Collateral law provides a system for increasing access to affordable credit in a competitive lending market by reducing the costs and risks of lending so that lenders can pass on savings to borrowers. The system is actually quite simple:
- The credit provider (whether a bank, supplier, or non-bank financial institution) determines whether the borrower will have sufficient income to repay the credit.
- The borrower gives the credit provider an interest in movable property, such as equipment, a vehicle, or inventory, which secures the obligation with the value of that property.
- The credit provider registers the interest in a registry in order to establish priority in case others obtain a right in the debtor’s property.
- If the borrower defaults on payment, the credit provider may take possession of the movable property, sell it, and use the proceeds to pay off the debt.
Collateral lending lowers the risk of non-payment because the borrower will normally pay off the loan instead of losing the property used as collateral. If the borrower does default, then the value of the collateral helps to pay off the debt, further reducing the overall risk of non-payment. Finally, enforcement provisions of a well-crafted collateral law allow secured lenders to seize and sell the movable property rapidly and more efficiently than would be possible through a longer law suit. This reduces the costs of collection.
As an added benefit, collateral lending reduces conflicts over rights in property by establishing priorities and eliminating unnecessary legal claims. It reduces attempted fraud by borrowers because the lender’s interest in the property follows the property—if the borrower fraudulently sells the collateral and hides the proceeds, the lender can still seize the property from the new buyer. Consequently, the system lowers the overall risk of loss through fraud for the banking community.
Well-structured collateral lending systems also expand the scope of property that can be used as collateral, and thus expand access to credit. Any property right that can be identified, used, defended, and transferred by the owner can be used as collateral. In modern systems, this ranges from tangible property like vehicles to intangible property such as accounts receivables or future crops. Livestock and inventory can also serve as collateral, even though the individual items may change over time.
Ethiopia’s collateral law system has significant gaps that limit its utility for supporting economic growth and development. The basic legal and institutional structure is inadequate to move significantly beyond existing levels of credit. Supporting institutions—especially the banking system—create further limitations on the utility of movable property for expanded access to credit. Reforms are needed before the demand for secured credit can be met. Fortunately, these reforms are neither difficult nor radical, but represent an appropriate next step in the evolution of Ethiopia’s collateral laws.
