Collateral-free loans: A risky bet

The Reserve Bank of India (RBI) has proposed that banks should not accept collateral for loans of up to ₹20 lakh extended to micro and small enterprises, while allowing the voluntary pledging of gold or silver.

- PRASANNA TANTRI

The intent is understandable. India’s small firms rely heavily on collateral-based lending, and shifting towards cash-flow-based lending is a desirable long-term objective.However, mandating such a shift is unlikely to solve the underlying problem. Credit markets operate under deep information gaps. Ignoring these gaps and banning collateral requirements risks making the financial system more fragile and may ultimately reduce the supply of credit rather than expand it.

To see why, consider why credit constraints exist. In most markets for goods, prices adjust until supply equals demand. If demand rises, prices increase and producers supply more. Credit markets behave differently. The classic work of Stiglitz and Weiss (1981) explains why. When lenders raise interest rates, they attract borrowers willing to take greater risks, while safer borrowers often exit because the higher rate is not worthwhile. As a result, the borrower pool becomes riskier as interest rates increase. This is adverse selection. There is also the problem of moral hazard. Once a borrower receives a loan, they may take actions that increase the chance of failure because they keep most of the upside while the lender bears much of the downside. A borrower may invest in a risky project or reduce effort after receiving the loan. Because of these problems, lenders do not always respond to higher loan demand by raising interest rates. Instead they ration credit, leaving some borrowers willing to pay higher rates without loans.