22 D Theoretical Steps for Ordinary Summons 35 E Theoretical Steps for Special/Provisional Summons 36 F Data Collected and Provided by Credit Bureaus 39 G ACCION International Partners in India 40 H Challenges to Individual Microenterprise Lending in India 45 I Eligibility Criteria for Grameen Leasing Programme 54 J CASE STUDY SELFINA Tanzania 54 K BRI Unit Desa Philosophy 59 L Explanation of the einvoice Clearing System 65 1

4 I Executive Summary and Recommendations Introduction The primary purpose of this investigation, initiated by FinMark Trust, is to determine whether collateral constraints are one of the causes for the perceived financing gap for micro and small enterprises (MSEs) in South Africa. The study further intends to identify risk management strategies utilised in other countries, which could become attractive to lenders in South Africa, and identify policy options which could lift constraints in order to stimulate greater investment in the MSE sector. The study focuses on collateral options for loans ranging from R ($1 133) to R ($33 333), defined as the primary financing gap. Collateral is an asset pledged by a borrower to a lender until a loan is paid back. If the borrower defaults, then the lender has the right to seize the collateral and sell it to pay off the loan. 1 Assets can be physical, such as land, buildings, equipment, or vehicles; financial, such as a bank deposit or share certificate; or intangible, such as a personal guarantee. Most lenders agree that collateral plays three roles in lending: it demonstrates the commitment of the borrower prior to disbursement of the loan; it concentrates the mind of the borrower during the life of the loan; and it partially mitigates the loss in the event of default. 2 Borrowers prefer collateral that is easily available, minimises impact on the household, and minimises transaction costs. Lenders prefer collateral that can be appropriated in a timely manner, is marketable, minimises transaction costs, and provides protection in the event of liquidation. Each collateral option will be assessed in relation to these preferences. Collateral law does not exist as a distinct entity, but as a range of compartments of private law which combine to regulate the manner in which parties go about creating, perfecting, and enforcing security interests. These include contract, property, credit, commercial, bankruptcy and judicial process laws, as well as decrees governing asset registers. A collateral substitute involves a consequence of default which is a deterrent to the borrower but does not involve an asset. These include such items as group guarantees, letters from a local authority, supplier credit arrangements, or a credit bureau listing. Collateral substitutes are not included in this investigation. Client Market in South Africa Considering the five business segments defined in the National Small Business Act, the two segments covered by this investigation are the micro enterprise segment and the very small enterprise segment. Excluded segments include the survivalist enterprises, which would not qualify for a loan of R10 000, and the small and medium enterprises, which generally require more than R in financing. 2 1 Balkenhol B and Schutte H, Collateral, Collateral Law, and Collateral Substitutes, Social Finance Programme, Working Paper No. 26, 2001, Employment Sector, International Labour Office, Geneva, pg 7. 2 Related to this final point is the advantage of lower loan loss provisions for loans with collateral.

5 Applying the segmentation system utilised in the FinScope Small Business Survey, Gauteng 2006, and summarised in Table 1 below, we have further defined the two distinct markets to be covered by this survey: 1. Microenterprise market: Enterprises falling into Business Sophistication Measure (BSM) segments 4 to 6, which could qualify for a loan of R to R50 000, comprise the upper end of the microenterprise market. The estimated size of this market nationwide is enterprises, of which approximately 27% reside in Gauteng. 2. Small enterprise market: Enterprises falling into segment BSM 7, which could qualify for a loan of R to R , comprise the very small enterprise market. The estimated size of this market nationwide is , of which approximately 50% reside in Gauteng. Table 1 Market Segments by Business Sophistication Measure 3 BSM 1 to 3 Survivalist BSM 4 to 6 Microenterprise BSM 7 Small Enterprise Estimated number Nationwide* n/a Registered 1% 16% 94% Business Sole Source of Household Income 81% 75% 74% Operate From Footpath Home Home/ Shop/ Office Education Level Some High School Some High School / Matric Post Matric Avg No. of Employees 0.1 to to Computers 0% 6% 77% Financial Records 18% 46% 93% * Only those estimated to qualify for loans of R and above The first three segments of the market (BSM 1 to 3) are operating at the low end of the microenterprise market and are not covered in this study. As illustrated, significant differences are found between the microenterprise market, represented by BSM levels 4 to 6, and the small enterprise market, represented by BSM Level 7. Business owners in the latter segment tend to be more educated and utilise computers and keep financial records. These businesses tend to be registered, often operate from premises separate from their homes, and provide employment. Despite these differences, however, the collateral options best suited to one segment are similar to those best suited to the other, and the same regulatory and judicial bottlenecks are hindering lending to both markets. Suppliers of MSE Loans in South Africa A profile of current lending to the MSE market in South Africa confirms that a financing gap exists for loans from R to R , and particularly among previously disadvantaged enterprise owners. This fact was also identified by the Task Group of the Policy Board for Financial Services and Regulation early in the decade: For those SMEs with acceptable credit histories and sufficient collateral, access to bank credit appears to be satisfactory. For start-ups, micro-enterprises, entrepreneurs from previously disadvantaged communities or any other group with limited collateral or weak (or limited) credit histories, access is more limited. 4 3 FinScope Small Business Survey, Gauteng, SME s Access to Finance in South Africa, a Supply-Side Regulatory Review,

6 Commercial Banks: The commercial banks all offer overdraft facilities to registered business entities which have maintained a current account for six months or more. These overdrafts are secured by personal sureties from the business owners. This form of financing, however, is not available to unregistered entities, the amounts are generally capped at 10% of annual turnover of the business, current account fees are high, and bank branches are not generally convenient to enterprises based in townships. As a result, less than 50% of these facilities are extended to previously disadvantaged individuals. ABSA Bank and Nedbank have launched strategic initiatives to better serve the small enterprise segment. These two institutions are the largest users of the Khula Indemnity Programme and have both introduced non-financial support programmes for small business. Both admitted, however, that the cost of serving this market is high and they prioritise term loans above R The cost of realising on collateral, including the Khula Indemnity Programme, leases, instalment sale agreements, or notarial bonds, is such that loans below approximately R are not attractive. Consumer Lending Organisations: Despite their familiarity with the lower income and previously disadvantaged markets, consumer lending institutions have not yet managed to succeed in MSE lending. While organisations claim that a significant proportion of their advances supports enterprise activities, the loans are approved in relation to a proven salary and not a self-employment income. Since over 75% of respondents in the FinScope Small Business Survey claimed that their business income was their sole source of household income, it is unlikely that the salary based consumer loans are reaching a large proportion of these households. African Bank attempted to serve this market in the early part of the decade with four separate initiatives: a contractor financing programme, a factoring programme, a taxi leasing programme, and a supplier credit franchise programme. For a variety of reasons unique to each programme, not one succeeded and African Bank lost a significant amount of money in this market segment. Where fraud was involved, it took many years for the cases to work through the court system and very little was realised at the end. Thuthukani Financial Services, the Real People Group, and Capitec Bank have all investigated this market but, due to perceived high costs, have not yet launched a product. Blue Financial Services is the only consumer lending organisation identified as currently active in this market, with the Small Business General Finance Programme having been launched in April While the policy provides for loans from R up to R , the smallest loan advanced by the end of 2008 was R and the average loan size was R ; Blue is clearly also prioritising loans at levels above R Developmental Enterprise Lenders: While three group lending microfinance institutions extending loans below R have managed to reach scale and a high level of operational self-sufficiency (Small Enterprise Foundation, Marang Financial Services, and Women s Development Business), not a single individual lending organisation extending loans from R to R has managed to do the same. Many institutions and initiatives have been launched but have not survived. The two existing individual lending organisations which participated in this research, New Business Finance and Business Finance Promotion Agency, have managed to maintain loan loss rates at reasonable levels of between 5% and 9% of average portfolio outstanding over the past five years, but their operating costs are high due to the personalised service required for each client and they have not yet reached a self sufficient level of operation despite portfolios of over R20 million each. Factoring Companies: While factoring and invoice discounting is a common form of financing for the better established small and medium business sector, given the ban on cessions of accounts receivable for government contracts, factoring companies currently do very little business with the previously disadvantaged small enterprise sector. 4 Development Finance Institutions (DFIs): Staff at the two direct lending DFIs which participated in this study, Umsobomvu Youth Fund microenterprise division and Ithala Development Finance Corporation, admitted that their loss rates are high. Due to political mandates, they do not follow best practices for commercial microenterprise lending, such as rigorous pre-loan assessments and timely collection of arrears. They also serve high risk clients, such as start-up businesses, and high cost clients, such as those located several hundred kilometres from a branch office. While some previously disadvantaged small business owners are clearly benefiting from these services, the cost of sustaining these programmes is very high. A private sector solution would be preferable in the long run.

7 Environmental Factors in South Africa South Africa does provide an environment which is generally lender friendly, with an established credit bureau sector, well functioning private auction houses, and a fair legislative framework. Several policy initiatives over the past five years have been targeted at improving the environment for lending to MSEs, such as the introduction of the National Credit Act to replace a problematic set of credit laws. The primary shortcoming in South Africa is the judicial system, which is widely recognised as being inefficient and open to favouritism or corruption. Although on paper the period from client default until court judgment should take no more than three months, in practice this period requires six to 12 months or more. Problems encountered include lost files, a limit on the number of summonses which are issued per day, inefficient service from sheriffs of the court, inexperienced clerks of the court, corruption, difficulty in tracing clients or assets, varying interpretations of the National Credit Act, and delays in the granting of judgments. Furthermore, by the time judgment is received, the assets which may have mitigated the loss are often sold, missing, or damaged. Since a creditor cannot secure an emolument order from a self employed individual, the delays are particularly harmful for MSE lending. A final challenge is the value to be realised from appropriated assets. With unsecured loans or loans secured solely by a personal surety, a creditor is obliged to utilise a public sheriff to repossess and auction the assets at a sale in execution, where assets are often sold at prices significantly below market value. 5 For a small loan below R , therefore, the costs of collection are very high in relation to the value to be realised. As shown in Table 7 in Section VII, the fixed costs of collection for a loan with a six month legal process, utilising a Magistrate s Court and irrespective of the loan size, are estimated to average R Once auctioneer fees are added, the realised value is even lower. Inefficient judicial systems are a common characteristic of developing countries: In the context of societies in transition, and developing economies in general, there is also often a divergence between the formal and the actual operations of the legal framework. A complex set of socio-political factors is commonly at play to create this divergence. A contributing factor, often at work, is the sheer inefficiency of the judiciary. In effect, this raises the transaction costs considerably, adding to the risks associated with small financial transactions. 7 In South Africa, the concept of self help in legal matters is not permitted and microenterprise lenders may not function in an extra legal manner as seen in other countries, where clients have not challenged lenders who have recovered assets. Growth in the micro and small enterprise lending sector will continue to be slow until judicial solutions are developed to reduce the costs of security realisation. These solutions will need to incorporate two strategies: 1) A reduction of the role of sheriffs and other court actors in the realisation process; and 2) An improvement in turnaround times of the courts. Comparison of South African with Global Security Practices Globally, micro and small enterprise lenders depend on a wide range of security instruments, depending on the economic and cultural context and legal and judicial framework in each country. In principle, MSE lenders have adopted the collateral options which allow for swift action, timely realisation, and preference in the event of liquidation. 5 If a judgment is issued to repossess an asset which is leased, or subject to an instalment sale agreement or specific notarial bond, a lender may choose to utilise a private repossession agent and sell the goods at an auction run by a private auctioneer, where values realised tend to be higher. 6 High court costs for loans over R would be even higher. Table 7 provides illustrative examples, recognising that there are a wide variety of situations. 7 SME s Access to Finance in South Africa. A Supply-Side Regulatory Review, by the Task Group of the Policy Board for Financial Services and Regulation, 2002, pg 32. 5

8 Unsecured Loans: While microenterprise lenders worldwide offer unsecured loans for small loan amounts, once loans reach R they are typically supported with some form of security. In South Africa, unsecured loans have propelled the dramatic growth of the consumer loans industry over the past decade. This approach to lending will not support satisfactory portfolio quality for MSE lending, however, for the following reasons: 1) an emolument order is not possible so a writ of execution to seize assets is the only recourse, 2) a public sheriff must be utilised to appropriate the assets, 3) the sheriff is likely to submit a nulla bona return claiming there are no assets of value (due to assets being moved or the sheriff favouring or being bribed by the borrower), and 4) for the small proportion of cases which do end in a sale in execution, the value realised is likely to be low. Bills of Exchange: In many countries, a signed cheque is considered an unconditional promise to pay, or an unequivocal acknowledgement of debt, and is therefore supported by an expedited legal process. Undated or postdated cheques are utilised in both Egypt and India to secure microenterprise loans. In both countries it is a punishable offence to write a cheque without sufficient funds to honour it and realisation steps are faster than for normal credit agreements. In Egypt, cheques can be purchased in book stores by individuals who wish to contract with one another. In India, most urban based micro and small enterprises operate a cheque account. In South Africa, bills of exchange are also entitled to an expedited legal process, as described in Section VIII. It is not permissible or acceptable, however, to incarcerate an individual for dishonouring a debt in South Africa. In addition, cheques are becoming outdated as electronic payment mechanisms take their place. Finally, possession of a returned cheque still does not address the time delays and inefficiencies of the courts. Personal sureties: Personal sureties from owners of micro and small enterprises are utilised globally and in South Africa to secure loans to registered entities. These instruments, however, do not provide preference in the event of insolvency and are just as vulnerable to inefficient court procedures and low returns on public auctions as unsecured loans, as discussed above. Since a creditor must exhaust legal proceedings against the registered entity before taking legal action against the surety, this form of collateral also involves further delays. Third party guarantees: In certain countries where there is a high level of formal employment or a strong cultural imperative to repay debts, such as in Zimbabwe early in the decade, personal guarantees have been utilised by microenterprise lenders as a primary source of security. Taking a guarantor is costly, however, for a lending organisation as it must conduct pre-loan screening on the guarantor as well as the borrower. In South Africa, the majority of microenterprise owners cannot provide guarantors who have a steady source of income. Furthermore, for those who do locate a guarantor, the courts hesitate to enforce the guarantee if the individual claims they did not understand the commitment they were making. Movable assets: Attachment of movable assets is the most common form of security utilised globally in individual microenterprise lending. This is because movable assets meet each of the borrower preference criteria: availability, minimal disruption to household or business and low transaction costs. The legislative framework is not always conducive to this type of collateral, however, and some microfinance institutions find themselves skirting the law or finding alternative approaches. In South Africa, the law is not supportive. If an asset is pledged, possession of the asset must pass to the creditor unless a notarial bond is registered, but perfection and realisation of notarial bonds is expensive and time consuming. Creation of a constructive pledge, whereby the client consents to appropriation at the point of default, tends to result in clients refusing to sign the release form, particularly among the microenterprise market. Peru is one example of a country which has introduced a new type of floating pledge in order to overcome these obstacles for loans up to USD $ secured by movable assets. In the Peruvian model, the borrower is deemed to be a custodian of pledged assets for the creditor. If the borrower defaults, the creditor may demand that the custodian return the assets within 24 hours, without obtaining a court order. It is a punishable offence if the custodian fails to comply. 6 Leases and instalment sale agreements: These instruments are utilised widely in financing for micro and small enterprises as they generally provide preference to the creditor in the event of default and, in many countries, a creditor does not require a court judgment prior to appropriating the asset. In some countries, such as Tanzania and Bangladesh, leases are offered for assets worth as little as USD $75. In South Africa, leasing and instalment sale agreements (referred to as asset finance) are preferred for assets worth R and above. With regards to registered businesses, a creditor can often succeed in getting the borrower to sign a release form upon default,

9 Table 2 Summary of Security Instrument Advantages and Disadvantages Characteristics Unsecured Loans An ordinary summons process is followed. Following judgment, a writ of execution is issued to seize assets. A negative listing is reported to the credit bureau. Bills of Exchange (signed cheques) A signed cheque is an unequivocal acknowledgement of debt. Utilised successfully in microfinance in countries where it is a criminal offence to dishonour a cheque (eg, Egypt and India). Personal Sureties (of owners of a registered business) The same as for unsecured loans, but consequences affect both the registered business and the owner(s). Third Party Guarantors Similar to unsecured loans but can rely on the guarantor to apply pressure on the borrower.). Pledging of Movable Assets (business and household equipment, furniture, and vehicles) For a pledge to be legally binding in South Africa, possession of the asset must transfer to the lender or a notarial bond must be registered with the deeds office, or the client must sign a consent form at the point of appropriation. This security is suitable for financing working capital requirements. Leases and Instalment Sale Agreements Appropriate instruments when a borrower is purchasing a new or used asset. Used widely in MSE financing globally, including assets with values as low as USD $75. Immovable Assets (land and buildings) Utilised widely in small enterprise financing globally. Perhaps the most reliable form of collateral. Cessions of Payments Cessions of accounts receivable in the form of invoice discounting and factoring are widely utilised in small enterprise financing worldwide. Advantages Administratively simple. Theoretical legal process 90 days. An expedited provisional summons process can be followed. Theoretical legal process 30 days. Legal action is taken against two entities: the registered business and the owner. More than one source of security is available. May proceed against the guarantor concurrent with the principal debtor. Provides more protection as the guarantor may have higher valued assets than the borrower, or an income against which an emolument order may be secured. Movable assets meet all borrower security preferences if they can remain with the borrower. Movable assets meet all lender security preferences if they can be appropriated in a timely manner. Specific notarial bonds provide preference in liquidation. General notarial bonds provide an opportunity for power of management. Allows for repossession and sale by a private auctioneer with a reserve value (only after issuance of a court order). Can be repossessed without a court order if client signs a release form. Can apply for an urgent application for judgment if the asset is at risk of being moved or damaged. Provides preference in liquidation. Procedures for registering and realising the asset are well understood and widely utilised. Provides preference in liquidation. The risk is based on the creditworthiness of the large buyer rather than the supplier. There is less risk than other securities as production and delivery have already taken place. Provides preference in liquidation. Disadvantages Actual legal process six to twelve months or more. Must use a public sheriff for repossession and sale. Majority of sheriff returns claim no assets of value. When assets are sold at a public auction, realised values tend to be low; the process is open to favouritism and corruption. No preference in bankruptcy. Provisional Summons still subject to inefficiencies of the courts. Subject to same disadvantages of public sheriffs and auctions as listed above. Cheques are becoming outdated. No preference in bankruptcy. Need to proceed against the registered entity first, before taking legal action against the individual. Subject to inefficiencies of the courts. Subject to same disadvantages of public sheriffs and auctions as listed above. Verifying a third party guarantor requires significant effort during the loan assessment phase, particularly if the individual is not employed. Few borrowers can identify a willing guarantor. The courts are hesitant to enforce this security if the guarantor is a family member who can claim they did not understand the commitment they were making. Subject to inefficiencies of the courts. Subject to same disadvantages of public sheriffs and auctions as listed above. If possession of the asset is transferred to the lender, the asset can no longer be utilised in a productive capacity. This approach no longer has commercial appeal except for the pawnbroking industry which makes short term loans primarily for consumption purposes. Notarial bonds are costly to register and realise; many attorneys are not experienced in this process; courts interpret requirements in different ways. Still subject to inefficiencies of the courts. Less flexible form of financing than pledging of movable assets; can only be accessed when purchasing a fixed asset. Tracing of assets can be a challenge. Involve more administration than other forms of financing, due to requirement to verify suppliers and quality of asset, track asset over time, and maintain more detailed accounting records. Still subject to inefficiencies of the courts. Still a small percentage of the previously disadvantaged market own property which can be appropriated and sold. Lenders may be reluctant to evict a borrower from a home for a small loan valued below R High cost of realisation in relation to a loan below R Full factoring is expensive. Non disclosure transactions are administratively onerous. Open to collusion between supplier and purchaser. Government ban on cessions to third parties eliminates a large proportion of this market. 7

10 convincing them that this will avoid costly legal proceedings and thereby eliminating the need for a court judgment. The disadvantages of leases and instalment sale agreements, however, are that they involve additional recordkeeping (due to the VAT, depreciation, and tax issues) and are only suitable for the financing of a new or used asset. Immovable assets: Lending against real/immovable property does not appear to be a solution for significantly expanding lending to the MSE market. There are only a few examples of the use of real property in microfinance globally, including Indonesia and Tanzania. In South Africa, a majority of the previously disadvantaged market still does not own real property. For those who do, many are subject to sale restrictions as the properties were acquired through a government support programme. A final disadvantage is the difficulty of evictions in terms of the Prevention of Illegal Evictions and Unlawful Occupation of Land Act 19 of Cessions: Cessions of accounts receivable, or factoring, have been growing as a source of finance for small and medium enterprises worldwide, particularly in Europe; however, factoring does not typically reach the microenterprise segment. In South Africa, government is the largest buyer of goods from the previously disadvantaged small enterprise segment, so that the restriction on cessions of government payments to third parties all but eliminates this financing option for the microenterprise market. 8 This same restriction also hinders the contractor financing programmes of MSE lenders. Findings and Policy Recommendations Based on this investigation, the four most promising collateral mechanisms for the MSE sector which are utilised internationally and appear to be well suited to the South African market if certain judicial bottlenecks could be removed are: (i) pledging of movable assets; (ii) asset finance (leasing and instalment sale); (iii) cession of contract payments, and; (iv) factoring or cession of accounts receivable. For the Micro Enterprise Market Loans of R to R Pledging of movable assets Asset Finance (Leasing and Installment Sale) Cession of contract payments For the Small Enterprise Market Loans of R to R Pledging of movable assets Asset Finance (Leasing and Instalment Sale) Cession of contract payments Factoring / Cession of Accounts Receivable The single biggest challenge facing lenders to MSEs in South Africa is the high cost of doing business in relation to loan sizes, particularly the cost of collateral perfection and realisation. In some cases, these costs are passed along to clients, resulting in a high cost of credit. In most cases, however, lenders have simply not pursued growth in these markets, resulting in a financing gap. With the collateral options available to them, few lenders are content to pursue loans below R This study concludes that the primary financing gap in South Africa is for loans from R to R The five recommendations below would reduce the cost of lending and collections, thereby beginning to fill this gap. 1. Facilitate pledging of movable assets Two separate elements are required to facilitate pledging of movable assets by micro and small enterprise owners. First, the assets must be allowed to remain in the possession of the owner. Second, the lender must be able to appropriate the collateral without going through expensive and lengthy court proceedings and without the consent of the borrower. We recommend that further investigation be done into options for achieving these elements for loans up to R within the South African legal framework. 8 8 The advisory to avoid cessions was introduced in the Public Finance Management Act (PFMA) of 1999 and the Municipal Finance Management Act (MFMA) of 2003.

11 One model to consider is the Global and Variable security instrument introduced by the Peruvian government in 1997 and described in Section X. This security is registered with a special register at the Movable Property Registrar of the National Public Register System. This instrument covers a range of assets in the business and household, including raw materials or inventory, which can be substituted for other property of equal nature and value. Through assignment of the role of custodian to the borrower, the creditor can demand that the assets be returned without obtaining a court judgment. This law has contributed to the dramatic growth of several large microfinance institutions in Peru, including MiBanco which has grown tenfold in the past ten years to active clients, a loan portfolio of USD $700 million, and an average loan size of just over USD $ One other approach would be to support the sale and leaseback of movable assets by MSEs, and to apply the advantages of leasing to these agreements, including preference in liquidation and the option to use private repossession agents and auctioneers. To control abuse of these instruments, government could consider restricting their issuance to lenders registered as developmental lenders with the NCR. 2. Reconsider jurisdiction for micro and small enterprise lending With court cases regularly extending beyond six months in the Magistrate s Courts, the cost of collections has become excessive and assets pledged are often missing or reduced in value by the time a judgment is issued. This is not the first time an investigation into MSE finance has suggested a review of the court system: Improving the accessibility and efficiency of the public infrastructure in this area (legal enforcement of claims against SMEs) would reduce the risk of and eventual loss resulting from an SME defaulting on debt or other obligations. It would therefore facilitate increased lending to SMEs. In addition, access to specialised courts to act against SMEs that default on loan obligations could also facilitate SME finance. 9 Two different international models could be considered to address this issue. The first model is an expansion of the scope of the small claims courts following the model of the United Kingdom, which includes small businesses and cases up to five thousand pounds (approximately R60 000). The UK small claims court also includes an arbitration stage which greatly accelerates resolution of cases. The Small Claims Court Act in South Africa presently provides a simple, speedy, and cost effective system for the resolution of disputes which, in our view, would suit the enforcement of debts owed by MSEs. Presently, the court s jurisdiction is limited to natural persons and amounts which do not exceed R The second model is an expansion of the scope of the commercial courts. Two examples have been cited as worthy of further study and consideration: the commercial courts in Tanzania and those in French West Africa. Recognising that either of these options would take some time to implement, several smaller amendments to current procedures could be introduced in the meantime to accelerate judgments: Magistrates could be encouraged to accept urgent applications for judgment for all collateral instruments which involve a movable asset, including special notarial bonds, instalment sale agreements, and leases. A creditor could be allowed to serve a summons for small enterprise loans below R , rather than having it served by a sheriff who cannot as easily locate the client and may not treat the file as urgent. Enhance the performance of sheriffs of the court through introducing incentives, competition, and a better service mentality. Steps could include assigning more than one sheriff for each geographical area, strengthening qualification criteria, and improving the performance management system, including performance measurement and stronger performance remuneration. For assets seized from a small enterprise through a writ of execution, allow lenders the option to have these sold by a private auctioneer. 9 SME s Access to Finance in South Africa. A Supply-Side Regulatory Review, by the Task Group of the Policy Board for Financial Services and Regulation, 2002, pg

12 3. Embrace and expand cessions of government payments to third parties Since government is the largest buyer of goods and services provided by MSEs, the current restriction on cessions of payments to third parties 10 has seriously curtailed both the factoring and contractor financing markets for previously disadvantaged MSE owners. With a cession, payments are made directly to the financier rather than to the MSE supplier. Valid reasons provided by government for the prohibition include concerns about fronting, the need to verify the financier to avoid fraudulent transactions, and administrative errors whereby invoices or contract payments are paid in error directly to suppliers, resulting in government being sued by financiers. We strongly recommend that other mechanisms are developed to manage these risks to replace the prohibition. The prohibition has resulted in factoring companies turning away a large percentage of the financing applications from the MSE segment. While some contractor financing programmes have continued to operate despite an inability to secure a cession, several have collapsed since the early part of the decade 11. Those institutions remaining in this sector, such as New Business Finance and the Business Finance Promotion Agency, are not operating on a self sufficient basis; they incur significant costs in their attempts to secure repayments. Once more fully established, the einvoice Clearing Bureau (ICB) will assist with preventing payment errors in invoice discounting, as described in Section XIII. In the meantime, however, we recommend that government develop other ways of managing the risks associated with cessions which would allow for a lifting of the prohibition. One option to consider is to limit cessions to the set of financiers registered as developmental lenders with the National Credit Regulator. At a minimum, this would eliminate the need for government departments to verify the existence and reputation of the financier. 4. Support the einvoice clearing bureau The einvoice or Validation Clearing Bureau hosted by BankServ, which provides electronic validation of accounts payable by purchasers, has the potential to significantly reduce both the cost and risk of invoice discounting, thereby encouraging more financiers to expand in this market. We recommend that government actively support this initiative. 5. Expansion of the registration system for collateral Registration of collateral is currently restricted to immovable property, vehicles, and movable assets registered under a notarial bond. Expanding the registration system to include all assets utilised in MSE lending would reduce the risk of duplicate assignment of assets and would provide stronger protection to lenders in the event of insolvency. We recommend that government further develop the registration system to include: i) assets subject to a lease or instalment sale agreement, ii) assets subject to a floating pledge, iii) accounts receivable, and iv) contract payments. Other Issues Affecting MSE Lending While not directly related to collateral, a number of other issues were raised by study participants as worthy of consideration. Most financiers mentioned the importance and value of post-loan monitoring to assist owners of small businesses, particularly those from previously disadvantaged segments of society. They believe, however, that support currently available from established service providers is not sufficient. Suggested reforms included the establishment of quality standards for business mentors and development of a new performance-based payment mechanism; perhaps based on the survival of the businesses assisted These prohibitions are suggested in the Public Finance Management Act No. 1 of 1999 and the Municipal Finance Management Act, No. 56 of Including the African Bank and Beehive contractor financing programmes.

13 Further enhancements to information collected by credit bureaus on micro and small enterprises represent another area for consideration, including the development of a rating agency specialising in small enterprises such as the one operated by NSIC in India (discussed in Section IV). Direct lending by government entities is a third issue to be addressed. There are very few global examples of state entities providing microenterprise loans directly and which have achieved an efficient or sustainable level of operation. Members of the two direct lending development finance institutions interviewed for this study, Umsobomvu Youth Fund and Ithala Development Finance, admitted that political pressure and an image of easy money had hindered loan quality. There is a danger that the presence of government lending programmes will make it more difficult for private sector lenders to reach a critical mass of clients in one market area, especially if subsidised interest rates or easier repayment terms are offered on government loans. Since most government institutions do not collect aggressively from delinquent clients, it may become harder for a private sector lender working in the same market area to discipline clients to take repayments seriously, thereby increasing operational costs. Now that several commercial lenders in South Africa (banks and consumer finance companies) are attempting to expand in the micro and small enterprise markets, these risks are more likely to materialise. One alternative strategy for government would be to loosen the conditions on the Khula Indemnity Programme to render these loans more lucrative for lenders and perhaps also reduce the guarantee fee paid by clients. Suggestions provided by study participants included raising the maximum rate allowed to be charged on loans to one percent above prime, reducing the penalties when reporting and paperwork are not fully compliant, and considering coverage for a portion of legal costs. Developing a stronger client service orientation and partnership with financiers, rather than penalising them for small infractions, was also suggested. Finally, several financiers interviewed felt that small businesses needed more equity rather than more debt, including active investors who would assist with capacity building of the entrepreneurs. We acknowledge the recent initiative by National Treasury to provide tax incentives to invest in venture capital companies specialising in small enterprises, and encourage further initiatives along the same lines for smaller enterprises Website of The National Treasury, 11

14 II Introduction Objectives of the Study This investigation into collateral options for micro and small enterprises (MSEs) was initiated by FinMark Trust, an independent trust based in Johannesburg, and supported by DFID, the aid agency of the UK government, which promotes research and institutional development with the objective of increasing access to financial services by the under-serviced communities of Southern Africa. The primary purpose of the investigation is to determine if collateral constraints are one of the causes for the perceived financing gap for MSEs in South Africa, and identify possible policy options which could lift these constraints and stimulate greater investment in the MSE sector. A secondary purpose is to identify risk management strategies developed by MSE lenders in other countries which may be attractive to lenders in South Africa and feasible to implement despite environmental constraints. The researcher recognises that collateral is just one of several risk management strategies utilised by successful lenders to the micro and small enterprise sector. All participants in the study emphasised that the upfront assessment of the viability of a business and the character and entrepreneurial skills of the owner is more important than collateral, but all participants also confirmed that collateral plays a critical role. All participants in the study emphasised that the upfront assessment of the viability of a business and the character and entrepreneurial skills of the owner is more important than collateral, but all participants also confirmed that collateral plays a critical role. As documented in Box A, several policy documents relating to the MSE sector and issued by the South African government over the past ten years have referred to the need to review the environment for collateral. While many positive steps have been taken to create a fair, vibrant, and stable credit sector overall, with regards to the passing of the National Credit Act (NCA), the establishment of the National Credit Regulator, and the revisions to the Companies Act, this investigation will be the first focussed attempt to study the environmental factors with regards to collateral for MSE lending since the release of the White Paper on the National Strategy for the Development and Promotion of Small Business in South Africa, Specific objectives of the study include: To identify which collateral vehicles used locally or internationally have proven to be effective (with the exception of liquid collateral, such as term deposits or life insurance policies). To identify potential alternate collateral types, not commonly employed, which may prove to be useful. To identify the efficacy of collateral options in terms of an appropriate benchmark. To produce a matrix of appropriate collateral according to loan sizes. To identify legislative and regulatory bottlenecks which are making certain collateral options not feasible. The research for this report was carried out in three parts. The first constituted a desk review regarding the topic of collateral and collateral law and a survey of MSE financing mechanisms employed internationally. The second comprised a review of the current legislative and judicial environment for collateral in South Africa. The final part consisted of a summary of findings from interviews held widely with MSE finance providers in South Africa, including members of banks, NGOs, consumer lenders, and specialised finance entities, in order to identify their current lending methodologies, challenges faced, and recommendations for policy interventions. This study focuses on collateral options for loans ranging from R up to R (US $1 133 to $33 333), defined as the primary financing gap. As such, it will address both the microenterprise market and the small enterprise market. It will exclude loans below R which can be serviced through group lending methods or through a non collateralised step up approach to individual micro lending. The study will encompass markets served by banks, non-banks, and the not-for-profit sectors, including both informal businesses and businesses registered as sole proprietors, closed corporations, and private companies. 12

15 Box A Government References to the Collateral Policy Environment for MSE Lending White Paper On National Strategy For The Development And Promotion Of Small Business In South Africa, 1995: Given the critical role collateral plays in the attraction of conventional bank credit, attention will be given to the recognition of other types of securities and collateral substitutes, especially in the rural areas where land is communally held and with respect to women entrepreneurs Credit Law Review, August 2003, Summary of Findings of the Technical Committee, Department of Trade and Industry, pg 3: [T]here are weaknesses in debt collection and in access to court orders; collateral mechanisms are inefficient and difficult to enforce. Inaccurate and incomplete credit bureau information undermines credit providers ability to assess risk and have a detrimental impact upon consumers. Pg 5: Serious weaknesses in insolvency law and certain sections of the Magistrates Court Act (as relating to debt collection and enforcement against security) undermine housing and SME finance. Making Credit Markets Work A Policy Framework for Consumer Credit, February 2004, Pg 7: Banks, retailers and other credit providers have a need for a simple and transparent regulatory framework that is relatively easy to comply with. Effective debt recovery and enforcement are particularly important. Effective debt recovery procedures would assist credit providers by reducing bad debt write-offs, and assist consumers by ensuring that high bad debts of a minority of consumers do not feed through into higher interest rates for the rest. Effective enforcement would similarly be of value to both credit providers and consumers by ensuring that reckless credit providers do not increase the risk and cost to all parties..it is therefore imperative that the new credit policy balance consumer protection measures with the regulatory burden it imposes on credit providers. Pg 12/13:, The situation in the consumer credit market is largely mirrored in the enterprise finance market, where there is a clear distinction between the volume and cost of credit made available to small businesses and that extended to medium-sized and large businesses. There is thus an urgent need to review the current regulatory framework, not just for consumer credit, but also for contract enforcement and debt collection. Is Collateral an Unnecessary Evil? Some developmental lenders believe it is inappropriate to take collateral from a microenterprise owner who has few assets and a marginal income. The author of this study concludes, however, that availability of collateral mechanisms can open the market for finance as well as support growth of the sector. Most lenders to micro and small enterprises in South Africa and elsewhere incorporate a developmental objective in their vision or mission statements. Although the commercial players in the South African market, such as the banks or consumer lending organisations, do not expect to lose money on their small business portfolios, they also accept that this is an expensive market to serve and profits may be elusive. Reasons provided by formal financial institutions for being wary of this market are common worldwide, as cited in Box B. Additional reasons would include the lack of financial records and the high costs of serving this market relative to the size of the loans. Box B. Why We Do Not Lend To MSEs 13 Often do not repay Operate in high risk sectors Many are overly optimistic Lack managerial skills Make low profits Face many managerial constraints Many have no borrowing experience Divert loans Source: Conditions For Access to Financial Services for Micro- and Small-Scale Entrepreneurs, Deloitte & Touche, Mutesasira, Osinde, Mule, Potential for Leasing Products: Asset Financing for Micro- and Small Businesses in Tanzania and Uganda, MicroSave, 2001, Pg 6. 13

16 With one or two exceptions, South African banks are involved in this market primarily as a way to meet the financial sector charter requirements and to foster a future clientele of medium sized companies. A few specialised lenders, such as New Business Finance, believe this market can be profitable in the long run but have not yet reached a break-even level of operation. In some countries, the value of a small business account is believed to derive primarily from the deposit services and not from the lending. 14 Due to the developmental orientation of suppliers to this market, all respondents confirmed that they go to lengths to help their clients succeed. Realising on collateral is a very last resort, initiated only when they conclude that the client is able but not willing to repay or the company is going into liquidation. Several of South Africa s banks have invested heavily in non financial support for their small business clients. ABSA has established ten of its own Enterprise Development Centres in order to provide non-financial support to emerging entrepreneurs, including access to markets and mentors and business advice. Over the past four years Nedbank has been offering business seminars two to three times per year in each of eighteen (18) locations in townships and city centres. These are highly popular, according to Nedbank staff, attracting an average of 300 attendees; these seminars include topics such as cash flow management, registrations and starting a business, human resources and labour relations, and sales and marketing. Nedbank also organises business mentorships through Business Partners and offers a low fee registration service called Swift Reg. New Business Finance (NBF) exemplifies strong relationship banking and customer care principles. Prior to approving a loan, the loan officer will assist a client to refine the business plan, cutting expenditures back to bare essentials to ensure the client does not become over-indebted. Disbursements are made primarily to suppliers, to avoid the temptation for a client to divert funds to consumption purposes. Loan officers maintain close contact with clients in their portfolio and provide extra counselling when it becomes apparent that a client is struggling. We ensure that the client is not worse off after receiving a loan from us. 15 A significant number of loans have been rescheduled by NBF during 2008 owing to the tougher economic climate facing clients. NBF exercises extreme patience in order to allow a client to get their business back on track. Over time, however, if the business is clearly failing or if the client is avoiding the loan officer, the client will be passed to the collections and legal departments to initiate legal steps. With regards to microenterprise lending with loan sizes from R500 to R50 000, leading microfinance institutions worldwide have consistently achieved average loss rates of below 5% of average portfolio per year, utilising both group lending and individual lending methodologies. In South Africa, the three largest microenterprise lenders: the Small Enterprise Foundation (over active loans), Women s Development Business (over active loans), and Marang Financial Services (over active loans), have also met these global standards of portfolio quality utilising group lending methodologies. Not one of South Africa s microenterprise lenders utilising an individual lending methodology, however, has managed to sustain strong portfolio quality over an extended period as well as reach a significant size. Many initiatives have been launched and have closed within three to five years, as discussed further in Section VI. While there are a variety of reasons to explain these failures, and each had its own unique circumstances, there is an argument to be made that a regulatory environment for collateral which better reflects the unique requirements of lending to micro and small enterprises could help to prevent future failures. The taking of collateral is an important tool for managing risk which could improve the quality of a portfolio just enough to ensure sustainability of the lender. When applied judiciously and efficiently, collateral is far from an unnecessary evil; it could support the continuity of an important service to the micro and small enterprise markets Allan Kauder, Vise President for Business Banking, Bank of America, Banking on the Future Conference, October 2008, Johannesburg. 15 Mohammed Hoosain Hamdulay, Legal Advisor LLB, New Business Finance, 2008

17 How this Paper is Organised Section I provides an Executive Summary of the report and outlines the findings and recommendations of the research team. Section III on Collateral Fundamentals provides a framework for conceptualising collateral issues, including a definition of collateral, the role of collateral, borrower and lender preferences for collateral, as well as the legal framework for collateral. Section IV, with regards to Collateral Substitutes, addresses consequences of default which do not involve the pledging of an asset but still result in discouraging a debtor from defaulting. Sections V, VI, and VII furnish an overview of the South African market for micro and small enterprise lending, covering a profile of clients, suppliers, and other environmental factors. The final six Sections, VIII to XIII, provide an assessment of six types of collateral, including Bills of Exchange (cheques), Guarantees and Sureties, Movable Assets, Leasing and Instalment Sale Agreements, Immovable Asset Collateral, and Cessions. For each of these collateral types, we provide examples of how they have been utilised internationally, the relevant legal framework in South Africa, lender practices in South Africa, and recommendations for policy changes with regards to that particular instrument. This paper is merely the beginning of a dialogue regarding how to support security options for lending to micro and small enterprises in South Africa. While we were able to identify certain bottlenecks and make initial recommendations, each one would benefit from a more complete feasibility study. We hope policymakers and other stakeholders will take this process forward. 15

18 III Collateral Fundamentals Definition of Collateral Collateral is an asset pledged by a borrower to a lender until a loan is paid back. If the borrower defaults, then the lender has the right to seize the collateral and sell it to pay off the loan. 16 An asset can be physical, financial, or off balance sheet, such as a personal guarantee. In their agreements, borrowers and lenders must clearly define the asset pledged. Some movable properties escape a precise definition of quantity and quality, such as stored merchandise or perishable goods. In these cases, it is not the asset as such that becomes the object of the pledge, but the storage room with its contents 17. Some countries require each asset to be enumerated (Uruguay) and others allow for floating pledges where contents of a specific warehouse are pledged (Peru). The latter is clearly more lender friendly than the former. Once a pledgeable asset is identified, a lender needs to verify ownership of this asset and ensure that another lender does not have a prior claim to the same collateral. Lender friendly jurisdictions maintain an electronic register of movables and real property which are up to date, complete, transparent, accessible, and not costly to consult. A pledge is a contractual obligation in advance of an exchange of money. When the asset pledged remains in the hands of the lender/creditor, such as in pawn-broking, the rights of the lender are easy to identify and enforce. However, when the asset pledged remains in the hands of the borrower, appropriation by the lender is dependent on the law. Notarial bonds (or chattel mortgages) are designed to protect the lender in such cases. These instruments, however, require costly registration procedures and cannot be realised without going through court procedures. For the micro-market, lender friendly jurisdictions allow for the realisation of assets pledged without court participation. In most jurisdictions, when the asset remains in the hands of the borrower, he or she also retains the right to any returns accruing from use of the asset. Role of Collateral Collateral is just one of the three primary C s of credit utilised by lenders to manage their bad debt risk; the other two being Character and Capacity. While most lenders will agree that verifying the character of the borrower and the capacity of the entity to repay the loan are more important tools in risk management, most will also agree that collateral is a crucial final element in the lending mix to discourage default and provide for recovery. Collateral is used to concentrate the mind of the borrower. Since many SMEs do not have significant cash invested in their business, collateral ensures they have something to lose if the loan is not repaid. To a certain extent, collateral also provides some means of loan recovery. 18 From the lender s point of view, collateral serves both as a screening tool and a means to mitigate losses. If a borrower is willing to pledge their home or land or a household asset, it demonstrates confidence in and commitment towards their business. The possibility of losing these assets ensures that the borrower does not take repayments lightly. They are more likely to work seven days a week, and less likely to go on holiday or purchase a new car, for example, in order to avoid delinquent payments and possible loss of the assets pledged. Collateral is important but it is not the be all and end all. The other three components: viability, financial projections, and ability of the entrepreneur are more important. 19 When loans are small, as in loans to small and micro businesses, and the value of collateral pledged often does not equal the value of the disbursed loan, funds recovered after costs of realising on the asset may be a small portion Balkenhol and Schutte, pg Balkenhol and Schutte, pg George Watson, New Business Finance, Graham Erasmus, National Sales Director, Small Business Services, Nedbank, 2008

19 of the capital at risk. Nevertheless, lenders still believe it is worthwhile to pursue recovery to communicate that the lender is serious. In the microenterprise market, word spreads quickly. If there are minimal consequences to default, loss rates are likely to rise beyond sustainable levels. In the small enterprise market, although word does not spread as quickly, a lender has more to lose if one loan turns bad. Mitigation of risk becomes the primary motivation for realising on collateral. Collateral is indicative of the extent to which the entrepreneurs will commit themselves and it partly mitigates your risk.. we would not lend without collateral unless the entrepreneur had found the cure for AIDS! 20 Collateral can also place a lender in a priority position against other creditors in the event of insolvency. A lender friendly jurisdiction will allow a creditor to realise on pledged collateral despite the borrower entering into receivership. Borrower Preferences Regarding Collateral Characteristics of collateral preferred by borrowers include: availability, minimal impact on the household and enterprise, and minimal transaction costs. Availability: It is advantageous to MSEs when a lender will accept a wide range of collateral. If collateral options are flexible, the MSE has a better chance of meeting lender requirements. Since the majority of MSEs in South Africa and around the world do not have either tangible financial assets or real immovable assets to offer, lenders have developed alternatives based on assets which are more generally available, such as business equipment, household assets, inventory, and accounts receivable. Minimal Impact: For the low end of the MSE market, assets commonly owned with a resale value include fixed assets used in the business, such as a sewing machine or refrigerator, or assets used in the household, such as a television or lounge suite. If a lender takes possession of these assets to secure a pledge, it will have a serious impact on the business and household. For this reason, asset pledges have lost their commercial appeal in South Africa. Transaction costs: When a lender is required to go through a costly registration process in order to perfect its collateral, these fees are ultimately paid by the borrower. SMEs prefer, therefore, collateral options which minimise these transaction costs. Lender Preferences Regarding Collateral Characteristics of collateral preferred by lenders include: timely appropriability, marketability, minimal transaction costs, and preference in liquidation. Appropriability: This refers to the act of taking possession of an asset in order to realise on a pledge. Lender friendly environments support a rapid seizure of assets once a client is deemed to be unwilling or forever unable to repay. The longer an asset is held by a delinquent debtor, the lower the resale value is likely to be. The asset could go missing, or get damaged, or require extensive refurbishing if control of that asset is not gained within a month or two of a breakdown in relations with the lender. Contracts preferred by lenders are those which allow for appropriation even in the event of insolvency. In the world of microfinance, it is widely accepted that late payments and defaulters must be dealt with swiftly. If a community develops the view that a lender is not serious about collections and borrowers can miss payments without consequences, delinquency spreads like a virus and the lender is saddled with the task of collecting a deteriorating portfolio. This increases the cost of lending; costs which are either passed on to borrowers or result in failure of the lending institution. 20 Kenneth Fischer, General Manager, Small Business Development, Blue Financial Services,

20 Astute borrowers learn the tricks to stave off legal action and these tricks are passed from one borrower to another. If the regulatory environment allows for multiple procedures to avoid or delay legal action, certain communities will take advantage of this and the sustainability of the institution will be placed at risk. Marketability: In the informal sector, it is generally not difficult to resell commonly held household and business articles. In the formal sector, however, where larger assets are involved, marketability is facilitated by more formal structures. Ideally there should be a mechanism to confirm ownership of the asset and ensure there are no prior assignments of the asset to another creditor. In addition, there needs to be an accepted procedure for valuing and selling the asset. MSE lending thrives in countries with active secondary markets and well managed auction houses which facilitate the realisation of a fair value for assets. Transaction Costs: Environmental factors which reduce transaction costs related to collateral include well functioning deeds offices and asset registries, efficient and low cost court procedures for realisation of assets, and the use of national ID numbers. Exemptions from registration and court proceedings for certain types of assets or certain types of transactions facilitate loans at the lower end. Each form of collateral and the collateral environment can be judged against how well they meet or support both the borrower and the lender preferences. Collateral Law It is widely recognised by development finance experts that inappropriate collateral laws and environments can unnecessarily restrict the flow of capital, particularly to micro and small enterprises which cannot meet traditional collateral requirements: If, because of a lack of collateral, a large number of loan contracts are not concluded, then Central Banks and other authorities responsible for the efficiency and security of transactions in the financial market and for a broad-based participation of the largest possible number of households and enterprises have a reason to be concerned. The social costs of collateral-related problems in terms of higher interest payments, a reduced volume of investment and lower output levels does therefore call for the attention of public authorities. 21 Collateral Law does not exist as a distinct entity. Rather, a range of compartments of private law combine to regulate how parties go about creating, perfecting, and enforcing security interests. These include: 22 Contract law (standard form contracts used by major banking groups); Property law (especially the dispositions of security rights over movables); Commercial law (especially concerning registers with information on ownership of company assets); Judicial process law; Bankruptcy code (especially priority claims to pledged assets); Special laws concerning foreclosure (judicial execution), sale by court order and sequestration; and Decrees governing land registers and other registers. An effective collateral law should encourage the conclusion of many financial contracts (density), broaden the financial sector by making it more accessible (access), and at the same time maintain or even raise the general level of financial contract security reflected in a low default rate and limited default losses across the financial sector (quality). 23 High transaction costs in connection with specifying, validating and realising collateral may ration out smaller and medium-sized borrowers. This is not at all unlikely, considering the way the law in many countries is administered. Often the institutions for the enforcement of claims do not exist (bailiff, courts) or, if they exist, they function too slowly. Rational lenders will require only collateral that can be liquidated without court orders, Balkenhol and Schutte, pg Balkenhol and Schutte, pg Balkenhol and Schutte, pg 21.