Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer November, 2020 COPYRIGHT © 2020 The World Bank Group 1818 H Street NW Washington, DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org All rights reserved. This work is a product of the staff and external authors of the World Bank Group. The World Bank Group refers to the member institutions of the World Bank Group: The World Bank (International Bank for Reconstruction and Development); International Finance Corporation (IFC); and Multilateral Investment Guarantee Agency (MIGA), which are separate and distinct legal entities each organized under its respective Articles of Agreement. We encourage use for educational and non- commercial purposes. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of the Directors or Executive Directors of the respective institutions of the World Bank Group or the governments they represent. The World Bank Group does not guarantee the accuracy of the data included in this work. Rights and Permissions The material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. All queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2422; e-mail: pubrights@worldbank.org. 2 ACKNOWLEDGMENTS The publication of this Primer was made possible through the generous support of the Swiss State Secretariat for Economic Affairs (SECO). The preparation of this Primer was led by a team composed of Giuliano G. Castellano (Associate Professor, University of Hong Kong, Faculty of Law and Asian Institute of International Financial Law), Pratibha Chhabra (Financial Sector Specialist), and John M. Wilson (Senior Financial Sector Specialist) within the World Bank Group under the guidance of Mahesh Uttamchandani (Practice Manager, Finance, Competitiveness & Innovation Global Practice).This publication benefitted immensely from the participation, guidance, and insights of other experts from the Secured Transactions and Asset Based Lending Team (Murat Sultanov and Elaine MacEachern) and from the input of Marek Dubovec (Kozolchyk National Law Center) on early versions of this Primer. The authors are indebted to the following peer reviewers for their excellent suggestions and thoughtful contributions that helped to improve the content of the Primer: Krishnamurti Damodaran (Lead Financial Sector Specialist), Bartol Letica (Senior Financial Sector Specialist) and Lillian Thyssen (Financial Sector Specialist) from the World Bank Group. The team would like to thank Nitin Kapoor from Vertical Accord for the design of the report. 3 4 ACRONYMS AND ABBREVIATIONS MABL Movable Asset-based lending (MABL) ECL Expected credit loss IFRS International Financial Reporting Standard IRB Internal rating-based MSME Micro-, small, and medium enterprise NBFI Non-bank financial institution SME Small and medium enterprise UNCITRAL United Nations Commission on International Trade Law 5 6 TABLE OF CONTENTS Acknowledgments 3 Acronyms and Abbreviations 5 Introduction 8 A. Coordination: Key Issues and Approaches 9 a) International Initiatives and Domestic Experiences 10 b) Fostering Coordination: The Way Forward 11 B. Prudential Regulation: Context, Rationale, and Key Elements 12 a) Scope of Application 12 b) Capital Requirements 13 c) Loan-loss Provisioning Requirements and Accounting Standards 14 d) Domestic Implementation and Structure of Incentives 15 C. Stakeholders 17 a) Regulators and Supervisors 17 b) Banks and NBFIs 17 c) Borrowers, Potential Borrowers, and the General Public 17 D. Key Challenges 19 a) Collateral Registry as Risk-Management Tool 19 b) Regulatory Compliance and Law Reforms 19 c) The Regulatory Treatment of Collateralized Transactions 19 d) Prudential Loan-loss Provisioning and Capital Requirements 20 e) Secondary Market for the Disposal and Valuation of Collateral 20 f) Development and Launch of MABL Credit Products 20 E. Addressing the Challenges by Developing a Regulatory Strategy 22 a) Mapping and Understanding the Domestic Environment 22 b) Regulatory Strategy: Key Elements 23 Conclusion 26 References 27 7 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer Introduction The existence of a legal and regulatory environment where of jurisdictions. The socioeconomic benefits sought with movable assets can serve as effective credit protection is the implementation of an efficient legal regime for secured of paramount importance for the development of a sound transactions stem from the possibility for creditors to manage and inclusive credit ecosystem.1 To this end, modern and curb the risks associated with lending activities. This, in secured transactions laws—governing creation, priority, turn, incentivizes lenders to extend more credit, reaching a third-party effectiveness, and enforcement of security larger portion of the population. rights on movables—have been implemented in a variety Secured Transactions Law Reforms: Objectives Secured transactions law reforms are implemented to achieve the following socioeconomic benefits: • Increase transparency in the credit market and promote legal certainty through the introduction of collateral registries and clear registry rules2 • Expand the availability of credit using movable assets (tangible, intangible, and financial instruments) as collateral 3 • Promote credit diversification, facilitating access to credit for micro-, small, and medium enterprises (MSMEs)4 • Mitigate lending risk and decrease the cost of credit5 • Increase the number of credit recipients, improving the livelihood of benefitting female entrepreneurs6 A legal framework conducive to secured transactions enables Access to credit and financial stability represent borrowers to use movable assets as collateral in order to gain complementary policy objectives.8 Hence, coordination access to capital.7 For instance, a farmer can acquire a new between legal and regulatory regimes supporting the creation tractor with a loan secured with that tractor; in a similar vein, of credit is key to ensuring the simultaneous attainment a seller of goods can pledge or sell receivables to finance its of multiple policies. Such coordination, in turn, requires business operations or expansion. a cohesive strategy tailored to local needs and aimed at promoting a synergic implementation of international legal All in all, a reformed secured transactions law facilitates the and regulatory standards.9 The key elements of such a reform development of a variety of credit products. Such products strategy are presented in this Primer, which anticipates range from simple installment loans that allow individuals a more comprehensive document, consisting of a toolkit to acquire consumer durables, such as motor vehicles and addressing the regulatory dimension of secured lending and household goods, to sophisticated financial transactions, related legal reforms. such as the securitization of receivables. Furthermore, some credit products can be developed to support the entire This Primer is organized in five parts. Part A illustrates why business cycle of the borrower – from the purchase of raw coordination between secured transactions law reforms and materials to the sale of finished goods, to the collection of prudential regulation is needed; in so doing, it identifies the receivables generated by the sale. Other products, such as core issues considered in this document. Part B introduces leasing and receivables financing, can be deployed to focus the rationale and key tenets of prudential regulatory regimes; solely on a single type of collateral and business needs. specific attention is given to capital requirements and Yet, these kinds of financing schemes require coordination prudential loan-loss provisioning. Part C maps out the key between legal reforms intended to increase access to credit, constituencies of stakeholders in the coordination between on the one hand, and regulatory regimes concerned with the secured transactions law and prudential regulation. Part D soundness of financial institutions and the stability of the identifies a set of typical issues emerging from the reform financial system, on the other. experiences of several jurisdictions. Part E presents the key elements of the regulatory strategy to approach such issues. Conclusive remarks follow. 8 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer A. Coordination: Key Issues and Approaches Movable asset-based lending (MABL) requires a series of and institutions is of primary importance to support the enabling elements; reforming domestic secured transactions establishment of a sound and inclusive credit ecosystem. law alone might not be sufficient to deliver the socioeconomic Yet, such a coordination requires an understanding of the benefits commonly associated with secured credit. The fundamental logics governing these branches of law that, establishment of transparent credit-reporting standards, the albeit both pursuing complementary policy objectives, existence of efficient insolvency rules, and the effectiveness often adopt different terminologies and approaches. A case of enforcement mechanisms are key to ensuring a predictable in point is offered by the very notion of “movable assets”, regime, where lenders are incentivized to extend credit while or “movable property”, used in secured transactions laws managing the risks associated with lending activities. In a to indicate a variety of tangible and intangible assets, and similar vein, coordination between secured transactions law the categorizations of different collateral under relevant and a growing body of rules regulating financial products prudential requirements. Movable Collateral: Legal & Regulatory Understandings As modern secured transactions laws enable a variety of credit products, the kind of movable assets that can be taken as collateral is heterogenous and include, but it is not limited to, the following assets: (i) consumer durables (e.g. motor vehicles), (ii) equipment, (iv) raw materials, (v) inventory (e.g. of crops or commodities), (vi) accounts receivable, (vii) negotiable instruments, (viii) gold, cash or cash equivalent, (ix) bank deposits, (x) warehouse receipts, (xi) bills of lading, (xii) letters of credit, (xiii) securities, (xiv) credit card receipts, (xv) intellectual property rights, and (xvi) digital assets. Regulatory regimes are likely to adopt a different terminology and attribute different treatments to transactions collateralized with different movables. For instance, reference to “financial collateral” or “financial assets” is often made to identify those assets, such as cash, gold, securities, or bank deposits, that are eligible to reduce credit risk and, thus, capital requirements. Whereas, consumer durables, raw materials, and equipment are often referred to as “physical collateral” and are not considered eligible to reduce capital requirements. Letters of credit, instead, might be subject to a special regime for off-balance exposures – rather than being considered as secured transactions, as it would occur in a commercial law context. Likewise, in some jurisdictions, arrangements secured by inventories of commodities or crops might not be considered as “collateralized transactions” but rather treated under a special set of rules. This Primer focuses on the intersections with prudential the economic benefits of secured lending and related law regulation—intended as that branch of financial regulation reforms.10 For instance, loans secured with some movable aimed at ensuring the safety and soundness of financial assets – in particular, “physical collateral” like a motor- institutions and markets. Specifically, the attention is on the vehicle or a piece equipment – are likely to be treated in the body of rules governing capital and prudential provisioning same guise as unsecured lending for regulatory purposes.11 requirements. At the international level, capital requirements In these circumstances, transactions collateralized with real are enshrined in international standards elaborated by estate or domestic treasury bills enjoy a more favorable the Basel Committee on Banking Supervision; whereas, treatment than commercial lending secured with tangible prudential provisioning requirements are largely shaped assets.12 Moreover, in certain jurisdictions, credit products at the domestic level. Collectively, capital and prudential secured with receivables or that entail the repayment of an provisioning requirements trace the regulatory perimeter for obligation through the cash-flow generated by the proceeds secured transactions. Coordination with these regimes is key resulting from the sale of collateral might also be treated as due to a number of reasons. unsecured credit. First, the lack of coordination between legal and regulatory elements supporting the credit ecosystem might thwart Second, financial institutions must comply with a variety of 9 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer regulatory requirements and ensure the proper management transactions law reforms in various domestic contexts of risks related to their activities. Domestic authorities, in turn, indicates the importance of ensuring a constant engagement are tasked with monitoring their thorough implementation. with domestic authorities entrusted with regulating and If such regulatory requirements and supervisory practices supervising the financial system. In particular, engagement have not been updated to consider the reformed secured with domestic regulators and central banks should start at transactions law, financial institutions might need to comply the outset of a reform process. Even when regulators are with regulatory and reporting requirements that are outdated, not mandated to assist in the drafting of a new secured e.g. if reporting standards or supervisory expectations refer transactions law, their involvement in the reform has proved to formalities that have been superseded by the introduction to be useful to the promotion of the use of MABL products of a modern collateral registry. More profoundly, even when in the domestic market and enhanced coordination between not specifically enshrined in reporting requirements, lenders reformed secured transactions and prudential regulatory might be inclined to disregard or misapply the otherwise standards. advantageous features of a reformed legal regime. In turn, if the core features of reformed secured transactions are not applied, the enforceability of legal rights over collateral might be compromised, and credit risk might not be effectively mitigated. Third, the existence of a reliable regulatory framework that promotes market fairness, efficiency, and stability is key for the development of an inclusive and sound credit ecosystem. A key function of regulation is to instill confidence in financial markets (including credit markets). Bolstering confidence in the credit market, in turn, increases liquidity, promoting lending and sustainable economic growth.13 a) International Initiatives and Domestic Experiences All in all, coordination between secured transactions law and financial regulation is key to promote secured lending and ensure that secured transactions law reforms achieve their full potential. Alignment with international secured lending standards is not sufficient in itself to realize an inclusive and sound credit ecosystem at the domestic level. In recent years, this challenge has progressively captured the attention of institutions active in promoting secured transactions law reforms. As an example, the United Nations Commission on International Trade Law (UNCITRAL) examined the regulatory dimension of secured transactions laws, indicating the need for coordination with prudential regulatory frameworks.14 Specifically, in its 2019 Practice Guide to the Model Law, UNCITRAL indicated a set of key regulatory issues that domestic regulators and regulated financial institutions should consider when operating in a legal environment that implements the UNCITRAL Model Law on Secured Transactions. Furthermore, regulatory matters are at the forefront of many institutions involved in secured transactions law reform, such as the European Bank for Reconstruction and Development. The experience gained from the implementation of secured 10 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer Colombia and Zambia In 2013, Colombia transitioned from a fragmented legal framework unsuitable for movables financing to a unitary, transparent system facilitating the use of movables as collateral. This process, which was led by the Ministry of Commerce (Ministerio de Comercio, Industria y Turismo) included the direct involvement of the Bank Regulatory Authority (Superintendencia Financiera de Colombia)—the Colombian agency responsible for preserving stability, integrity, and confidence in the financial system. The Superintendencia Financiera, together with other governmental agencies, participated directly in such reforms to provide the legal and financial certainty necessary to promote prudential lending using movables as collateral. Its role proved to be particularly crucial in the post-reform phase, when amendments to the existing regulatory framework (including those regarding eligibility and valuation of movables as collateral) were necessary to ensure coordination. In 2016, the Zambian National Assembly enacted the Moveable Property (Security Interest) Act No. 3 of 2016. Pursuant to Part II of the Act, an electronic collateral registry for security interests was established and is housed at the Patents and Companies Registration Agency. In this context, the involvement of Bank of Zambia, the prudential regulatory agency in the country, was crucial for the successful completion of the project. Representatives of both Bank of Zambia and the Patents and Companies Registration Agency co-chaired the working group tasked with reforming secured transactions law. Moreover, Bank of Zambia provided insight into the needs and activities of financial institutions. Currently, as the secured transactions law reform has been completed, Bank of Zambia is looking to review and update its prudential framework concerning loan-loss provisioning and capital-adequacy standards to align more closely and support a movables-based lending environment. b) Fostering Coordination: The Way For- avoiding inconsistencies that might undermine confidence in ward domestic regulatory and supervisory frameworks. Effective coordination between legal and regulatory A cohesive reform strategy is, thus, required to coordinate elements requires engagement with different constituencies secured transactions law reforms—and secured lending of stakeholders. Sharing information on the regulatory practices, more broadly—with prudential regulation.15 By dimension of MABL with lawmakers and judicial bodies and large, this strategy aims to ensure coherence among legal is helpful for raising awareness of the broader implications and regulatory components supporting the credit ecosystem. that legal certainty, transparency, and predictability of rules Specifically, it ensures coordination between prudential have on the safety and soundness of the domestic financial regulatory regimes (governing capital requirements and system. Additionally, a dialogue with business enterprises loan-loss provisioning) and reformed secured transactions can ensure the correct and effective application of relevant laws (governing use of movables as collateral). Accordingly, legal and regulatory standards while promoting a culture of coordination with the regulatory components presupposes compliance. the existence of a modern secured transactions law and a functioning collateral registry. Nonetheless, the involvement Addressing the challenges posed by the lack of coordination of regulators at the outset provides the opportunity to between legal and regulatory regimes cannot occur with undertake secured transactions reforms with these goals in mere tweaks or abolishment of existing domestic rules. mind. More generally, as the experience of Colombia and Specific needs and local idiosyncrasies should be taken into Zambia have indicated, regulators proved to be strategic account in order to design a cohesive reform strategy where partners in supporting the delivery of effective law reforms, regulatory standards are applied proportionally to domestic and their participation at the early stages of the reform necessities and in alignment with international standards and process facilitates the implementation of a cohesive set of best practices. The correct implementation of international legal and regulatory rules. legal and regulatory standards is instrumental to the mandates of the World Bank Group, the International Monetary Fund, and other multilateral development institutions. Therefore, in promoting secured transactions law reforms, the World Bank Group can provide assistance to domestic regulators, 11 B. Prudential Regulation: Context, Rationale, and Key Elements Regulatory regimes concerning financial activities are regulatory rules should be construed to be simultaneously typically classified into two broad categories. One category consistent both with each other and their underlying policy encompasses rules designed to protect the integrity of objectives.17 For instance, a transaction secured with a financial markets—that is, the ability of markets to operate tangible asset might not be eligible to reduce credit risk fairly, efficiently, and in support of licit activities. For the and, consequentially, collateral is not considered for the most part, the protection of market integrity consists of calculation of capital requirements. However, the same measures aimed at both protecting customers, including transaction might be considered as an exposure to SMEs retail, and regulating the conduct of financial institutions subject to requirements that are more favorable than those (particularly intermediaries). normally applied to unsecured credit. In such circumstances, A second category is represented by prudential regulation, given that financial institutions have strong incentives to which aims at maintaining the soundness of individual take collateral for risk management purposes, the interaction financial institutions and the stability of the financial system between legal rules and regulatory standards is unproblematic in its entirety. Drawing from this general definition, a and consistency between their respective systems of rules and distinction is commonly advanced separating microprudential policy objectives is preserved. Hence, changes in regulatory policies, which are concerned primarily with the ability of standards not only would not yield any significant benefits individual financial institutions to withstand losses, and but might also undermine the achievement of underlying macroprudential policies aiming to strengthen the resilience policies. of the financial system as a whole. However, depending on the jurisdiction, fostering Albeit to a different extent, both branches of financial coordination might not be as immediate and a cohesive regulation are poised to interact with secured lending strategy should be deployed. Hence, in order to address activities. The convergence between secured transactions the diverse range of coordination issues that might emerge law, conduct of business, and prudential regulation generates in different domestic contexts, it is crucial to identify the a legal phenomenon that has been labeled a “commercial core tenets of prudential regulatory standards that are law intersection.”16 MABL products are particularly prone likely intersect with secured transactions law in the context to spawn such commercial law intersections, as they fall of MABL products. The remainder of this Part offer a simultaneously within the purview of multiple sector-specific summary of the basic mechanisms underpinning of capital branches of commercial law, such as secured transactions, requirements and loan-loss provisioning in the context of banking law, prudential and conduct of business regulation. secured transactions and MABL. Coordination between these intersecting branches is key to support the sound and sustainable development of secured a) Scope of Application credit products. Typically, financial institutions that are subject to capital In particular, coordination between secured transactions law requirements are those, like banks, authorized to receive and prudential regulation represents the first and most urgent demand deposits from the public and to extend loans. aspect that law reformers should take into account in order Accepting deposits places banks at the center of the financial to promote a sound and inclusive credit ecosystem. This is system and renders them a key agent for economic growth. primarily because two key prudential regulatory regimes— The core economic functions performed by banks—that that is, capital requirements and loan-loss provisioning— is, savings mobilization, maturity transformation, and are directly concerned with the treatment of risk associated management of liquidity—allow for the conversion of with lending activities, including secured lending. Hence, savings into long-term investments. In addition, a sound coordination between these branches of law is achieved by banking system also promotes the development of alternative promoting legal and regulatory coherence. lenders. In fact, factoring and leasing companies, which do not have direct access to deposits, might also recur to In order to promote coherence, intersecting legal and bank financing for their business activities.18 Hence, banks 12 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer provide liquidity while ensuring that savings are sheltered promote confidence in the financial system by addressing from the risks associated with illiquid investments. However, risks that are inherent to lending and banking operations. for this mechanism to operate efficiently, savers, and especially depositors, must have confidence in the formal Although it is fair to state that capital requirements and loan- banking system. In fact, given that depositors are exposed loss provisioning requirements have been devised primarily to potential losses associated with the investment choices of for traditional banking, non-bank financial institutions banks without having the power to monitor their conduct, a (NBFIs) might enter within the purview of prudential problem of moral hazard emerges.19 Through these lenses, regulatory regimes. Over the years, NBFIs have become prudential regulation should be understood as a tool to an increasingly important source of funding for both firms Capital and Loan-Loss Provisioning Requirements Capital requirements are intended to strengthen the loss-absorption capacity of regulated financial institutions with regards to unexpected losses, while addressing the moral hazard issues entrenched in the banker-depositor relationship. In particular, capital requirements aim to ensure that banks have adequate levels of “capital,” primarily composed of own funds, such as shareholder equity, to absorb losses without impairing deposits. Capital requirements are established in the Basel Capital Accords, defined by the Basel Committee on Banking Supervision. Loan-loss provisioning requirements are defined and applied in coordination with both capital requirements and accounting standards. They are concerned with establishing a prudential backstop, in addition to accounting allowances, to absorb expected losses associated with any given credit facility or portfolio. Loan-loss provisioning requirements are established at the domestic level, and, although there are general trends and guidelines, there is no uniform approach. Coordination between capital requirements and loan-loss provisioning is key to promote resilience. and households. In addition, depending on the jurisdiction, losses, representing a mechanism to control the moral hazard they often represent a counterparty in bank lending activities associated with lending. Regulatory capital is calculated and, depending on the jurisdiction, they might also provide through a ratio, referred to as the capital adequacy ratio. funds denominated in international currencies to banks.20 Banks are thus required to maintain, at any point in time, a It is precisely the connection with the banking system and specific proportion of capital—primarily shareholders’ equity NBFIs’ engagement in intermediation activities that render and debt instruments that are treated like equity—relative to them potentially harmful for the stability of the financial the risks associated with their activities. In 1988, the First system, requiring specific regulatory measures.21 In this Basel Accord (Basel I) set, as an international standard, regard, the Financial Stability Board has been particularly a risk-based approach to calculate capital requirements active, and several initiatives have been launched to monitor with a capital adequacy ratio at 8 percent. Under the risk- the expansion of credit outside the banking system.22 based approach, different coefficients—referred to as risk- weights—are attributed to various categories of financing At the domestic level, the scope and approach of regulatory transactions and borrowers. regimes for NBFIs varies considerably. Some jurisdictions extend banking regulation, including capital requirements In practical terms, for every financing transaction, banks and loan-loss provisioning, to NBFIs. This generally occurs must calculate a capital charge representing a portion of when jurisdictions qualify lending, leasing, or factoring as regulatory capital that is commensurate to the riskiness of that regulated activities or “banking activities”. The result is transaction. Capital charges are calculated by multiplying that in some jurisdictions a banking license is required to the amount of the loan by the prescribed capital ratio and offer MABL products, even when deposits are not collected the corresponding risk weights. Hence, the higher the risk- from the public. Other jurisdictions regulate banking and weight coefficient, the more capital is required. The Basel II non-banking activities under separate regimes, although Accord was adopted in 2004 and implemented in 2006 with licensing requirements might apply, and supervision is the intent of increasing this risk sensitivity. Subsequently, generally performed by the same regulatory authorities. several amendments to the Basel II Accord were negotiated to address the weaknesses that emerged during the 2007– b) Capital Requirements 2008 financial crisis. These efforts eventually led to the adoption of the Third Basel Accord (Basel III), which Banks must maintain, at all time, a minimum level of was finalized in 2017. Basel III maintained a three-pillar regulatory capital. In this respect, regulatory capital is a structure, introduced in Basel II, but introduced significant cushion for the absorption of a reasonable level of unexpected changes aimed at addressing macroprudential concerns as 13 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer well as limiting the discrepancies in the application of capital the previous regime of IAS39, provisioning allowances regulation across banks and jurisdictions. In addition, a few were determined based on incurred losses—that is, after changes were introduced with respect to the calculation of a credit facility is reported impaired. IFRS9, by contrast, credit risk for small- and medium-sized enterprises (SMEs) requires financial institutions to determine whether a and specialized lending; these changes may be considered in financial asset, such as a loan, is unlikely to be repaid before devising a regulatory strategy, as further illustrated below in incurring any loss and prior to the facility’s impairment Section E(b). (See the accompanying table for a comparison.) Under this approach, financial institutions should resort to historical In general terms, under Pillar I of the Basel framework, data—adjusted to consider current conditions and objective a domestic regulatory framework may implement a indications of losses—as well as any other information that straightforward methodology, referred to as the standardized allows identification of possible losses that might occur in approach. Basel II introduced the possibility for banks the future (expected losses). either to rely on statutorily prescribed risk weights under the standardized approach or to apply internal rating-based IFRS9 requires financial institutions to recognize expected (IRB) methodologies upon supervisory approval. Basel III credit losses (ECLs) when loans are originated or purchased. maintained this possibility, although further limits have been Following initial recognition, credit risk should be regularly introduced to the use of IRB approaches. reassessed and may subsequently change due to relevant factors affecting either an entire portfolio of exposures or Many jurisdictions plan to implement or are implementing individual lending exposures. Given that the focus is on ECLs Basel III, supported by international efforts to foster rather than incurred losses, every financial asset (even if regulatory consistency and supervisory coordination.23 performing) is subject to provisioning requirements and will These economies prioritize the implementation of the have an accounting allowance. The improved risk sensitivity fundamental aspects of the post-2008 regulatory agenda, of IFRS9 is reflected in a classification that comprises while paying particular attention to the enhanced definition different risk categories. Rather than distinguishing only of regulatory capital, the standards of liquidity risk, between the two general categories provided under IAS39— countercyclical buffers, the regime for domestic systemically that is, “unimpaired” and “impaired” financial assets— important banks, and the large exposure framework. As IFRS9 creates the following three categories:24 further illustrated below, the new framework for credit-risk measurement and assessment is based on the blueprint set by • Stage 1 (performing financial assets). When a financial Basel II. The result is that under the standardized approach asset is originated or purchased, allowance is calculated the types of collateral that banks can use to calculate capital to cover ECLs resulting from default events that are charges include only financial collateral, such as domestic possible within the next 12 months (12-month ECL). treasury bills, cash, high-rated securities, and gold. The IRB • Stage 2 (underperforming financial assets). If the credit methodologies allow banks to recognize additional forms of risk has increased significantly since initial recognition collateral, yet their implementation requires reliable data and and signs of potential impairment emerge, allowance is sufficient capacity, both in the industry and among regulators established to cover ECLs calculated based on the entire (as further illustrated below). IRB methodologies are not lifetime of such financial asset (ECL lifetime). commonly deployed by banks and banking systems of most • Stage 3 (nonperforming financial assets). If credit risk of the jurisdictions where the WBG Secured Transactions increases to the point that a financial asset is considered Team provides assistance. This is due to a variety of reasons, impaired, allowance must cover any incurred losses and including the complexities and difficulties associated with lifetime ECLs are recognized (ECL lifetime). the implementation and supervision of such methodologies. c) Loan-loss Provisioning Requirements and Accounting Standards Recent changes in the International Financial Reporting Standards (IFRS) elaborated by the International Accounting Standards Board have been affecting domestic policies on prudential loan-loss provisioning. In particular, while replacing IAS39, IFRS9 introduced a forward-looking approach to estimate losses on a credit facility. Under 14 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer Accounting Standards Comparison IAS39 Unimpaired Impaired No provisioning Provisioning IFRS9 Stage 1 Stage 2 Stage 3 (Performing) (Underperforming) (Impaired) Provisioning Provisioning Provisioning ECL 12 months ECL lifetime ECL lifetime + incurred losses The prudential requirements for loan-loss provisioning are d) Domestic Implementation and Structure intended to bridge a gap between accounting standards and of Incentives capital requirements. Hence, the introduction of the IFRS9 forward-looking approach to calculate accounting allowances At the domestic level, international regulatory standards have posed and, in some jurisdictions, is still posing, relevant are implemented through a mix of primary legislative acts, challenges. In broad terms, domestic prudential policies for delegated legislation, and administrative rules. Typically, the loan-loss provisioning have been aimed at complementing core elements concerning capital and liquidity requirements the limited risk sensitivity of accounting standards by and supervisory functions are contained in legislative acts, providing a prudential backstop. They did so by adding whereas delegated legislation provides further details, and new categories, such as “substandard” or “special mention,” administrative guidelines specify supervisory expectations requiring banks to increase their allowances progressively and procedures. as credit facilities deteriorate.25 Changes in the prudential provisioning requirements may require coordination Furthermore, domestic laws and regulatory provisions with secured transactions law to ensure that the effects of are often designed to address specific vulnerabilities collateral, where relevant, are properly considered. characterizing local economies and markets, rendering each regulatory environment unique. These distinctive features As financial institutions are compliant with relevant might have a direct impact on the success of secured accounting standards, such as IFRS9, prudential provisioning transactions law reforms and, more broadly, should be requirements are also adjusted. For instance, while ensuring taken into account when designing a strategy to develop an sound backstops through prudential provisioning, firms can inclusive and sound credit ecosystem. be incentivized to familiarize themselves with forward- looking models also for ABL products. Prudential regulation does not prevent banks from extending loans; rather, it requires adequate regulatory capital and To ensure the implementation of prudential policies that provisioning to absorb any losses, unexpected and expected, are sufficiently risk sensitive, it is crucial to stimulate with respect to those loans. Regulatory capital is composed the acquisition of reliable data. Specifically, the effect of of a bank’s own funds and, thus, is more expensive than collateral should be calculated with data that demonstrates borrowed funds, such as deposits. This is to say that, from the risk-reduction effect that is effectively achieved in the standpoint of individual banks, capital regulation may a given market for different ABL products. To this end, be perceived as a cost even if maintaining sufficient levels support to lenders and regulators could be offered to obtain of capital is key to preserving the stability of financial and maintain data concerning the deployment of collateral institutions and of the financial system as a whole. for different ABL products. In particular, the recoverability of movable collateral and their recovery rates is of primary Prudential regulation, together with other factors, influences importance. Hence, coordination should be promoted the business decisions of financial institutions. In general, through a holistic reform strategy aimed at gathering reliable this is due to the fact that legal and regulatory regimes affect data and promoting sound risk management practice, as part the structure of incentives of firms in different ways. In the of general capacity building initiatives. As further illustrated context of capital regulation, depending on their risk appetite, below, the adoption of pilot programs might serve this banks might be incentivized to lower their exposures to credit purpose. risk in order to reduce capital charges and, thus, maximize their return on equity.26 In a similar vein, while banks may increase their provisioning through different channels, 15 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer prudential requirements may incentivize banks to minimize As a consequence, capital regulation connects the amount of their exposures against nonperforming and problematic credit “by binding its creation to an amount of equity [own assets, in order to increase their resilience towards expected funds] that is proportionate to the level of risk acquired by losses. In both instances, the regulatory framework may each bank.”27 Hence, risk-weighting mechanisms steer the influence the decision of financial institutions. In the case choices of individual banks, as they determine the costs of of risk-based capital regulation, reduced capital charges funding for the extension of credit. Differently, prudential apply when banks lend to borrowers with lower risk weights loan-loss provisioning requirements connect provisioning or when they implement credit-risk mitigations that are reserves to the performance of loans, incentivizing banks to considered eligible to reduce credit risk. In the case of adopt a prudent approach.28 prudential requirements for loan-loss provisioning, both the classification of a credit facility and the recognition of collateral determines the amount of provisions. Zambia: Prudential Provisioning As a part of the recent policy response for COVID- 19, Bank of Zambia has incorporated some of the prudential guidelines to support a movables-based lending environment. These additions have been implemented in accordance to Banking and Financial Services Act 2017 and are contained in the Banking and Financial Services Classification and Provisioning of Loans Directives 2020 (Directives). These Directives provide for a number of valuable changes, offering an illustration of the trajectory to promote coordination between secured transactions law and prudential regulation. First, the Directives provide clarity on the use of internal models based on well-defined measures and processes for estimating expected credit losses, which should further promote the availability of asset-based lending products in the market. Reference to the Moveable Property (Security Interest) Act 2016 and to the requirements to perfect security rights established by that Act have been added. Moreover, specific mention to the registration method introduced with the secured transactions law reform was considered particularly useful, to promote a sound credit risk management. Second, the Directives do not rely solely onto the past-due criterion for the classification of loans-performing loans. Instead, they incentivize banks to adopt a forward-looking approach. The Directive has been published in the Zambia Gazette, April 3rd, 2020 issue. 16 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer C. Stakeholders This part identifies the key groups of stakeholders that take making processes and organizational structures of financial part to the efforts of legal and regulatory coordination. institutions. Notably, banks are the primary addressees of Central to these efforts is the role played by regulatory capital and loan-loss provisioning requirements. However, agencies and central banks performing supervisory functions. in different jurisdictions, the extension of credit per se or Financial institutions, both banks and NBFIs, perform a key specific activities like leasing and factoring may be regulated function in ensuring compliance to regulatory standards either under special regulatory regimes or under banking while developing and deploying ABL products. Whereas, regulation. In addition, whenever leasing and factoring borrowers, potential borrowers and the public at large are companies are established as subsidiaries of a banking the ultimate beneficiaries of coordination efforts aimed at institution, they may be subject to capital regulation under a promoting a sound and inclusive access to credit. consolidated approach. a) Regulators and Supervisors c) Borrowers, Potential Borrowers, and the General Public A key role in promoting legal and regulatory coordination is played by specialized administrative authorities, which Since this group of stakeholders is one of the primary typically perform both regulatory functions and supervisory beneficiaries of secured transactions law reforms, raising tasks in line with international principles and best practices.29 awareness among them is of particular importance. Pre- Depending on their remits, the administrative authorities and post-reform engagement as well as capacity-building might be directly involved in drafting legislative acts activities are particularly useful to promote the emergence implementing international standards. In addition, they are of liquid and transparent secondary markets for collateral. likely to be entrusted with the power to adopt binding rules Engagement might also be sought with initiatives that are in the form of administrative acts or guidelines. Supervisory targeted to specific groups of domestic economies—such as functions typically include licensing and authorization (M)SMEs operating in manufacturing or agricultural sectors. powers, ongoing monitoring (on-site and off-site inspections), Vulnerable stakeholder groups and constituencies typically and product approval procedures. Furthermore, these considered high risk would benefit greatly from outreach authorities routinely require that banks provide detailed data activities illustrating how movables can be used in access to required to identify and address systemwide vulnerabilities. credit and how collateral can be valued and disposed. Though not always the case, it is not uncommon for domestic The involvement of different groups of borrowers and central banks to be involved in prudential regulation and potential borrowers from the general public would allow related supervisory activities. Moreover, central banks might banks to pilot new products and to gather sufficient play an active role in pursuing access to credit policies. For information. Information should gauge the impact of instance, many central banks have also established credit collateral on credit risk and assess the liquidity of secondary registries30 to report loans exceeding a certain threshold markets for collateral. In addition, coordination with as a form of supervision mechanism to identify systemic domestic regulators – as new products are developed, risk within the lending portfolios of the regulated financial launched, and tested in new markets – would promote a institutions.31 Additionally, in a few jurisdictions, central collaborative environment, enabling them to monitor new banks may have been entrusted with overseeing the collateral products, build capacity, and acquire data on new products registry once secured transactions law reforms have been in a systematic fashion. Ultimately, if a sufficiently long completed. history of reliable data is gathered, regulatory policies can be informed accordingly. In particular, provided the existence b) Banks and NBFIs of consistent evidence, provisioning requirements can be fine-tuned to reflect different levels of risks associated to At its broadest, prudential regulation translates into a set different types of collateral and ABL products. In addition, of compliance requirements embedded into the decision- goals and realistic expectations for access to credit based on 17 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer movable collateral can be established as a part of a roadmap that is tailored to the local needs. 18 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer D. Key Challenges Recently completed secured transactions law reforms have b) Regulatory Compliance and Law Re- produced mixed results in terms of promised credit growth, forms financial inclusion, and facilitating sound risk-management practices. Reasons for these results include a transition Absent coordination between secured transactions law period for reforms to be understood, allowing stakeholders reforms and prudential regulation, the deployment of to familiarize themselves with the newly implemented legal sound risk-management practices may be hindered. The framework and, in particular, financial institutions to develop crucial problem is that regulatory regimes concerned with and launch ABL products that comply with regulatory the prudent management of risk might not account for the standards. This section presents some of the key challenges mitigation of credit risk afforded by the implementation of concerning the lack of coordination between the secured a modern secured transactions law and collateral registry. transactions law and domestic regulatory environment. Furthermore, in some jurisdictions, regulatory and reporting standards may explicitly refer to pre-reform mechanisms a) Collateral Registry as Risk-Manage- for creation and perfection of security rights. As a result, ment Tool a paradoxical situation emerges: financial institutions are formally compliant with domestic regulatory standards even Although statistics concerning the usage of newly if they fail to adhere to the reformed secured transactions implemented collateral registries generally indicate an law. Such a result is problematic for the following reasons: increase in registrations, closer analyses often reveal that a large portion of registrations relate to consumer financing • First, compliance with regulatory standards that are of cars. Only a small percentage of registrations pertain not updated to the reformed legal framework does not to commercial asset-based loans secured by equipment, ensure the effective mitigation of credit risk, given that inventory, or receivables.32 Furthermore, examination of priority could be lost. collateral registries in a number of economies might reveal • Second, prudential regulation shaped around unreformed the emergence of conduct that is not prudentially sound. secured transactions frameworks typically displays For instance, an increase in registrations that is grossly a suspicious attitude toward lending secured with disproportional to the number of searches may indicate that movables. Such skepticism is rooted in the fact that some lenders do not perform adequate due diligence. In pre-reform secured transactions laws generally have principle, searches should be (at least) double the number significant deficiencies—for example, not allowing for of registrations, given that prudent lenders are expected to the predictable allocation of priorities or the expeditious search the registry before registering a notice and then do enforcement of security interests. occasional searches as circumstances necessitate. Thus, a low number of searches is a potential indicator of weak risk- From the above it emerges that, without an effective effort to management practices and credit policies. Another indicator enhance coordination, neither sound credit-risk management of weak credit risk management practice is the disproportion nor lending against collateral is incentivized. between the number of movables-based loans being reported to the regulator and those being registered in the collateral c) The Regulatory Treatment of Collateral- registry. A number of registrations that is significantly lower ized Transactions than the amount of secured loans reported for accounting and regulatory purposes might signal the existence of Under the standardized approach, the types of collateral that unperfected security interest. Large volumes of unperfected banks use to calculate capital charges include only highly security interests, in turn, can lead to legal uncertainty for liquid assets (financial assets), such as funds held in deposit third parties and might give raise to prudential concerns, as accounts with the bank itself, gold, and investment-rated credit risk is not properly mitigated. securities. Security rights on tangible movable collateral (also referred to as “physical collateral”) are typically not recognized for capital adequacy purposes. In addition to this 19 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer regime, the standardized approach offers other methods that d) Prudential Loan-loss Provisioning and deserve special attention in the context of trade finance and Capital Requirements for the development of MABL products. First, transactions where commercial letters of credit are used to finance Without a coordinated approach, prudential requirements imports and exports of goods can be taken into account when for loan-loss provisioning might not consider the risk- capital charges are calculated through a credit conversion mitigation effect of movable collateral. Albeit a reliable factor for off-balance-sheet exposures. Second, personal or and consistent set of data on various MABL products is public guarantees as well as insurance policies might also needed in order to inform regulatory policies, such data be considered for credit-risk mitigation purposes; if specific should be gathered within a stable legal and regulatory conditions are met, the risk weighting of the grantor replaces environment, where key building-blocks are coordinated. the risk weighting of the borrower for the portion of the loan When loan-loss provisioning requirements are implemented, covered by the guarantee. coordination with both capital requirements and accounting If authorized, banks may adopt IRB approaches and then standards—in particular IFRS9—is often ensured. However, rely on their own internal estimates of risk components notwithstanding the best efforts in this regard, many to calculate capital charges for a given exposure. Risk jurisdictions might not have a fully coordinated system. For components include the probability of default, loss given instance, the impairment criteria under capital requirements default, exposure at default, and effective maturity. IRB may differ from the one contained in prudential provisioning banks may recognize additional forms of collateral, such requirements or might not be aligned with new accounting as certain financial assets, digital assets, and physical standards. This typically occurs when key definitions of collateral, subject to meeting further conditions.33 However, “default” are not uniform (across capital and provisioning Basel III, reflecting a general skepticism toward the ability requirements) or when the treatment of fully collateralized of those models to reflect accurately the risks assumed by loans is not clear. Ultimately, this leads to the paradoxical banks, has limited the use of IRBs with the introduction of situation in which secured transactions law reforms minimum floors and risk categories. Banks may be required incentivize the use of movable assets as collateral to reduce to use a value established by national regulatory authorities, credit risk, whereas, in practice, movable assets might not rather than an internal estimate, for one or more of the risk be reflected neither in the calculation of capital charges components. In order for banks to obtain approval to use for the absorption of unexpected losses nor in prudential their own estimated values of loss given default, the estimate provisioning to cover expected losses. must be grounded in historical recovery rates and not based solely on the collateral’s estimated market value. e) Secondary Market for the Disposal and Valuation of Collateral In practice, the effective application of IRBs requires banks and domestic supervisors to familiarize themselves with For the establishment of an inclusive credit ecosystem where sophisticated models, acquire reliable data, and comply with secured transactions provide an effective device to manage several disclosure requirements. Those conditions might credit risk, the existence of secondary markets for collateral be difficult to achieve in the context of (M)SME lending is essential. However, data on movable collateral commonly generally and in developing economies in particular, given used by small businesses—particularly by MSMEs—is that historical data on recovery rates might be nonexistent. limited. Without a transparent pricing mechanism, the In this respect, it is not uncommon for jurisdictions to be ability of financial institutions to consider movable assets to aligned with Basel II (or Basel III) without implementing the serve as an effective risk-management device is significantly IRB regimes for credit risk. impaired; absent reliable and publicly available data, the recovery rates, time, and costs cannot be properly assessed. Furthermore, in the context of MABL, the application of IRBs is problematic. In addition to the lack of reliable data, f) Development and Launch of MABL there is also a problem of insufficient expertise both in the Credit Products industry (to construct reliable models) and in regulatory circles (to vet, approve, and monitor the usage of internal Lack of coordination between legal and regulatory components models). In practice, this might imply that loans secured of the credit ecosystem may disincentivize banks to develop with movables are treated, for the purpose of calculating and launch ABL credit products, particularly those targeting capital requirements, in the same guise as unsecured credit. small borrowers. A reformed secured transactions framework may provide the drive and necessary legal infrastructure for the development of innovative lending products using 20 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer tangible and intangible movables as collateral. However, a prudential regulatory environment that is unable to gauge (e.g., due to sufficient evidence) the risk-mitigation abilities offered by a reformed secured transactions framework may treat secured and unsecured products in the same manner. As a result, development of MABL financing, combining collateral and other risk mitigants to lessen the risk of lending to SMEs, is not incentivized. 21 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer E. Addressing the Challenges by Developing a Regulatory Strategy Addressing the aforementioned challenges cannot occur philosophy and approaches. Engagement with other key through shortsighted regulatory adjustments. As noted stakeholder is aimed to stimulate awareness and pave the earlier, uncoordinated changes in the regulatory framework way to a collaborative reform process. might depart from international standards and undermine confidence in the domestic credit market. A cohesive Regulatory Diagnostic reform strategy should be implemented based on the legal, regulatory, and economic idiosyncrasies of the jurisdiction The key elements of the diagnostic should include the under consideration, and care should be taken neither to following: compromise alignment with international standards nor to • An analysis of (i) prudential requirements for loan-loss weaken the domestic regulatory framework. provisioning, including loan classification for impaired credit facilities (collateral should not influence such a Such a strategy should aim at ensuring coordination classification, the analysis is part, however, of the general between legal and regulatory components of the credit diagnostic); (ii) guidelines and supervisory expectations ecosystem by putting forward a holistic approach whereby for credit-risk policies and risk-management procedures; financial inclusion, responsible lending, access to credit, and (iii) capital requirements potentially applicable to financial stability, and market-integrity policies are pursued MABL products. concomitantly. The core elements of a holistic strategy are • An assessment of the applicable rules for banking and presented in this section. non-banking institutions that offer or are in the process of developing ABL products. The assessment will a) Mapping and Understanding the Do- determine key compliance requirements and possible mestic Environment inconsistencies. In some cases, an assessment of the compliance requirements to launch specific products— Diagnostics of existing regulatory standards for risk for example, supply-chain finance products—might be management, loan-loss provisioning, and capital regulation helpful to identify general gaps and present possible will help identify the core elements of the regulatory solutions. strategy. Such a diagnostic, part of a legal and regulatory • A survey of existing programs designed to stimulate due diligence process, should map different aspects, access to credit, financial inclusion, and technological including current and planned alignment with the Basel innovation, such as public guarantees. Capital Accords, possible inconsistencies between domestic • An analysis of the macroeconomic and macroprudential reporting standards and the reformed secured transactions conditions. Crises and other sources of instability might law framework, and other elements that might affect the have shaped the existing regulatory environment. Hence, extension of credit to MSMEs and the use of movable assets any suggestions to modify regulatory elements should fit as collateral. Mostly, the required diagnostic involves desk- into the general policies of the considered jurisdiction based research. In addition, interviews with regulators, supervisors, and financial institutions would contribute insights about the landscape, risk trends, regulatory Broadening the Diagnostic: A Macroprudential Understanding of Lending Rules Specific prudential concerns and vulnerabilities would be revealed by reports, such as those offered by the Financial Sector Assessment Program; results from central bank stress testing; and other assessments, such as those aimed at measuring the level of implementation of capital requirements, as well as engagements with domestic regulators. Identified vulnerabilities might explain why regulatory requirements are particularly stringent with regard to certain practices and may indicate where supervisory resources are directed. 22 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer Stakeholders Objectives Engagement with relevant stakeholders from the very As prudential policies should follow a risk-based and data- beginning is of primary importance. In particular, the driven approach, information on the functioning of the following activities should be considered: domestic credit market must be collected and analyzed • Engage with prudential regulators to raise awareness on in order to suggest targeted policy changes. Data may be the issue and indicate the necessity of pursuing access to generated directly by the financial institutions and through credit and financial stability concomitantly. various support and complementary mechanisms, such • Illustrate to prudential regulators the key features of as public guarantee schemes,34 existing (or soon-to-be- the reformed legal framework for secured lending established) sandboxes, and the launch of pilot programs and indicate the impact that the new law will have on that are designed to facilitate small-business financing and the compliance process of regulated firms and, more ABL. broadly, on the regulators’ mandate. • Discuss with the regulators the general objectives of Based on these considerations, a reform strategy should aim a possible strategy to address existing hindrances and to foster coordination. The aim is to establish a collaborative • Integrate secured transactions law reforms cohesively environment. with domestic legal and regulatory frameworks (based • Foster coordination between financial institutions on international standards); developing (or planning to develop) MABL products • Promote a culture of regulatory compliance to incentivize and regulators tasked to approve and evaluate such a prudent and sustainable extension of secured credit, products from a prudential standpoint. including through the gradual but steady introduction of MABL products; and Market Analysis • Generate and gather reliable data on the performance of secured transactions reforms and, specifically, on the Market- and firm-level analyses and surveys would further risk-mitigation effects of ABL and products in order to the understanding of existing constraints and advance inform regulatory reforms while enhancing capacity possible solutions. In particular, the following elements building.35 should be considered: • Survey existing credit policies and systems for internal Alignment of Domestic Regulatory Framework with controls that have been adopted by the industry for International Standards movable MABL. This survey should aim at assessing whether credit-risk policies and systems of internal A strategy that simultaneously promotes various policy controls have been adapted to coordinate with the new goals must be grounded in a thorough implementation of law. regulatory and prudential policies enshrined in international • Survey existing or potential secondary markets for standards and best practices.36 Deviation from such standards movables in order to determine potential credit products could have far-reaching consequences, including reduced that could be launched within the existing legal and availability of credit. In this respect, the primary aim is regulatory environment. to promote consistency between the legal and regulatory frameworks. b) Regulatory Strategy: Key Elements Interventions aimed at stimulating access to credit through For a regulatory framework to incorporate the benefits of secured lending should be presented as an element that a reformed secured transactions law, amending specific complements a timely, full, and effective implementation rules, as outlined above, might not be sufficient. Once a new of international regulatory standards, thus contributing secured transactions law has been implemented, different to building a resilient and inclusive financial system. In components of the domestic credit environment need to be this regard, other than credit-risk mitigation mechanisms, coordinated. Depending on the broader legal and regulatory coordination between access to credit policies and financial framework, as well as specific economic conditions, a inclusion might be achieved through the implementation of recalibration of regulatory elements in line with international other elements of the prudential regulatory framework. standards requires data. In particular, the Basel framework provides other mechanisms to calculate capital charges when a bank lends to SMEs, or when exposures are secured against certain types of movable assets, such as certain types of inventory and the proceeds 23 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer generated by their sale, accounts receivable, or credit card regulatory compliance. For instance, regulatory guidelines receivables. In the standardized approach, such mechanisms could point to the applicable secured transactions law, include risk weights for:37 noting the perfection requirements, other than registration, that financial institutions may deploy to secure their priority (i) Regulatory retail portfolio; (for example, control of bank accounts). With respect to (ii) SMEs, which might also include microenterprises; legislative changes, the diagnostic might reveal that some and laws could benefit from modifications—for instance, to (iii) Specialized lending. ensure that the definition of “default” applied to determine when a credit facility is nonperforming is consistently Under the regulatory retail portfolio regime, a risk weight implemented in capital adequacy standards and prudential of 75 percent is applied to the entire portfolio of loans requirements for loan-loss provisioning. extended to individuals and small businesses, rather than weighting the risk for each individual loan. In addition, a Beyond Regulatory Adjustments: Developing Secondary special category of exposures with risk weighting of 85 Markets and Conducting Pilot Programs percent has been introduced with Basel III for SME loans that do not qualify for the regulatory retail portfolio. Finally, Coordination between secured transactions law reforms and some MABL products might fit in one of the categories prudential regulation requires designing jurisdiction-specific of specialized lending (typically, in the case of inventory reform strategies.38 Fostering the establishment of secondary financing for commodities and crops). However, treating an markets for movable collateral is of critical importance. The MABL product as a specialized lending exposure might occur documented existence of liquid secondary markets allows only in sophisticate environment and with a specific kind regulated financial institutions to assess their exposures of transactions, generally involving large and experienced more accurately for the purpose of calculating capital and regulators and SMEs. provisioning requirements (if allowed under domestic regulatory regimes). Furthermore, the existence of such Possible Regulatory Adjustments markets is pivotal to the banks’ need to assess the value of collateral and the protection offered. Some calibrated adjustments in domestic regulatory frameworks might be required in order to ensure a coherent However, the lack of a transparent pricing mechanism legal and regulatory framework. For instance, prudential and, more generally, the absence of sufficient data on the provisioning requirements and guidelines for credit-risk realization of collateral commonly used by MSMEs might policies might need to be updated to reflect a reformed limit the ability of financial institutions to consider movable secured transactions law framework. This might include, assets as an alternative repayment mechanism. Moreover, among other things, a reference to the use of collateral when prudential regulatory requirements establish fixed registries as part of sound risk-management practices risk weightings to calculate capital charges or provisioning and compliance procedures, enforcement remedies, and allowances, financial institutions might not be incentivized mechanisms to exercise control over movables and over the to gather more data concerning the realization of movable proceeds resulting from their disposal. As the experience collateral. Therefore, the extent to which movable collateral of Zambia demonstrates, reference to these features of curbs the credit risk remains undetermined. secured transactions law reforms provides guidance to both supervisors and regulated entities on the changes that In order to reverse this trend, more data on collateral and are required for a prudent management of credit risk. This credit products should be gathered. To this end, different means that financial institutions would be required to embed methods can be deployed. For instance, the World Bank in their internal systems of controls procedures to search the Group is working in Jamaica to assess the development of collateral registry, register their notices in a timely manner, secondary markets for movable assets and the viability of and, more generally, ensure the enforceability of their MABL products. In general, existing sandboxes and public security rights. As a consequence, auditors and supervisors guarantee programs could offer a solution to generate and performing on- and off-site inspections would then consider gather data as well as to test the use of different MABL searching the collateral registry as a benchmark to assess products. Such programs might allow for selected financial whether sound risk-management practices have been institutions to deploy lower capital requirements and more implemented in a given financial institution. favorable loan-loss provisioning, given the protection offered by the guarantee. In turn, selected financial institutions that Additional changes might be considered to promote sound participate in the scheme could be requested to collect key 24 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer variables, such as expected losses and loss given default cooperated with the International Finance Corporation team. when collateral has been implemented. Time of enforcement, Information gathered and parameters would need regulatory valuation, and other parameters might also be gathered. The approval; thus, the coordination with domestic regulatory results of such analyses and pilot programs can be used to authorities could facilitate this process. Pilots of this nature adjust regulatory parameters while ensuring alignment with can dovetail with existing programs aimed at stimulating international standards. capacity building, developing secondary markets, and incentivizing the development of MABL credit products for The data gathered would affect key determinations, including MSMEs in a prudential and sound manner. the existence and viability of secondary markets for collateral and the effective risk reduction offered by different movable- based products. It follows that data must be reliable and must meet regulatory standards. In this regard, this element of the strategy would benefit if it were conducted through a pilot project where one or more firms—banks and NBFIs— 25 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer Conclusion Coordination between secured transactions law and The World Bank Group’s Secured Transactions Team prudential regulation is key to supporting the establishment has been working with many jurisdictions to support of a sound and inclusive credit ecosystem. A comprehensive coordination between regulatory regimes and secured regulatory strategy tailored to domestic needs is required transactions frameworks. Such efforts pursue the twofold to unlock the full potential of secured transactions law objectives of increasing access to finance—with particular reforms and promote lending to MSMEs through movable attention to the needs of MSMEs and female entrepreneurs— asset-based financing. To this end, early engagement with and maintaining financial stability. Drawing from these regulators and central banks has proved to be strategic to experiences, the team is now aiming to produce a more both raise awareness among financial institutions and define comprehensive guide to facilitate the implementation of a adequate regulatory approaches. comprehensive regulatory strategy. 26 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer References 1. See Giuliano G. Castellano & Marek Dubovec, Credit Creation: Reconciling Legal and Regulatory Incentives, 81 LAW & CONTEMP. PROBS. 63 (2018), https://ssrn.com/abstract=3069594. 2. See Inessa Love et al., Collateral Registries for Movable Assets: Does Their Introduction Spur Firms’ Access to Bank Financing?, 49 J FINANC SERV RES 1 (2016). On the relevance of registry systems and publicity regimes for security rights, see Giuliano G. Castellano, Reforming Non-Possessory Secured Transactions Laws: A New Strategy?, 78 Modern Law Review 611 (2015), https://ssrn.com/abstract=2723248. 3. See Heywood Fleisig et al., How Reforming Collateral Laws Improves Access to Finance, 307 (Private Sector Development Viewpoint, World Bank). 4. In this regard, the high-level principles elaborated by the Group of Twenty and the Organisation for Economic Co- operation and Development (OECD) noted that policy makers should encourage the use of movable assets as collateral to facilitate access to capital for small business; see Effective Approaches for Implementing the G20/OECD High Level Principles on SME Financing, OECD (July 2018), http://www.oecd.org/g20/Effective-Approaches-for-Implementing-HL-Principles-on-SME-Financing-OECD.pdf 5. On the impact of collateral on the cost of credit, see Castellano, supra note 2, at 618; see also Love et al., supra note 2. 6. See Strengthening Access to Finance for Women-Owned SMEs in Developing Countries, International Finance Corporation, (Oct. 2011), http://www.ifc.org/wps/wcm/connect/a4774a004a3f66539f0f9f8969adcc27/G20_Women_Report.pdf?MOD=AJPERES. 7. See Castellano, supra note 2. 8. See Giuliano G. Castellano & Marek Dubovec, Global Regulatory Standards and Secured Transactions Law Reforms: At the Crossroad Between Access to Credit and Financial Stability, 41 FORDHAM INT’L L.J. 531 (2018), https://ssrn.com/abstract=3152934. 9. See Knowledge Guide on Secured Transactions, Collateral Registries and Movable Asset-Based Financing, WORLD BANK (2019) at 31, http://hdl.handle.net/10986/32551. The idea of devising a domestic strategy to implement international standards aimed at modernizing secured transactions law has been advanced in Castellano, supra note 2 (noting the need for a reform strategy to implement secured transactions law domestically). The core traits of the strategy to coordinate secured transactions law and prudential regulation at the domestic level have been put forward in Giuliano G. Castellano & Marek Dubovec, Bridging the Gap: The Regulatory Dimension of Secured Transactions Law Reforms, 22 UNIF. LAW. REV. 663, 684 (2017) (noting that “[a] comprehensive regulatory strategy, rather than ad hoc interventions, is required to unlock the full potential of secured transactions law reforms.”), https://ssrn.com/abstract=3076082. 10. Castellano & Dubovec, supra note 8. 11. Id. 12. Castellano & Dubovec, supra note 1. 13. See Castellano & Dubovec, supra note 8, at 539. 14. The proposal for this work was first formulated during the UNCITRAL Colloquium on Secured Transactions in Giuliano G. Castellano, Secured Transactions Law and Capital Requirements: Enhancing Access to Credit and Financial Stability, United Nations Commision on International Trade Law (2017), http://www.uncitral.org/uncitral/en/ commission/colloquia/4thint.html, and during the UNCITRAL 50th Anniversary Congress; see Giuliano G. Castellano and Marek Dubovec, Coordinating Secured Transactions Law and Capital Requirements, http://www.uncitral.org/pdf/ english/congress/17-06783_ebook.pdf. The supporting research was advanced in Castellano & Dubovec, supra note 8; Castellano & Dubovec, supra note 1 (focusing on the conflictual incentives that a lack of coordination between secured transactions law and capital requirements generate); and Castellano & Dubovec, supra note 9 (indicating possible solutions and advancing recommendations to address the lack of coordination between secured transactions law and capital requirements). Based on these findings, the Plenary Session of the UNCITRAL mandated Working Group VI to include in the Practice Guide to the Model Law on Secured Transactions a chapter on the connection between secured 27 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer transactions law and prudential regulation; see Report of the United Nations Commission on International Trade Law Fiftieth Session (3–21 July 2017); General Assembly Official Records Seventy-second Session Supplement No. 17 (UN doc. A/72/17). 15. Castellano & Dubovec, supra note 9. 16. See Giuliano G. Castellano and Andrea Tosato, Commercial Law Intersections, 72 Hastings L.J. (forthcoming, 2021) https://ssrn.com/abstract=3558378. For a summary of the main argument see Commercial Law Intersections: Coordination Failures and the Quest For Legal Coherence, The Finreg Blog (Global Financial Markets Center, Duke University School of Law, June 2020), https://perma.cc/JKS4-XQCD. 17. In this context, legal coherence is intended as the lack of contradictions and the logical compatibility among legal and regulatory rules governing the transaction under consideration, see Castellano & Tosato, supra note 16 at 29-31. This is to say that, collectively considered, legal and regulatory rules should design a logical system of rules and deductions to govern different aspects of ABL products. 18. Castellano & Dubovec, supra note 8, at 586. 19. Castellano & Tosato supra note 16, at 44, indicating that, in banking, regulatory regimes have been often developed to address the moral hazard issues arising from the legal qualification of the depositors-bankers relationship; that is a creditor-debtor one. 20. Pablo Garcia Luna and Bryan Hardy. Non-Bank Counterparties in International Banking. BIS Quarterly Review. Bank for International Settlements (2019), https://www.bis.org/publ/qtrpdf/r_qt1909b.htm. 21. Castellano & Dubovec, supra note 1, at 84. 22. The Financial Stability Board (FSB) was established in 2009 and has been mandated to monitor and assess vulnerabilities affecting the global financial system. It reports to the Group of Twenty and proposes recommendations to address the vulnerabilities it identifies. Since 2011, the FSB has been conducting an annual survey to monitor global trends and risks related to NBFIs. The FSB is composed of the representatives of 25 central banks and monetary authorities. The Basel Committee on Banking Supervision cooperates with the FSB and, together with other standard setters and international financial institutions, such as the World Bank Group and International Monetary Fund, is one of its members; see https:// www.fsb.org. 23. The Basel Committee on Banking Supervision closely monitors and reports to the Group of Twenty on the implementation of the Basel Capital Accords in its 27 member jurisdictions; see Implementation of Basel Standards: A Report to G20 Leaders on Implementation of the Basel III Regulatory Reforms, Basel Committee on Banking Supervision (2018), https://www.bis.org/bcbs/publ/d453.htm. In addition, a study found that 100 jurisdictions that are not members of the Basel Committee on Banking Supervision have implemented some version of the Basel risk-based capital regime, while most have implemented, in some manner, quantitative liquidity standards and the large exposures rule; see Stefan Hohl, Maria Cynthia Sison, Tomas Stastny, and Raihan Zamil, The Basel Framework in 100 Jurisdictions: Implementation Status and Proportionality Practices, Financial Stability Institute Paper No. 11 (2018), https://www.bis.org/fsi/publ/ insights11.htm. 24. See IFRS9 and Expected Loss Provisioning, Bank for International Settlements (2017), https://www.bis.org/fsi/fsisummaries/ifrs9.htm. 25. See Loan Classification and Provisioning: Current Practices in 26 Countries: Overview Paper, Financial Sector Advisory Centre, World Bank (Aug. 2014). 26. The tendency of banks to maximize return on equity by reducing the cost of capital has also been associated with strategies that might result in a mismatch between the risk accounted for regulatory purposes and the actual risk; see David Jones, Emerging Problems with the Basel Capital Accord: Regulatory Capital Arbitrage and Related Issues, 24 Journal of Banking & Finance 35 (2000); Erik Gerding, The Dialectics of Bank Capital: Regulation and Regulatory Capital Arbitrage, 55 WASHBURN L. J. 357 (2016). 27. Castellano & Dubovec, supra note 1, at 71. 28. Giuliano G. Castellano, Marek Dubovec, and Chris Tassis, Towards a Sound and Inclusive Credit Infrastructure, Asian Institute of International Financial Law Working Paper (forthcoming, 2021) (University of Hong Kong, Faculty of Law). 29. Core Principles for Effective Banking Supervision, Bank for International Settlements (BCBS) (2012), https://www.bis. org/publ/bcbs230.htm. Different principles cover different segments of financial markets; see, for example, Insurance Core Principles, International Association of Insurance Supervisors (2018); Objectives and Principles of Securities Regulation, International Organization of Securities Commissions (2017). 30. In this context, a credit registry refers to an internal credit-reporting registry or credit information agency. 28 Coordinating Prudential Regulation and Secured Transactions Frameworks: A Primer 31. Credit Reporting Knowledge Guide, World Bank (2012), at 14. 32. Knowledge Guide on Secured Transactions, supra note 9, at 30. 33. In addition to credit-risk mitigation techniques, the Basel framework provides other mechanisms to calculate capital charges when a bank lends to SMEs; see infra Part E (b). For an analysis of the regulatory treatment of digital assets in the context of secured lending see Distributed Ledger Technology and Secured Transactions: Note 2. Regulatory Implications of Integrating Digital Assets and Distributed Ledgers in Credit Ecosystems, WORLD BANK (2020), http://hdl.handle.net/10986/34008. 34. Castellano & Dubovec, supra note 9, at 691. 35. Id. at 686. 36. Id. at 685–86. 37. It must be noted that for exposures that qualify for the regulatory retail portfolio or fit into the SME category of exposure, the existence of collateral is immaterial for the calculation of capital charges. Id. at 674 (noting that “even if banks would still take different kinds of collateral, they have no incentives to gather information and construct a reliable dataset concerning, for instance, the realization value of different movable assets”). For this reason, it is key to incentivize banks to gather sufficient data on collateral; see Id. at 690. 38. See Castellano, supra note 2; and Castellano & Dubovec, supra note 9. 29