Good Practices in Secured Transactions
- Establishing a functional approach to secured transactions
- Allowing a general description of collateral
- Maintaining a unified registry
- Protecting secured creditors’ rights during an automatic stay when a debtor enters a court-supervised reorganization procedure
- Allowing out-of-court-enforcement
Good Practices in Credit Information
- Reporting good as well as bad
- Collecting and distributing data from retailers and utility companies
- Lowering or eliminating minimum loan thresholds
- Providing online access for banks and financial institutions
- Offering bureau or registry credit scores as a value added service
GOOD PRACTICES IN SECURED TRANSACTIONS
A number of good practices in secured transactions have evolved through experience with collateral reforms in economies around the world.
ESTABLISHING A FUNCTIONAL APPROACH TO SECURED TRANSACTIONS
What is an effective secured transactions system? One that promotes the availability of credit by reducing the risk to lenders of accepting movable assets as collateral. This can be achieved by taking a functional approach to secured transactions—by creating an integrated or unified legal framework that extends to the creation, publicity and enforcement of functional equivalents to traditional security interests in movable assets. This eliminates the need to have different laws governing different types of secured transactions, which is cumbersome; instead, economies can adopt a single piece of legislation covering all types (1). This approach provides transparency and predictability for creditors—because the legal framework covers all rights in movable assets that secure the performance of an obligation, regardless of the type of transaction. What matters is no longer the form that the agreement takes (whether a floating charge or a pledge agreement, for example) but the rights and obligations that it creates.
Forty-nine of 190 economies have a functional approach as recorded by Doing Business. In assessing whether economies use a functional approach, Doing Business takes into account the 4 most common functional equivalents to traditional types of security: fiduciary transfer of title; financial lease; assignment or transfer of receivables; and sale with retention of title.
ALLOWING A GENERAL DESCRIPTION OF COLLATERAL
Some collateral laws require security agreements to include a specific description of the assets pledged as collateral. This increases transactions costs when revolving assets such as inventory are used as collateral—because every time inventory is purchased or sold, the security agreement needs to be updated and perhaps even re-registered. Allowing a general description of the collateral makes security agreements more flexible and increases access to finance.
Laws providing the most flexibility allow security interests in all types of movable property and permit a generic description of the assets to secure a loan as long as these assets are identifiable—for example, allowing the contract to stipulate as the collateral “inventory of general merchandise as of [date] and for [amount].” Such contracts typically obligate the debtor to maintain the same aggregate value of inventory and the same type of goods. For nonpossessory security interests to be effective, the debtor needs total freedom to use the assets as long as proper care is taken to preserve their commercial value.
MAINTAINING A MODERN COLLATERAL REGISTRY
Before accepting collateral, creditors need an effective way to find out whether the potential borrower has already granted a security interest in the collateral and, if so, what priority those rights have. This can best be done where there is a centralized collateral registry—one that is unified geographically and recording interests in all types of movable assets (figure 1). If registries are not unified across regions, a creditor will have no way of knowing whether a security interest in an asset has already been registered in another jurisdiction. And a need to search multiple registries increases transactions costs. But where registries are unified and computerized, a creditor can immediately check all the registries in an economy from one location, by searching the debtor’s name.
Collateral registries therefore support the use of movable collateral to secure loans. Studies show that establishing a new collateral registry can have an economically significant impact. In economies undertaking such reforms, access to bank finance increases by about 8 percentage points on average, while interest rates decline by about 3 percentage points and the terms of loans increase by about 6 months. The positive impact tends to be larger for smaller firms (2).
As model laws and legislative guides have evolved with technology over the years, they have encapsulated a set of good practices that serve as generally accepted standards for modern collateral registries. In addition to centralizing registries, these include using notice-based registration and allowing online access to data.
While traditional registries usually require a copy of the loan agreement or other documents, notice-based registries require no documentation other than a simple generic form that records the existence of a security interest, providing the names of the creditor and the debtor as well as a general description of the collateral asset and the obligation secured. This avoids the need for a specialist to review lengthy documents, which can be costly and time-consuming. It also improves the quality of registration: with less documentation, the potential for errors is minimized. Notice-based registration has also been successfully adopted for other registration systems, such as patent and trademark registries.
Online systems allow users to perform searches and register security interests from anywhere and at any time. Unlike with paper-based systems, there is no need for users to appear before the registrar and wait their turn to enter information in the registry index. Online registration also transfers the burden of preventing errors to the interested party.
PROTECTING SECURED CREDITORS’ RIGHTS DURING AN AUTOMATIC STAY WHEN A DEBTOR ENTERS A COURT-SUPERVISED REORGANIZATION PROCEDURE
An automatic stay or moratorium is an order that automatically stops all collection actions against the debtor, generally because a judicial process has started. An automatic stay should be imposed during reorganization proceedings to ensure the recovery of the debtor and enable the creditors to collect their claims. Because the automatic stay privileges the debtor by stopping debt collection by most creditors, good-practice standards emphasize the importance of protecting secured creditors’ rights during the automatic stay: “the insolvency law should specify that the court may grant relief of a provisional nature, at the request of the debtor, creditors or third parties, where relief is needed to protect and preserve the value of the assets of the debtor or the interests of creditors, between the time an application to commence insolvency proceedings is made and commencement of the proceedings”(3).
To ensure this protection, the laws of an economy need to clearly prescribe a short time limit for the stay so as to enable the secured creditors to collect their debts (since they are not allowed to take any action during the stay). They also need to stipulate a relief from the stay when the collateral is not needed for the debtor’s reorganization or when the stay poses a great risk to the existence of the collateral (such as for perishable goods). And the laws need to allow insolvency representatives to provide additional or substitute assets to compensate for the diminution of value of the encumbered assets due to the stay—as well as the payment of interest during the period of stay.
ALLOWING OUT-OF-COURT ENFORCEMENT
Creditors are unlikely to extend loans secured by collateral if they must rely on long, costly and burdensome court proceedings to enforce their rights in case of a default. Quick enforcement is particularly important for movable property, which depreciates over time. One way to ensure quick enforcement is to allow parties to a security agreement to agree to out-of-court enforcement at the time the security interest is created. In this approach the security agreement is essentially considered to be an execution deed, allowing the secured creditor to seize the collateral or ask a nonjudicial official to do so if the debtor contests the enforcement. This has the added benefit of reducing dependence on the courts and thus freeing up court resources.
Nevertheless, not all extrajudicial procedures are efficient. In some economies, for example, the law requires notarization of the agreement. This requirement can protect unsophisticated debtors from abusive creditors, but if not managed well, notarization might also imply an added cost for credit. In other economies the law overprotects the debtor, making the procedure expensive and unappealing to secured creditors. When legal reform introduces a system of out-of-court enforcement, it needs to strike the right balance—to protect the rights of all those affected, including the debtor and other creditors. Provisions that allow options for public auctions and private tenders and that permit the secured creditor to take the asset in satisfaction of the debt save time and cost in the enforcement of security rights.
GOOD PRACTICES IN CREDIT INFORMATION
Specific practices help increase credit information coverage and encourage the use of credit reporting systems. Among the most common are expanding the range and type of information shared, collecting and distributing data from sources other than banks and regulated financial institutions, lowering or eliminating minimum thresholds for the loans included in a credit bureau’s or credit registry’s database, providing subscribed banks and financial institutions online access to the credit bureau’s or credit registry’s database and providing bureau or registry credit scores as a value added service.
REPORTING GOOD AS WELL AS BAD
Credit information can be broadly divided into 2 categories: negative and positive. Negative information covers defaults and late payments. Positive information includes, for example, on-time loan repayments and the original and outstanding amounts of loans.
A credit reporting system that reports only negative information penalizes borrowers who default on payments—but it fails to reward diligent borrowers who pay on time. Sharing information on reliable repayment allows customers to establish a positive credit history and improves the ability of lenders to distinguish good borrowers from bad ones. Sharing more than just negative information also ensures that a credit reporting system will include high-risk borrowers that have accumulated significant debt exposure without yet defaulting on any loans.
Sharing full information makes a difference for lenders. A study in the United States simulated individual credit scores using only negative information and then using both negative and positive information. The negative-only model produced a 3.35% default rate among approved applicants, while the use of both positive and negative information led to a 1.9% default rate (4).
Experience in Hong Kong SAR, China provides another example. Between 1998 and 2002 credit cards became popular. Perhaps too popular—many consumers could accumulate several credit cards because positive credit information was not shared at the time. There were many credit card defaults, and in 2002 Hong Kong SAR, China, was hit by a severe credit card crisis. Lenders wrote off nearly 13% of their total card receivables, compared with 7.5% for lenders in the United States. Since then the credit bureau has shifted to a full credit reporting system (5).
A study of Latin American economies suggests that where credit bureaus distribute both positive and negative information and have 100% participation from banks, lending to the private sector is greater (at least 47.5% greater) (6). Another study also looked at the effect of providing positive and negative information in Latin America (7). In Brazil it found that having access to positive information would reduce the default rate from 3.37% to 1.84%—equivalent to about a 45% reduction in portfolio losses for Brazilian banks. The study also showed the gains in terms of access to credit. While 56% of the sample population would get credit if only negative information is used, more than 82% would if full information were available.
In recent years several economies moved to a full information sharing system. One was New Zealand. According to amendments to its Credit Reporting Privacy Code that came into effect on April 1, 2012, credit bureaus can collect positive information on individuals and firms from banks, financial institutions and telephone companies. Because the provision of positive credit data was voluntary, it took some time for banks to begin sharing their information, and throughout 2013 New Zealand was still transitioning to the new system, called Comprehensive Credit Reporting. But the data sharing rules in New Zealand state that a credit provider must supply positive credit data to receive positive credit data—and since early 2014 credit reporting institutions in the country have been collecting and sharing positive credit information, such as the limit of a loan and a pattern of on-time repayments over a 24-month period.
There was also good news for potential borrowers in Brazil; after 10 years of work to create an appropriate legal framework for sharing positive credit data, a new law entered into force on June 9, 2011, that allows credit bureaus to share positive information. In Oman the Bank Credit and Statistical Bureau System, launched by the central bank on December 20, 2010, collects positive and negative information on firms and individuals—including information on any type of credit facility and on both performing and nonperforming loans.
In Georgia the credit reporting system started distributing positive and negative information in the summer of 2007. This was in response to banks’ demand for a better understanding of customers’ payment patterns. The banks wanted to improve their risk management tools as their lending grew. The largest banks participated actively in sharing positive information. The new approach contributed to a 20-fold increase in coverage compared with the previous year, from 8,000 borrowers to 160,000.
COLLECTING AND DISTRIBUTING DATA FROM RETAILERS AND UTILITY COMPANIES
One effective way to expand the range of information distributed by credit registries is to include credit information from retailers or utility companies, such as electricity providers and mobile phone companies. Providing information on payment of electricity and phone bills can help establish a good credit history for those without previous bank loans or credit cards. In these economies coverage of borrowers tends to be higher than in those where credit bureaus or credit registries do not include information from retailers or utility companies. This represents an important opportunity for including people without traditional banking relationships. A recent study across 8 global mobile money operators found that 37% of their customers lacked a bank account (8).
But including this information can be challenging. Utilities and retailers are regulated by different institutions than financial companies are. They also might have to be convinced that the benefits of reporting bill payment outweigh the costs.
One utility in the United States has clearly benefited. In August 2006 DTE Energy, an electricity and natural gas company, began full reporting of customer payment data to credit bureaus. DTE customers with no prior credit history—8.1% of the total, according to a recent study (9) —gained either a credit file or a credit score. And customers began to make payments to DTE a priority. Within 6 months DTE had 80,000 fewer accounts in arrears.
In Rwanda 3 utility companies—2 mobile phone companies (MTN and Tigo) and an electricity and gas company (EWSA)—started providing credit information to the credit bureau in April 2011. This led to an immediate 2% increase in the number of firms and individuals registered in its database.
LOWERING OR ELIMINATING MINIMUM LOAN THRESHOLDS
Where thresholds for the loans included in a credit bureau’s database are high, retail and small business loans are more likely to be excluded. This can hurt those that benefit the most from credit reporting systems—such as female entrepreneurs and small enterprises, whose loans are typically smaller. Women represent 76% of total borrowers from microfinance institutions (10). Therefore, credit bureaus and credit registries that collect and distribute microfinance data are more likely to benefit female entrepreneurship by building credit histories for women. Credit registries usually set relatively high thresholds for loans, since their primary purpose is to support bank supervision and the monitoring of systemic risks. Credit bureaus tend to have lower minimum loan thresholds.
Indonesia, Tunisia, and West Bank and Gaza eliminated their loan thresholds in 2008. Azerbaijan eliminated 3 thresholds in 2009: 1,000 manat ($1,314) for individuals, 5,000 manat ($6,572) for firms and 10,000 manat ($13,144) for credit cards. This action was spurred by the rapid growth in consumer loans, which had led banks to request more detailed information on a larger group of borrowers (11). In 2010 Mongolia’s credit registry eliminated the minimum threshold for loans included in its database. As a result the registry’s coverage doubled after just 1 year. In Brazil a circular that went into force in 2011 reduced the minimum threshold for loans reported by the central bank’s credit information system by 80%. The Central Bank of Cyprus adopted a directive in December 2013 eliminating the minimum threshold for loans to be included in credit bureaus’ databases. As a result, loans of all sizes are now included in the database of the credit bureau Artemis Bank Information Systems.
PROVIDING ONLINE ACCESS FOR SUBSCRIBED BANKS AND FINANCIAL INSTITUTIONS
More efficient credit reporting service providers share their data online. Offering online access for subscribed banks and financial institutions has become a must for many credit bureaus and credit registries.
One way to do so is through an online platform accessed with a traditional internet browser. This kind of system allows a user to connect once it has validated the user’s log-in information. Once connected to the system, the user can retrieve credit reports autonomously. Another way to provide online access is through a system-to-system connection, where the user’s system is connected to and integrated with the credit reporting service provider’s system. Both parties have software installed that allows host-to-host connectivity without human interaction. Data are updated automatically, and users retrieve credit information by accessing their own system, with no need to log into the service provider’s system (12). Online access to data is fast and can ensure transparency, data quality and security. A system-to-system connection further ensures system efficiency and high service standards for users because it eliminates data duplication, reduces the risk of human error and allows the streamlining of work flows with appropriate business and validation rules. These advantages may encourage more data providers to share information with the credit bureaus and registries.
Ethiopia’s central bank established a credit information center to allow banks to submit data and inquiries electronically. A pilot program was launched in August 2011 with 3 commercial banks, and by April 2012 the online system was fully implemented. Today 19 Ethiopian banks are registered as data users and provide monthly updates.
Bangladesh’s central bank (Bangladesh Bank) launched an online system for its credit information bureau in July 2011 to allow banks and other financial institutions to exchange information on borrowers and loan repayments electronically.
Paraguay’s central bank introduced a new online system in April 2011. This system is aimed at improving both the credit registry’s efficiency—by reducing the time it takes to verify credit information from one week to just a few minutes—and the accuracy of data. The system, called Red de Comunicación Financiera, allows financial institutions to transfer data to the credit registry and access credit information on both firms and individuals.
OFFERING BUREAU OR REGISTRY CREDIT SCORES AS A VALUE ADDED SERVICE
Many credit bureaus and registries provide value added services to data users. These include credit scoring, marketing services, portfolio monitoring, fraud detection and debt collection. An important tool in expanding access to finance is credit scoring, a statistical method of evaluating the probability that a prospective borrower will fulfill the financial obligations associated with a loan.
Credit scores based on credit bureau or credit registry data pool information across many creditors as well as some public information sources. They therefore include characteristics otherwise unavailable to any individual creditor, such as total exposure, number of outstanding loans and previous defaults within the system. Credit scores may improve market efficiency and provide borrowers with more opportunities to obtain credit. The availability of credit scores allows lenders that would otherwise not be capable of analyzing the raw credit data to extend credit to underserved markets at lower cost.
The credit bureau TransUnion Nicaragua introduced credit scoring based on the data in its database as a value-added service for its subscribed banks and financial institutions in June 2013. The new service helps creditors predict the likelihood of a consumer becoming more than 90 days delinquent on one or more lines of credit over the next 12 months, including credit cards, personal loans, home loans and automobile loans.
1. UNCITRAL (United Nations Commission on International Trade Law). 2007. Legislative Guide on Secured Transactions. New York: United Nations.
2. Love, Inessa, María Soledad Martínez Pería and Sandeep Singh. 2013. “Collateral Registries for Movable Assets: Does Their Introduction Spur Firms’ Access to Bank Finance?” Policy Research Working Paper 6477, World Bank, Washington, DC.
3. UNCITRAL (United Nations Commission on International Trade Law). 2007. Legislative Guide on Secured Transactions. New York: United Nations.
4. Barron, John, and Michael Staten. 2003. “The Value of Comprehensive Credit Reports: Lessons from the US Experience.” In Credit Reporting Systems and the International Economy, ed., Margaret M. Miller, 273–310. Cambridge, MA: MIT Press.
5. Bailey, Andre, Suzi Chun and Jeffrey Wong. 2003. “Wanted: Asian Credit Bureaus.” McKinsey Quarterly, no. 2. Available at http:// www.forbes.com/.
6. Turner, Michael, and Robin Varghese. 2007. Economic Impacts of Payment Reporting Participation in Latin America. Chapel Hill, NC: PERC Press.
7. Powell, Andrew, Nataliya Mylenko, Margaret Miller and Giovanni Majnoni. 2004. “Improving Credit Information, Bank Regulation and Supervision: On the Role and Design of Public Credit Registries.” Policy Research Working Paper 3443, World Bank, Washington, DC.
8. CGAP (Consultative Group to Assist the Poor) and World Bank. 2010. Branchless Banking 2010: Who’s Served? At What Price? What’s Next? Washington, DC: World Bank.
9. World Bank Conference. Financial Infrastructure Week. Brazil, March 15-17, 2010.
10. World Bank. 2010. Women, Business and the Law 2010: Measuring Legal Gender Parity for Entrepreneurs and Workers in 128 Economies. Washington, DC: World Bank Group.
11. Interview with a credit bureau in Azerbaijan.
12. IFC. 2012. Credit Reporting Knowledge Guide. Washington, DC: World Bank Group.