Privatesector P U B L I C P O L I C Y F O R T H E The World Bank April 1995 Note No. 43 The Power of Collateral How problems in securing transactions limit private credit for movable property Heywood Fleisig The first question any private loan officer is taught to ask is, “How do I get my money back?” Bor- rowers have offered two broad answers to that question: giving an unsecured promise to pay, and offering collateral that can be seized and sold by the lender if the borrower fails to pay. This Note discusses the second type of borrowing. Drawing on several World Bank–supported projects, it sets out how legal and regulatory constraints on using movable property as collateral limit access to credit in many client countries. The problem is potentially severe. In industrial countries, movable property—livestock, machines, inventory, equipment, standing crops—can represent as much as a third of the capital stock and half of investment. Where borrowers cannot use this property as collat- eral for loans, they must pay higher unsecured interest rates. Consequently, they hold less capital per worker and produce less output per person. In Bolivia, the loss in GDP from an inadequate framework for secured transactions is estimated at between 5 percent and 10 percent. Collateral and lending interest rate than the 15- or 30-year mortgage interest rate. These practices are not peculiar to Why does a lender believe a borrower will pay? the Credit Union. Private lenders in Bolivia, Bul- One way for the borrower to prove sincerity is garia, or Boston behave the same way. to offer collateral: to place property at risk of being seized if the borrower fails to pay. The Barriers to using movable property as power of collateral to increase the amount that a collateral creditor is willing to offer is apparent in most lending institutions. For example, the Bank-Fund Despite the importance of collateral in enabling Federal Credit Union offers loans of 6 months’ private lenders to offer larger loans with less salary with only a signature, 12 months’ salary risk and therefore at lower interest rates, legal against a car or other movable property, and 4 and regulatory barriers make movable prop- years’ salary against a house or other real estate. erty nearly useless as collateral in many Bank In these examples, the borrower, loan officer, client countries. The barriers arise in the fol- loan committee, and lending institution are the lowing way. When a lender offers a loan against same; only the collateral differs. In addition, the collateral offered by the borrower, the lender power of collateral to reduce risk overrides the is said to take a security interest in the collat- increase in the term of the loan—the 6-month eral. Three legal and regulatory issues are of unsecured loan will have a higher rate than the key economic importance in limiting security 4-year car loan; the car loan will have a higher interests in movable property: Private Sector Development Department ▪ Vice Presidency for Finance and Private Sector Development The Power of Collateral ▪ The creation of security interests calves would become cows, and the legal se- ▪ The perfection of security interests curity of the contract would be questionable. ▪ The enforcement of security interests. By contrast, in the United States or Canada a binding agreement can be written secured by These are abstract notions that are easiest to a floating security interest in “$200,000 in understand with an example. Consider cattle cattle.” in Uruguay and Kansas. These places have simi- lar topographies, well-educated populations, Moreover, in Uruguay, the bank would have and advanced agricultural systems that place to worry that the farmer would sell the cattle them among the world’s most competitive ag- without notifying the bank. The U.S. or Cana- dian bank, however, would automatically get a continuing security interest in the proceeds In Uruguay, no private bank would of the sale and could automatically attach them —whether they had been put into a bank ac- accept cattle as collateral for a loan. count or a tractor. By contrast, in Kansas, cattle are Perfecting security interests considered the best collateral for a loan. Second, it is difficult to perfect a security inter- est in Uruguay. To have confidence that collat- eral has value, the lender must be sure that no ricultural exporters. In Uruguay, no private prior superior claims to the collateral exist. But bank would accept cattle as collateral for a loan. how can the lender even be sure that the col- By contrast, in Kansas, cattle are considered lateral belongs to the person possessing it? the best collateral for a loan. This is the view Suppose the cattle had already secured a loan not only of private banks, but also of bank or had been purchased on credit? In Uruguay, examiners. In Kansas, good banks have “cattle it is extremely difficult to search the records paper,” and risky banks have “exposure to real for prior claims against collateral. The lender estate.” But in Uruguay, where banks also are must know the date of a prior agreement and closely regulated, the bank examiners prefer cannot search by the name of the borrower or that banks take real estate as collateral for se- the description of the pledged asset. It is even cured loans. How can such a difference exist? more difficult in Bolivia, where the pledges are filed chronologically and the entire registry Creating security interests must be searched to discover a prior pledge. In Bulgaria, no separate registry for such secu- First, it is difficult to create a security interest rity interests exists, and a search for prior claims in cattle in Uruguay. Suppose a bank lends would have to extend to each notarial registry against 100 cattle worth $200,000. Uruguayan in the country. In the United States and Canada, law calls for enumeration of the property—an however, registries are public and easily easy “pledge” against cattle might name the searched, and it is not uncommon for all com- cattle: Bessie, Elmer, . . . —or identify them by mercial agents in an area to know the size and tattoo. But this specific identification makes sequence of the security interests in a farmer’s monitoring the loan expensive for the bank livestock. because the loan officer must ensure that his bank’s specified 100 cattle are in the farmer’s Enforcing security interests field—a different herd of 100 cattle would not secure the loan. The bank might try to get Finally, it is difficult to repossess and sell the around this by writing a general pledge con- pledged collateral in Uruguay. Repossessing tract against, say, 100 calves—but in a year the and selling collateral requires six months to two years. Unlike in other systems, private Abuse the law. In some countries, lenders use parties cannot contract to repossess and sell a postdated check to convert nonpayment into collateral without a lengthy legal process. Nei- a criminal offense. In Bolivia, for example, a ther can nonjudicial government officials. Nor lender will demand a postdated check in the are parties permitted to attach other property amount of the loan and the interest. On the of the borrower, such as the proceeds of the date that the loan is due, the lender requests sale of collateral. In Kansas, by contrast, cattle payment. If the borrower cannot pay, the lender offered as collateral may be repossessed and deposits the check and gets it back from the sold in as little as one to five days. Loans rep- bank marked “check without funds.” The lender resent a high percentage of the collateral’s mar- brings the marked check to the police, who ket value, so interest rates charged range between the prime rate and the home mort- gage rates. . . . in Uruguay . . . repossessing and What to do? selling collateral requires six months First, consider some attempts to deal with the to two years. . . . In Kansas, by contrast, problem that have major shortcomings: cattle offered as collateral may be Make the loans anyway. Since no private bank will do this on its own, some kind of loan guar- repossessed and sold in as little as one antee system will be required. Alternatively, a state-owned institution could make these loans. to five days. However, two problems arise with these op- tions. First, the guarantee fund or the institu- tion that makes these loans is going to have arrest the borrower for writing a check with- the same trouble collecting the loans as the out funds, a criminal act in Bolivia. The bor- private bank. Second, because borrowers will rower spends about a week in the downtown know that these loans are hard to collect there jail, trying to raise the money through friends is a greater chance the loans will not be put to and relatives. If the borrower fails, conviction good use. The result is a money-losing gov- is virtually certain. The sentence for writing bad ernment program without much effect on pro- checks now is about four years. But before a ductivity and therefore a program that is subject legal reform in 1994, the judge also would set to increasing political attack as the credit line a civil penalty equal to the value of the bad goes into default and potential borrowers wait check—and borrowers would stay in prison longer and longer for a chance to get ever- until they paid their debts. In La Paz, half the dwindling numbers of cheap loans. prison inmates are serving sentences for non- drug offenses; of that half, half are there for Ignore the law. Some lenders simply seize and postdated checks. All of those interviewed in sell the collateral for a loan despite the ab- the course of the World Bank study were sence of any legal sanction for these actions. businesspeople. Many of them are single Some leasing operations disguise the transac- women without family connections to raise tion, pretending that a seizure is not a repos- funds to cover the bad check. And many have session. Some nongovernmental organization their children living in the jail with them. lenders take the debtor’s property with the passive consent or active participation of the What’s wrong with these solutions? To para- police. In several countries, men with guns are phrase, they are not only wrong, they are in- dispatched to repossess and sell large and valu- advisable. Formal sector lenders cannot afford able pieces of machinery sold on credit. to use illegal collection techniques because the The Power of Collateral risk of civil and criminal damages is too great. Consequently, the vast resources of the formal sector are not tapped for credit. Movable prop- erty remains the domain of expensive infor- mal sector methods. Why expensive? Expensive to individuals, because the subjective cost to a businessman of going to jail for a business mis- calculation will tend to reserve these loans for only the highest-return operations. And expen- sive to society, because incarcerating risk-tak- ing businesspeople is a dubious development strategy. Better solutions In the Bank’s operations in Argentina, Bolivia, Bulgaria, and Uruguay, the following possible solutions have emerged for government con- sideration: Creation of security interests: change the law to permit the creation of a wide variety of se- curity interests in a wide variety of property. Perfection of security interests: make public the This series is published records of the registries, restructure the public to share ideas and invite registries, change their incentives by introduc- discussion. It covers financial and private ing competition among public registries or sector development as permitting private registries to compete with well as industry and public registries. energy. The views expressed are those of the authors and are not Enforcement of security interests: change the intended to represent law to permit private parties to contract for an official statement of Bank policy or strategy. nonjudicial enforcement of debt contracts. Comments are welcome. Please call the FPD This Note draws on World Bank economic and sector work and Note line to leave a lending operations in Argentina, Bolivia, Bulgaria, and Uruguay, un- message (202-458-1111) dertaken under the broad supervision of Zeljko Bogetic, Mariluz or contact Suzanne Cortes, Vicente Fretes-Cibils, Jonathan Parker, R. Kyle Peters, Stephen Smith, editor, Room Schonberger, and William Shaw. The work was carried out by a team G8105, The World Bank, that included Willem Buiter, Ronald C.C. Cuming, Nuria de la Peña, 1818 H Street, NW, Ulrich Drobnig, Alejandro Garro, Lance Girton, Boris Kozolchyk, Washington, D.C., 20433, Graciela Rodriguez-Ferrand, Stephen Salant, Harry Sigman, and J.A. or Internet address Spanogle, as well as many lawyers, economists, and financial spe- ssmith7@worldbank.org. cialists in the borrowing member countries. The underlying papers are available from the author. 9 Printed on recycled paper. Heywood Fleisig, Economic Adviser, Private Sec- tor Development Department