Why it matters - Legal Rights
Doing Business measures the legal rights of borrowers and lenders in secured transactions (or collateral) laws and bankruptcy laws to assess how well these laws facilitate lending. These rights matter: lenders are unwilling to provide credit if there is no guarantee that they will be able to enforce their rights and collect a debt or repossess collateral through a timely and inexpensive process. Nowhere are the consequences of the absence of such a guarantee more apparent than in the lack of credit for small and medium-size enterprises (SMEs) in the developing world.(1)
WHY DO SECURED TRANSACTIONS REGULATIONS MATTER?
Movable assets, rather than land or buildings, often comprise most of the capital stock of private firms; this is especially true for SMEs. In the developing world, an average of 78% of the capital stock of businesses is in movable assets (such as machinery, equipment or receivables) while only 22% is in immovable property.(2) In economies with a modern secured transactions system, these assets can easily be used as collateral. However, in many developing economies lenders may consider movable property to be an unacceptable form of collateral—either because the law does not recognize nonpossessory interests in movable collateral or because it does not provide sufficient protection for those lenders accepting it. This constraint matters: research shows that in developed economies borrowers with collateral obtain nine times as much credit as those without it. These borrowers also benefit from repayment periods 11 times as long and up to 50% lower interest rates.(3)
For lenders considering a loan to a SME, one of the biggest deterrents is the possibility that the borrower has hidden liens—that is, that the borrower has already given its assets as collateral to another lender. As more complex financial instruments develop and are adopted worldwide—such as factoring (where a business sells its invoices to a third party, called a factor, at a discount) or financial leases that create hidden rights over property held by the borrowing company—the need for a system that limits the impression of “false wealth” becomes paramount.
One way to minimize the potential for secret liens is to adopt a functional approach to secured transactions. This approach requires legislation that covers all rights in movable assets that are created by agreement and that secure the payment or performance of an obligation, regardless of the type of transaction or the terminology used. (4) In this approach, 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. Indeed, a modern secured transactions system provides for the use of both possessory and nonpossessory security interests in movable assets—whether tangible or intangible, whether present, after-acquired or future assets and wherever located—and the functional equivalents of such security interests.(5)
A modern secured transactions system also allows secured creditors to establish their priority over collateral in an efficient and transparent manner—in part because of the uniform treatment of different types of securities in the law. It also establishes clear priority rules to resolve conflicting claims between secured creditors when a debtor defaults, whether in a bankruptcy procedure or not. One effective way to establish priority rights is to record the security interest in a centralized collateral registry.
Creditor rights and access to finance
Research has shown that legal protections for both creditors and institutions for sharing credit information are associated with higher ratios of private credit to GDP. In developing economies with poorly functioning legal systems, credit markets might depend only on credit information sharing. But in developed economies with effective systems of bankruptcy, creditor rights can play a greater role.(6) Strong creditor rights expand the availability of loans—when lenders have better legal protection during bankruptcy and reorganization of the debtor, they become more confident about the return of their investment in cases of default and therefore more willing to extend credit on favorable terms.
Legal and institutional differences may also shape the ownership and terms of bank loans around the world. Research finds that where creditor protection is stronger, loans have more concentrated ownership, longer maturities and lower interest rates.(7) Similarly, where secured creditors have priority over unsecured ones, the recovery rate for loans tends to be higher and the risks for secured creditors lower.(8) And some studies find that creditor rights can help prevent some effects of an economic crisis since weak creditor protection and weak enforcement make credit markets more volatile.(9) Reforming the legal framework for secured transactions can affect the behavior of lenders. Studies show that banks tend to increase their lending after amendments of collateral laws.(10) But for a legal reform to have a real impact, enforcement of the rights stipulated in laws needs to be possible in practice. And the enforceability of contracts matters for the structure and pricing of loans.(11) Where enforcement of property rights is weak, lenders tend to offer short-term credit as a way to protect themselves from debtor behavior such as defaults.(12)
WHY IT MATTERS - CREDIT INFORMATION
Globally, 27% of firms identify access to finance as a major constraint (13) while around 70% of formal SMEs in developing economies are estimated to be either unserved or underserved by the formal financial sector.(14) Credit bureaus and registries are essential elements of the financial infrastructure that helps to address the issue of access to financial services, including credit. By sharing credit information, they help to reduce information asymmetries, increase access to credit for small firms, lower interest rates, improve borrower discipline and support bank supervision and credit risk monitoring.
When banks share information, loan officers can assess borrowers’ creditworthiness using objective criteria. For regulators, credit information systems provide a powerful tool for supervising and monitoring credit risk in the economy. Access to credit information also benefits deserving borrowers, particularly small business owners, by increasing their chances of getting credit. Aside from simply providing credit information, credit bureaus and registries can offer fraud detection, debt collection, marketing services, credit scoring and other services to both lenders and financial supervisors.
Reduced information asymmetries
Borrowers typically know their financial abilities and investment opportunities much better than lenders do. The inability of lenders to accurately assess the creditworthiness of borrowers contributes to higher default rates and smaller loan portfolios. Lenders are also more likely to lend to larger firms, which may be more transparent as a result of more elaborate legal and accounting rules and regular publication of certified auditors' reports on their financial transactions. Credit reporting systems offer one way to minimize problems of asymmetric information since past behavior is considered a reliable predictor of future behavior. A good credit history—sometimes referred to as “reputational collateral”—minimizes the perception of risk, thus enabling an individual or firm to gain access to financing.
Greater access to credit for small firms
Credit bureaus and credit registries are one way of increasing access to finance for individuals and small firms.(15) With better, cheaper and faster access to credit information, lending officers can use accurate and objective data to make unbiased decisions in offering loans. And when they can assess the risk of default, banks have more incentive to lend to individuals and small firms. Supported by credit reporting systems, banks can base their credit decisions on past borrower behavior and therefore sensibly extend credit to smaller firms.(16) Research shows that basing credit decisions on objective information may improve the availability of credit to the poor and increase entrepreneurs’ opportunities for success, supporting the development of micro and small businesses in developing economies.(17)
A study using firm-level surveys from 63 economies covering more than 75,000 firms found that the introduction of a credit bureau improves firms’ likelihood of access to finance with longer-term loans, lower interest rates and a higher share of working capital financed by banks. The study also found that the greater the coverage of the credit bureau and the scope and accessibility of the credit information, the more profound its impact is on firm financing.(18)
Research in 27 transition economies shows that introducing a credit reporting system is associated with an increase of 4.2 percentage points in firms’ reliance on credit.(19) Such an effect would be welcome in the Middle East and North Africa, where banks cite lack of transparency among SMEs and weak financial infrastructure (credit information, creditors' rights and collateral registry) as the main obstacles to lending more to such enterprises.(20)
Sharing credit information reduces lenders’ uncertainty about borrowers’ total debt exposure, decreasing the costs of screening and lowering interest rates.(21) By aiding the exchange of information among lenders, credit bureaus and credit registries help creditors to sort good borrowers from bad ones and price loans correctly.
Using data on loans in Mozambique from 2000–06, researchers found that a better and more intense bank-borrower relationship improved the likelihood that a loan would be approved by 4.2% and reduced the processing time by 0.6 days. With the existence of data on repayment behavior, banks required 11.6% less in collateral value for each additional loan a firm took.(22)
Better borrower discipline
Credit information sharing can act as a disciplinary device for borrowers. When lenders are known to share information about customers’ credit records, borrowers know that defaults on loans from one lender may disrupt future access to credit from all other lenders. As a result, borrowers have greater incentive to repay. (23) Research has shown that repayment rates can increase by up to 80% when a credit registry or bureau starts operation.(24) According to a recent study surveying 70 utility companies in the United States, 72% reported that the benefits of credit reporting amounted to at least 2–5 times the costs. Half of all customers said that they would be more likely to pay their bills on time if those payments were fully reported to credit bureaus and could affect their credit score.(25)
Support for bank supervision and credit risk monitoring
For regulators, credit information systems provide a powerful tool for supervising banks and monitoring credit risk and credit trends in an economy. Regulators often use information from credit bureaus and credit registries to assess whether current provisioning is adequate and to analyze developments in credit markets and interest rates. The results may guide changes in the legislation governing financial institutions. Research in Argentina, Brazil and Mexico found that credit registries play a valuable role in credit risk evaluation and in supervision, including in calculations of credit risk for capital or as a check on a bank’s internal ratings.(26)
As more credit information becomes available, competition among banks and nonbank financial institutions should increase. A recent study in the Middle East and North Africa found that lack of credit information systems may curtail competition in the banking sector.(27)
1. Boris Kozolchyk. 2009. “Modernization of Commercial Law: International Uniformity and Economic Development.” Brooklyn Journal of International Law 2009, Arizona Legal Studies Discussion Paper No. 09-12.
2. Alvarez de la Campa, Alejandro, Everett T. Wohlers, Yair Baranes and Sevi Simavi. 2010. Secured Transactions Systems and Collateral Registries. Washington, DC: International Finance Corporation.
3. Alvarez de la Campa, Alejandro, Everett T. Wohlers, Yair Baranes and Sevi Simavi. 2010. Secured Transactions Systems and Collateral Registries. Washington, DC: International Finance Corporation.
4. UNCITRAL (United Nations Commission on International Trade Law). 2007. Legislative Guide on Secured Transactions. New York: United Nations.
5. UNCITRAL (United Nations Commission on International Trade Law). 2007. Legislative Guide on Secured Transactions. New York: United Nations.
6. Djankov, Simeon, Caralee McLiesh and Andrei Shleifer. 2007. “Private Credit in 129 Countries.” Journal of Financial Economics 84 (2): 299–329.
7. Qian, Jun, and Philip E. Strahan. 2007. “How Laws and Institutions Shape Financial Contracts: The Case of Bank Loans.” Journal of Finance 62 (6): 2803–34.
8. Djankov, Simeon, Oliver Hart, Caralee McLiesh and Andrei Shleifer. 2008. “Debt Enforcement around the World.” Journal of Political Economy 116 (6): 1105–49.
9. Galindo, Arturo José, and Alejandro Micco. 2007. “Creditor Protection and Credit Response to Shocks.” World Bank Economic Review 21 (3): 413–38.
10. Haselmann, Rainer, Katharina Pistor and Vikrant Vig. 2010. “How Law Affects Lending.” Review of Financial Studies 23 (2): 549–80.
11. Bae, Kee-Hong, and Vidhan K. Goyal. 2009. “Creditor Rights, Enforcement, and Bank Loans.” Journal of Finance 64 (2): 823–60.
12. Diamond, Douglas. 2004. “Presidential Address, Committing to Commit: Short-Term Debt When Enforcement Is Costly.” Journal of Finance 59 (4): 1447–79.
13. Enterprise Surveys database (http://www.enterprisesurveys.org/), World Bank.
14. Stein, Peer, Oya Pinar Ardic and Martin Hommes. 2013. “Closing the Credit Gap for Formal and Informal Micro, Small and Medium Enterprises.” Washington, DC: International Finance Corporation.
15. Brown, Martin, Tullio Jappelli and Marco Pagano. 2009. “Information Sharing and Credit: Firm-Level Evidence from Transition Countries.” Journal of Financial Intermediation 18: 151–72.; Jappelli, Tullio, and Marco Pagano. 1993. “Information Sharing in Credit Markets.” Journal of Finance 48 (5): 1693–718.
16. Brown, Martin, Tullio Jappelli and Marco Pagano. 2009. “Information Sharing and Credit: Firm-Level Evidence from Transition Countries.” Journal of Financial Intermediation 18: 151–72.
17. Luoto, Jill, Craig McIntosh and Bruce Wydick. 2004. “Credit Information Systems in Less-Developed Countries: Recent History and a Test.” Economic Development and Cultural Change 55 (2): 313–34.; Brown, Martin, Tullio Jappelli and Marco Pagano. 2009. “Information Sharing and Credit: Firm-Level Evidence from Transition Countries.” Journal of Financial Intermediation 18: 151–72.
18. Martínez Peria, María Soledad and Sandeep Singh. 2014. “The Impact of Credit Information Sharing Reforms on Firm Financing.” World Bank Policy Research Working Paper 7013. World Bank: Washington, DC.
19. Brown, Martin, Tullio Jappelli and Marco Pagano. 2009. “Information Sharing and Credit: Firm-Level Evidence from Transition Countries.” Journal of Financial Intermediation 18: 151–72.
20. Rocha, Roberto, Subika Farazi, Rania Khouri and Douglas Pearce. 2010. “The Status of Bank Lending to SMEs in the Middle East and North Africa Region: The Results of a Joint Survey of the Union of Arab Banks and the World Bank.” World Bank, Washington, DC; and Union of Arab Banks, Beirut.
21. Brown, Martin, and Christian Zehnder. 2007. “Credit Registries, Relationship Banking, and Loan Repayment.” Journal of Money, Credit and Banking 39 (8): 1883–918.; Luoto, Jill, Craig McIntosh and Bruce Wydick. 2004. “Credit Information Systems in Less-Developed Countries: Recent History and a Test.” Economic Development and Cultural Change 55 (2): 313–34.; Brown, Martin, Tullio Jappelli and Marco Pagano. 2009. “Information Sharing and Credit: Firm-Level Evidence from Transition Countries.” Journal of Financial Intermediation 18: 151–72.; Behr, Patrick, Annekathrin Entzian and Andre Guettler. 2011. “How Do Lending Relationships Affect Access to Credit and Loan Conditions in Microlending?” Journal of Banking and Finance 35: 2169–78.
22. Behr, Patrick, Annekathrin Entzian and Andre Guettler. 2011. “How Do Lending Relationships Affect Access to Credit and Loan Conditions in Microlending?” Journal of Banking and Finance 35: 2169–78.
23. Padilla, Jorge, and Marco Pagano. 2000. “Sharing Default Information as a Borrower Discipline Device.” European Economic Review 44 (10): 1951–80.
24. Brown, Martin, and Christian Zehnder. 2007. “Credit Registries, Relationship Banking, and Loan Repayment.” Journal of Money, Credit and Banking 39 (8): 1883–918.
25. Turner, Michael, Robin Varghese, Patrick Walker and Katrina Dusek. 2009. Credit Reporting Customer Payment Data: Impact on Customer Payment Behavior and Furnisher Costs and Benefits. Chapel Hill, NC: PERC Press.
26. 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.
27. Anzoategui, Diego, María Soledad Martinez Pería and Roberto Rocha. 2010. “Bank Competition in the Middle East and Northern Africa Region.” Policy Research Working Paper 5363, World Bank, Washington, DC.
Why it Matters — Credit Information