The paper measures economic loss from the problem of inadequate collateral in Bulgaria and proposes solutions consisting of creation of security interests, perfection, and enforcement.collateral, finance, access to credit, investment, Bulgaria

Zeljko Bogetic

English

Research Papers in Economics

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

Collateral, Access to Credit, and Investment in Bulgaria, chap. 8 in D. Jones and J. Miller (eds) THE BULGARIAN ECONOMY: LESSONS FROM REFORM DURING EARLY TRANSITION, Ashgate 97.

http://128.118.178.162/eps/fin/papers/0510/0510004.pdf

Collateral, Access to Credit, and Investment in Bulgaria, chap. 8 in D. Jones and J. Miller (eds) THE BULGARIAN ECONOMY: LESSONS FROM REFORM DURING EARLY TRANSITION, Ashgate 97.

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