Collateral-free lending may widen risks for banks before helping MSMEs

Mandating such a shift may not solve the problem. Ignoring information gaps and banning collateral risks weakening the financial system and could reduce, not expand, credit supply

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. 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. 

Collateral exists precisely to address these concerns. When lenders have limited information about a borrower’s ability to generate cash flows and worry about post-loan behaviour, collateral changes incentives. By pledging an asset, the borrower signals seriousness and accepts that failure will impose a personal cost. This strengthens repayment incentives and gives lenders confidence to extend credit. Collateral also allows borrowers with weaker credit histories to regain access to credit markets. By pledging assets, they reassure lenders that repayment incentives exist even when past behaviour has created doubts. 

The proposed regulation implicitly assumes that banks demand collateral because they are reluctant to assess business cash flows or because they exercise market power. It assumes that loan risk does not materially change if collateral is removed. Evidence from many countries suggests otherwise. Across both emerging and developed economies, secured loans tend to default more often than unsecured loans. This does not mean collateral causes default. Rather, lenders require collateral precisely from borrowers they perceive to be riskier. Without collateral protection, banks would face higher losses when lending to such borrowers. 

If collateral is restricted, several outcomes are possible. Banks may deny credit to borrowers who would otherwise have received loans backed by collateral. Alternatively, banks may increasingly insist on gold or silver as collateral, which the regulation explicitly permits. This could create unintended consequences. Much of the collateral pledged by small firms consists of business assets such as machinery, vehicles, or equipment that are directly tied to the business. Requiring borrowers instead to pledge household gold or silver effectively means asking them to demonstrate higher personal wealth. Many small firms may own productive assets but may not possess household gold. Restricting acceptable collateral in this way may exclude precisely the borrowers the policy intends to help. 

There is also a broader risk. If banks are pushed to lend without adequate safeguards, loan defaults may rise. India has already experienced the consequences of policy nudges in lending. Between roughly 2008 and 2018, large expansions of bank lending to infrastructure and related sectors were encouraged by policy signals and regulatory forbearance. The result was a major banking crisis marked by rising non-performing assets and stressed bank balance sheets. 

If the goal is to expand credit access, a better approach is to reduce the frictions that prevent lenders from assessing risk and recovering loans. Strengthening creditor rights is one step. Even under the Sarfaesi framework, financial institutions often wait months or years before collateral can be effectively transferred or liquidated after default. Faster enforcement would reduce recovery costs and encourage lending. Improving information infrastructure is equally important. The development of the Unified Lending Interface and the requirement that credit scores be updated regularly are positive steps. These initiatives should be expanded. Encouraging competition in credit scoring, expanding data access, and developing alternative credit scores using government administrative data can significantly reduce information gaps. 

In sum, the intent behind the RBI’s proposal is laudable. But market failures are best addressed by removing frictions that impede the working of markets, not by prohibiting mechanisms that help them function despite those frictions. Mandating collateral-free lending risks shifting and postponing risk rather than solving the underlying problem. 

The author teaches at the Indian School of Business