Efficient infrastructure for access to financial services

Access to credit is crucial for economic growth and development. A survey has revealed that about two thirds of the adult population in developing countries or 2.7 billion people lack access to basic formal financial services, such as savings or checking accounts. Most of the unbanked live in Sub-Saharan Africa (12 per cent having access to banking) and South Asia (24 per cent having access to banking). East Asia, Middle East, North Africa, Latin America, Eastern Europe and Central Asia are the regions where less than 50 per cent of their people have access to banking. A large number of the unbanked people live on less than $5 a day.
Another study finds that more than a half of business enterprises in emerging markets have no access to credit mostly due to the lack of security guarantee as expected by financial institutions (FI). The majority of the FIs use the Five Cs (capacity, character, capital, collateral and conditions) methodology or its adaptation as part of their credit evaluation process. Collateral is typically considered a precedent, not just an evaluation criterion. Out of these variables, collateral very frequently influences the eventual approval of a credit application. Banks heavily prefer land and real estate as collateral. The security is taken by an FI to ensure an alternative source of repayment in the event the debtor fails to meet his or her contractual obligations to discharge the debt. In many cases, business owners did not even bother to apply for loans, because they were certain that they could not meet the collateral requirements often asked for by banks. A common trend among the FIs is  rejection of credit applications mostly due to insufficient collateral, i.e. unacceptable or unsuitable collateral.
Recognising the benefits for financial markets, many countries have modernised their secured transactions laws relating to movable properties. They have broadened the range of movable assets that borrowers can use as security, established collateral registries to help avoid priority conflicts, provided secured creditors with priority to their claims, clarified the rankings of other claimants and permitted effective, speedy and inexpensive enforcement of security interests. This is particularly important for small and medium firms that do not own any significant real properties, but hold inventory and receivables as their primary assets, instead.
Loans secured by movable assets as collateral-often also called asset-based loans-are an alternative to traditional bank lending. Because, they serve borrowers, quite aware of the risk characteristics that typically fall o    utside a bank's comfort level. The movable assets as collateral include present, future, tangible and intangible assets. Such assets are inventories, accounts receivable, livestock, crops, equipment and machinery. These assets have no contribution to economic activities and are defined as dead capital, since these assets cannot be used as collateral for a loan in the traditional banking system.
An in-depth analysis indicates that unavailability of collateral is frequently not the problem. Rather, it is the inability to utilise valuable assets as collateral. Asset-based loans secured by movable assets disproportionately benefit small and new enterprises. Asset-based lenders often extend funds, when traditional sources are not available. Asset-based lending, as practised by non-bank financial institutions (NBFI), is different from the traditional bank lending. Because NBFIs address the borrowers' risk characteristics that typically fall outside a bank's comfort level. The NBFI business model is considerably different from that of commercial banks.
Asset-based NBFIs look beyond financial statements to determine how much money they are prepared to offer at and after close. Asset-based lenders' primary focus is on collateral and liquidity, with leverage and cash flow being the secondary consideration. The amount of credit depends on the type of business and the content and quality of the collateral. The lender provides funds secured by the assets of the borrower. The collateral can include accounts receivable, inventory, raw materials and work in process, machinery, vehicles, intellectual property rights or other assets like book debts, jewelry and other household objects where value can be determined. Typically, asset-based lenders provide borrowers with more liquidity and fewer financial covenants. Asset-based borrowers usually have higher financial leverage and marginal cash flows. The cost of asset-based loans is influenced by credit risk and collateral associated with the transaction.
A sound legal and institutional infrastructure is important to maximise the economic potential of movable assets, so that they can be used as collateral. Well-designed and secured transaction systems contribute to robust financial systems by promoting credit diversification, allowing NBFIs to provide credit and to rely less on real estate collateral. FIs also benefit from these systems by:
(i) being able to diversify their portfolios by accepting movables, including more liquid assets such as receivables or investment instruments;
(ii) having access to information on existing security interests in movable assets and their priorities;
(iii) strengthening their risk management policies by making more informed credit decisions on collateral-based lending; and
(iv) making possible a better reporting mechanism on collateralised lending practices.
The model provides legal structures, through which movable assets in emerging markets can be effectively used as collateral while significantly improving access to finance by those firms that need it the most. Even in the most advanced jurisdictions where reliable credit information and a wide range of financial products are available, only the largest and best connected businesses can obtain unsecured loans. The rest have to offer collateral.
Where one or more private or public but a special type of credit information bureau (CIB) exists in the jurisdiction, the diagnosis should involve examination of their structure. There are potential synergies between secured transactions and credit information systems that may be beneficially developed.
A key feature of a modern secured transaction law is an efficient centralised registration system. Such movable collateral registration serves two functions: (1) it notifies third parties of the existence of security interest and (2) it establishes the priority status of a security interest based on the date of registration.
Speedy, effective and inexpensive enforcement mechanisms are essential to realise security interests. Enforcement is most effective when parties can agree on rights and remedies upon default, including seizure and sale of the collateral outside the judicial process. When seizure and disposition of the collateral does call for judicial intervention, expedited summary legal proceedings should limit judicial findings to the existence of an agreement granting the security interest.
The most common model is an asset-based loan. In this model, the lender has first-priority security interests in all inventories and accounts receivable. All incoming funds for the business are deposited in the asset-based lender's account. In this scenario, the asset-based lender has complete control over the cash flow. The lender can then manage risks more effectively through weekly monitoring of cash inflows and outflows. The lender is prepared to free up the equity held in inventories and receivables so that more inventories can be purchased to meet the demand.
The second model is inventory financing that involves purchase orders. This model is most common with wholesalers and brokers trying to facilitate buy-and-sell block orders. The inventory lender can potentially finance the purchase of the inventory required to complete the sale, provided that (1) it is shipped directly to the borrower's customer and (2) the customer agrees to pay the lender directly. In this scenario, the borrower does not touch the inventory or the payment. Once payment is received, the inventory lender deducts the cost of the inventory and the financing costs and forwards the balance to the borrower.
Finally, in the third model, the lender has complete control over the inventory. Under this model, an inventory is purchased with the lender's funds and stored in a third-party warehouse. The lender releases the inventory, as the goods are paid for.
The most important step that can be taken to improve accuracy, speed, accessibility and cost effectiveness is to enable registrants to enter their registrations directly into the database and to conduct their own searches, that is, registration. Searching should be made available as widely as possible to end users of the registry via the internet. Doing so will: (1) improve accuracy by eliminating the risk of errors for such registrations and by applying fixed a logic to produce reliable searches; (2) improve speed by permitting registrations to be completed and confirmed instantaneously upon submission, and by providing immediate search results upon submission of a request; (3) improve accessibility by making the registry available to users at any location at any time; and (4) reduce costs of operation by transferring the labour burden of data entry from the registry staff to the end users.
The formalities for creating security interests are simplified. It places no restrictions on who could give or take a pledge nor does it mandate excessive contractual terms. Further, notaries and other third parties do not have to be involved in creating security in the form of collateral or solemnising a security agreement.
Further economic analysis suggests that small and medium-sized businesses in countries that have stronger secured transaction laws and registries have greater access to credit, better ratings of financial system stability, lower rates of non-performing loans and a lower cost of credit. The end result is higher productivity and more growth. Countries that have introduced new or reformed secured transaction systems (legal framework and registries) have achieved a higher degree of development in the area of their credit system by increasing the effective use of movable collateral to secure credit.
All the conditions and liberal credit system must be backed by a secured transaction law. It should apply to all rights to movable assets created under an agreement that secures payment or other performance of an obligation, regardless of the form of the transaction, the type of the movable asset, the status of the grantor or secured creditor or the nature of the secured obligation.
The law should apply to: (a) security rights to all types of movable asset, tangible or intangible, present or future, including inventory, equipment and other tangible assets, contractual and non-contractual receivables, contractual non-monetary claims, negotiable instruments, negotiable documents, rights to payment of funds credited to a bank account, rights to receive the proceeds under an independent undertaking and intellectual property; (b) security rights created or acquired by all legal and natural persons, including consumers, without, however, affecting rights under a consumer-protection legislation; (c) security rights securing all types of obligation, present or future, determined or determinable, including fluctuating obligations and obligations described in a generic way; and d) all property rights created contractually to secure the payment or other performance of an obligation, including transfers of title to tangible assets for security purposes.
New laws are significantly improving the existing lending environment. Experiences of other reformers suggest that the legal provisions need to be backed by broader institutional reforms and assistance in implementation in order to maximise the impact. Implementation measures require (1) reforming the National Registration Authority for Secured Transactions (NRAST) and updating the current registry to an electronic platform, (2) building capacity within the financial sector in close coordination with the key stakeholders, and (3) monitoring the implementation of laws and removing remaining shortcomings as necessary.
Reforming the movable collateral framework enables businesses to leverage the greatest part of their assets and obtain credit for growth. Movable collateral strengthens financial systems by:
(a) Diversification of assets held by financial institutions efficiently spreading the risk;
(b) Reducing concentration in the financial system, by providing banks with profitable lending opportunities in the SME sector to increase their financial market share;
(c) Improved liquidity of assets, especially short-term assets such as accounts receivables;
(d) Increased competition for financial services by enabling non-banks to offer secured loans;
(e) Improved ability of regulators to analyse portfolio risks in line with both standardised approaches and internal risk rating models.
The law should have a provision for a regulatory body with a scope to frame regulations to look after interests of both debtor (natural and juridical persons) and creditors. It will establish a special CIB that will a registry, the place to register security interests in movable assets, and assign responsibility for its operation, and a centralised registry for the whole jurisdiction. It should allow access to all stakeholders.
It is imperative to support development of sound and efficient financial infrastructure to strengthen financial stability and enhance access to financial services. A sound financial infrastructure includes secured transactions systems, payment systems, insolvency regimes, credit information reporting, inter-bank lending and central bank support.
The writer is a legal economist pursuing PhD in Open University, Malaysia.
shah@banglachemical.com