307 36079 privatesector P U B L I C P O L I C Y F O R T H E NUMBER NOTE 2006 Unlocking Dead Capital MARCH Mehnaz Safavian, How Reforming Collateral Laws Improves Access to Finance Heywood Fleisig, and Jevgenijs Steinbuks Collateral can increase access to finance, especially for small firms, and lead to better terms for loan contracts. Many argue that firms Mehnaz Safavian (msafavian@worldbank are excluded from formal credit markets because they lack assets .org) is an economist with that can serve as collateral. In fact, firms generally have a wide the World Bank Group's Investment Climate array of productive assets that could secure a loan--but the legal Department. Heywood PRESIDENCY framework prevents this. Reforming collateral laws can unlock "dead Fleisig (hfleisig@ceal.org) capital," as seen in Albania and Romania. VICE is a research associate at the Center for the Collateral matters: when businesses use collat- for loans because they know in advance that Economic Analysis of eral to secure loans, lenders give them better they will be unable to meet the bank's collateral Law. Jevgenijs Steinbuks terms. Take the example of Banco Solidario in requirements. (steinbuk@gwu.edu) is Bolivia, one of the most successful microfinance DEVELOPMENT with the Economics Loans secured by collateral have banks in Latin America. When borrowers offer Department at George Figure better terms collateral, BancoSol provides larger loans (rela- 1 Washington University. Terms on loans from BancoSol for borrowers repaying SECTOR tive to income), longer repayment periods, and $870 a month, March 2005 (index: unsecured loan = 100) lower interest rates (figure 1).1 Loan size Repayment period Interest rate Collateralized loans are the most common Loan size and Interest PRIVATE lending contract in the formal financial sector. In repayment period rate low- and middle-income countries 70­80 percent 1,600 120 of loans require some form of collateral.2 The 100 same holds true in high-income countries: in the 1,200 GROUP 80 United States, for example, 70 percent of loans are secured by collateral.3 This makes sense from 800 60 BANK a lender's perspective: loan contracts can be 40 400 more easily enforced when secured by property. 20 Across developing regions, when firms apply 0 0 for a loan or a line of credit, the most common Unsecured Loan Loan WORLD loan secured by secured by reason that their application is rejected is insuf- automobile real estate ficient collateral (figure 2). Entrepreneurs rec- Note: Interest rates are derived algebraically from the terms of the loans. THE ognize this: firms report not bothering to apply Source: Banco Solidario data (http://www.bancosol.com.bo/en/productos_cr.html). U N L O C K I N G D E A D C A P I T A L H O W R E F O R M I N G C O L L A T E R A L L A W S I M P R O V E S A C C E S S T O F I N A N C E sources of collateral. But in countries where the Figure Collateral requirements can shut firms out of formal credit markets legal system governing the use of collateral is 2 Firms whose credit application was rejected Firms not applying for credit because collateral unreformed, most of the assets that firms hold, because of insufficient collateral (percent) requirements too high (percent) especially movable property, cannot be used to 80 40 secure loans. These assets are "dead capital." 60 30 The key to unlocking dead capital? Reform If banks are interested in accepting as collateral 40 20 property that has economic and market value, why limit them to a narrow range such as land 20 10 or buildings? Many legal systems place unneces- sary restrictions on creating collateral, leaving 0 0 & & lenders unsure whether a loan agreement will Africa AsiaPacific Asia Asia Africa AsiaPacific Asia Asia East & Europe America East & Europe America be enforced by the courts. Where such restric- Central Latin Caribbean Caribbean & South Central Latin & South tions mean that only agreements involving cer- tain types of collateral--say, real estate or Note: Left-hand chart shows firms whose applications were rejected because of insufficient collateral as a percentage of all firms whose applications were rejected. Data are from surveys conducted in more than 60 low- and middle-income countries in 2001­05. automobiles--will be enforced, only these assets Source: World Bank Group, Enterprise Surveys database. can effectively serve as collateral for bank loans. Most firms have collateral--but can't use it Other property--equipment, livestock, lease- Is lack of sufficient collateral truly the reason holds, accounts receivable--is worthless for this that firms cannot access finance? Many devel- purpose. To take one example, nearly 90 per- opment specialists and policymakers believe this cent of movable property that could serve as col- is so, but it is not true. Firms have assets that lateral for a loan in the United States would could easily be used to secure loans--movable likely be unacceptable to a lender in Nigeria.4 assets such as the goods they produce or process, Uruguay provides another example showing the machinery they use in manufacturing, how unreformed collateral systems can severely accounts receivable from clients, intellectual limit the assets that can secure loans. Wool is a property rights, and warehouse receipts. major export and, in principle, excellent collateral The problem lies in the mismatch between for a loan. If the Uruguayan peso depreciated, the the assets firms own and the assets banks accept dollar price of wool would remain roughly as collateral (figure 3). Private firms worldwide unchanged while the peso price would rise. For hold more than 50 percent of their capital in this reason Uruguayan banks in the past willingly movable assets rather than in land or buildings. made loans secured by wool stored in warehouses. In Canada, New Zealand, and the United States A problem arose when a borrower failed to banks consider such assets to be excellent make payments due and the bank moved to fore- close. The borrower asserted that the wool in the warehouse was not the wool pledged to the bank: Figure The assets firms hold are a poor match for those banks accept as collateral "Your wool is gone--it is in sweaters, in rugs. This 3 Composition of assets held by firms Composition of assets banks have accepted wool is pledged to another lender." The bank as collateral from firms Land and argued that this was absurd, that the bank had buildings Machinery renewed for years a loan secured by the firm's 22% 18% wool inventory, wherever it might be found and Machinery in whatever state. But the court ruled in favor of 44% Accounts the borrower. Uruguay's laws required that the Land and receivable buildings 9% good taken as collateral be specifically identified. Accounts 73% The court noted that each bale of wool had an receivable 34% identification number stenciled on it. The bank should have kept track of these numbers and Note: Data are from surveys conducted in more than 60 low- and middle-income countries in 2001­05. rewritten the pledge of collateral each time the Source: World Bank Group, Enterprise Surveys database. wool rotated--a requirement that meant enor- mous monitoring costs for lenders (Fleisig, many legal formalities to expedite settlement, can Safavian, and de la Peña forthcoming). also provide rapid enforcement. In a summary proceeding the court requires only a valid collat- What should reform emphasize? eral agreement and proof of default. In Albania Canada, New Zealand, and the United States enforcement takes 10 days. Compare that with the were the first to reform the legal system govern- one to three years it generally takes in countries ing the use of movable property as collateral and with unreformed systems. By that time most mov- now have among the most advanced systems. able property will have lost its value. Low- and middle-income countries have also suc- Bosnia and Herzegovina also introduced a 3 cessfully reformed these systems. Top reformers system allowing enforcement of creditors' rights include Albania, Bosnia and Herzegovina, against collateral on presentation to the court of Romania, and the Slovak Republic. All these just two documents: the collateral agreement countries have several things in common. and proof of a valid registration in the pledge registry. The process takes a maximum of 18 No limits on what can serve as collateral days. Moreover, as in Albania, creditors and Laws impose no limits on the types of property debtors are free to agree to out-of-court pro- that can serve as collateral and allow a general ceedings, reducing time and costs even more. description of assets. In Uruguay, allowing a general description of assets would have entitled Two success stories the lender to the borrower's wool--in whatever Experience in Albania and Romania shows how incarnation it had taken--or to the proceeds reforming collateral systems can have favorable generated by the sale of the wool. effects in the financial sector (though not all gains discussed here can be attributed solely to the Clarity on which creditors have priority reform). In Albania after a new law governing the Secured creditors have first priority to their col- use of collateral was passed and a pledge registry lateral and its proceeds and can verify their prior- set up in 2001, the risk premium on lending fell by ity through an electronic archive of security half,theinterestratespreadby43percent,andthe filings. Where secured creditors have absolute pri- interest rate on lending by 5 percentage points. ority, more credit is available (figure 4). Priority The pledge registry receives around 40 pledges a rules work best when a country has a single reg- day on average, and the World Bank Group's istry for pledges of collateral, so that prospective Doing Business project now ranks Albania fourth lenders can easily establish whether there is a (among 154 countries) on the strength of legal prior claim on an asset. And even if other rights for borrowers and lenders. claimants are given priority--a second best for Absolute priority for secured creditors credit markets--laws can require that their claims Figure means more credit for the private sector be registered in the collateral registry. Ukraine's 4 Private credit as a percentage of GDP in countries reform made registering pledges mandatory for with different priority rules all claimants, even the state. If the state fails to reg- 60 ister tax liens, it loses priority. That way banks can 50 accurately account for the risk of tax liens against an asset in deciding whether or not to lend. 40 30 Rapid enforcement of collateral agreements 20 Creditors can seize and sell collateral privately or 10 through summary proceedings, dramatically reducing the time it takes to enforce a collateral 0 Secured One claimant Two or more agreement. When creditors can seize and sell col- creditor has group has groups have absolute priority higher priority higher priority lateral without resorting to the courts, enforce- ment can be fast. But when a case winds up in Note: Relationships are significant at 5 percent level when controlling for income per capita, growth, enforcement, and credit information. court, summary proceedings, which dispense with Source: World Bank 2005. U N L O C K I N G D E A D C A P I T A L H O W R E F O R M I N G C O L L A T E R A L L A W S I M P R O V E S A C C E S S T O F I N A N C E Figure Reforming the collateral system helped improve access to finance in Albania and Romania 5 Financial sector indicators, 2002 and 2005 Firms' sources of finance for new investments, 2002 and 2005 Percent Average share of total (percent) 60 12 viewpoint Albania 50 10 2002 40 8 2005 30 6 is an open forum to 20 Romania 4 encourage dissemination of 10 2002 2 public policy innovations for 0 2005 0 private sector­led and Firms with a Firms pledging Bank loans Family and Money- Financial bank loan machinery as collateral friends lenders leasing market-based solutions for development. The views Source: World Bank Group, Enterprise Surveys database. published are those of the authors and should not be Romania had a similar experience after it attributed to the World reformed the operation of its pledge registry in Bank or any other affiliated 2000: the interest rate spread dropped by 6 per- Notes organizations. Nor do any of cent and the interest rate on lending by 20 per- 1. For more on terms for secured and unsecured the conclusions represent cent, while the number of borrowers increased loans, see Fleisig, Safavian, and de la Peña (forthcoming). official policy of the World by 30 percent (Chaves, de la Peña, and Fleisig 2. World Bank Group, Enterprise Surveys database. Bank or of its Executive 2004). A 2003 survey suggests that the Romanian 3. U.S. Federal Reserve Bank, Survey of Small Directors or the countries registry system is in high demand--with at least Business Finances, 1998 and June 2006 (forthcoming). they represent. 190,000 pledges registered annually.5 4. Estimate by authors, calculated on the basis of an The situation for firms in Albania and analysis of secured transactions in Nigeria by Cuming and To order additional copies Romania continued to improve between 2002 Baranes (2004) and authors' projections given movable contact Suzanne Smith, and 2005. More firms were able to borrow from property finance in the United States. managing editor, banks, and the use of movable property as col- Room F 4K-206, 5. European Bank for Reconstruction and Develop- lateral continued to grow (figure 5). How firms The World Bank, ment survey of registries in the Balkans. 1818 H Street, NW, financed investments also changed for the bet- Washington, DC 20433. ter. Firms relied increasingly on commercial References sources of finance (bank loans, financial leases) Chaves, Rodrigo, Nuria de la Peña, and Heywood Telephone: and less on informal sources (family, friends, Fleisig. 2004. "Secured Transactions Reform: Early 001 202 458 7281 moneylenders). Evidence from Romania." CEAL Issues Brief. Center for Fax: the Economic Analysis of Law, Washington, D.C. 001 202 522 3480 Conclusion Cuming, Ronald C. C., and Yair Baranes. 2004. "A Email: Reforms to improve collateral regimes can be an Modern Secured Financing System Involving Personal ssmith7@worldbank.org important part of improving access to finance for Property Collateral for the Federal Republic of Nigeria." the private sector. Businesses are not rationed Report prepared for the World Bank, Africa Region, Produced by Grammarians, out of credit markets because they lack enough Private Sector Development Department, Washington, Inc. assets to meet the (unnecessarily high) collateral D.C. requirements of banks and other lenders. Fleisig, Heywood, Mehnaz Safavian, and Nuria de la Printed on recycled paper Instead, they are rationed out because the legal Peña. Forthcoming. How to Reform Laws Governing framework for collateral prevents them from Collateral. Washington, D.C.: World Bank. using their assets to secure loans. Experience in World Bank. 2005. Doing Business in 2006: Creating Jobs. Albania and Romania shows how reforms of the Washington, D.C. collateral regime can improve firms' ability to finance their operations and investments, help- ing to generate economic growth and employ- ment where they are most needed. T h i s N o t e i s a v a i l a b l e o n l i n e : h t t p : / / r r u . w o r l d b a n k . o r g / P u b l i c P o l i c y J o u r n a l