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Assessing Infrastructure for Intermediation: Legal Framework and Credit Information Systems

Thorsten Beck

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Introduction

Infrastructure is set of institutions and rules for functioning of financial system

Legal infrastructure: laws and their enforcement, corporate governance

Informational infrastructure: credit information sharing, accounting and auditing rules and practice

Transactional infrastructure: retail and wholesale payment systems

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Legal framework

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The Importance of the Legal Framework for the Financial System

Financial contracts depend on certainty of legal rights and predictability and speed of their fair and impartial enforcement

Regulation and supervision of financial system requires legal and regulatory framework

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Private Credit and Creditor Rights

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Creditor Rights Index

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Private Credit and contract enforcement0

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Days to Enforce a Contract

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Legal framework - overview

Financial sector legislation Corporate sector framework Collateral and creditor rights Insolvency framework Judicial system

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Legal Framework: Financial Sector Legislation

Central Bank, Bank Supervisory Authority Legislation Independence, objectives, accountability

Banking/financial institutions legislation From cradle to grave, bank secrecy

Payment system legislation and regulation Finality of payment, zero hour rule

Anti-money-laundering (AML), Combating the financing of terrorism (CFT) legislation

Government debt management legislation Capital markets legislation Insurance sector legislation

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Legal Framework: Corporate Sector Framework

Company law Regime for formation, registration and operation of

companies Different types of companies (limited liability, joint

stock, partnerships etc.) Corporate governance

Relationship between stakeholders of companies Directors’ duties Shareholder rights Audit and accounting practices

Laws and regulations Regulatory agencies enforcing legislation and

regulations Business culture and practices

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Legal Framework: Collateral and Creditor Rights

Predictable, transparent and affordable enforcement of unsecured and secured claims outside the insolvency system

Civil Code, laws on insolvency, land, pledge, mortgages, execution

Registers for movable and immovable property, registration procedures

Restrictions on ownership, transfer, pledge Loan documentation Role of Notary Public Court / non-court enforcement procedures

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Legal Framework: Insolvency Framework

Legal framework for corporate insolvency Provide for timely, efficient and impartial

resolution Maximize value of assets and recoveries Efficient liquidation of nonviable and rehabilitation

of viable businesses Equitable treatment of similarly situated creditors Transparent procedure Framework for cross-border insolvencies

Informal out-of-court procedures for work-out Institutional framework

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Legal Framework: Effective Insolvency and Creditor Rights Systems

Principles and Guidelines for Effective Insolvency and Creditor Rights Systems

Developed in 1999/2000 by WB and other organizations and experts

35 principles in four areas: Creditor rights and enforcement systems Corporate insolvency Credit risk management, debt recovery and

informal enterprise workout practices Effective implementation of legal mechanisms

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Legal Framework: Judicial System

Courts are “slow, corrupt, incompetent and expensive”. Judges

Appointment, dismissal, independence, salaries, promotion Infrastructure

Location of courts, buildings, libraries, computerization, budget, administration

Procedures Code of Civil Procedure, filing fees, appeal procedures,

injunctions, case management, allocation of cases, execution of judgments

Court Officials Prosecutors, bailiffs, police, court staff, lawyers, bar

associations, discipline Arbitration, mediation, specialized courts

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Legal framework: Cross-country comparisons

Doing Business database; case study approach: Claim equals twice country’s income per capita, creditor

(plaintiff) is 100% right, judicial process, which ends in favor of creditor:

Number of procedures legally required between the parties Time (days) spent in dispute resolution until payment Cost (fees, duties etc.) of going through the court procedure, relative to

debt value

Transfer of land and building in a peri-urban area of the country’s most populous city, 50 times income per capita.

Number of procedures legally required to register property Time (days) spent in completing procedures Cost (taxes, fees, duties etc.) relative to property, only official costs

Insolvency: time (in days), cost (as percentage of estate) and recovery rate (cents on the dollar)

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Legal framework: Cross-country comparisons

0 100 200 300 400 500 600

Mozambique

Zimbabwe

Zambia

Tanzania

Malawi

South Africa

Days to Recover Debt Outside Insolvency

600 700 800 900 1000 1100 1200 1300 1400 1500

Mozambique

Zimbabwe

Zambia

Tanzania

Malawi

South Africa

Days to Resolve Insolvency

Source: Doing Business project, http:\\rru.worldbank.org\doingbusiness

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Credit information systems

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The Role of Credit Reporting Systems in Financial Markets

Reduce asymmetric information between borrowers and lenders

Allow lenders to more accurately evaluate risk and avoid adverse selection

Strengthen incentives for borrowers to repay, reducing moral hazard Increase the cost of default Provide an incentive for good borrowers:

Reputation Collateral

Increase competitiveness, reduce segmentation

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Private Credit and Credit Information Sharing

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Credit Information Index

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Credit information systems - overview

Institutions and sources of information

Public vs. private registries Elements of a robust credit registry

system

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Financial Information Infrastructure: Primary Institutions & Sources of Data

Consumer Credit Reporting Firms & Registries Commercial Credit Reporting Firms & Registries Corporate Registries Ratings Firms Microfinance Credit Bureaus Industry Specific Databases (insurance,

property management, utilities, cell phones, agricultural commodities, etc.)

Other Public Data (public databases, Chambers of Commerce / Better Business Bureau, media)

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Information in credit reports

The heart of the credit report is the detailed payment history it providesPositive payment history empowers good

borrowers, creates reputation collateralNegative payment data encourages honoring

obligations

Lender Account No. Date Opened & Credit Limit & Payment

Date Reported Past Due History

B of A XXXX 1-1-2000 $5,000 30 day - 1

6-1-2004 $0

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Public vs. Private Credit Registries

Feature Public Private

Purpose Bank supervision & credit checks for lenders

Credit checks for lenders

Source of information

Supervised institutions (banks)

Varied sources (banks, retailers, telecoms)

Participation mandatory?

Yes No

Positive Info? Yes In some cases

Minimum loan size

In some countries No

Fee for service No charge or minimal charge

Yes

Basis for operations

Government Regulation

Contract

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Advantages and Shortcomings of

Public Credit Registries

Advantages Public credit registries can compel banks to report, especially

important in economies with concentrated financial systems Public credit registries can operate where the legal

environment is inhospitable for private ventures Public credit registries may engender additional confidence,

depending on country experiences Public credit registries provide data for bank supervision

Shortcomings: Data sources and distribution of data are more limited for

private credit registries Public credit registries have fewer resources (staff, funding,

technology) Public credit registries do not offer value-added services such

as credit scoring Public credit registries offer limited consumer attention

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Elements of a Robust Credit Reporting System

Providers and users of credit data Institutional arrangements Quality of the data collected Quality of the data distributed Legal framework for credit reporting Regulatory framework for credit reports Use of credit information for bank

supervision Consumer outreach & education

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Providers and users of credit data

Commercial Banks and other regulated financial institutions (credit card issuers, insurance firms, automobile finance companies, mortgage lenders/guarantors)

Retailers (appliance retailers, other stores) Firms providing business-to-business credit,

trade credit Microfinance institutions Other businesses which provide goods or

services on credit (utilities, cell phone providers, agribusiness, etc.)

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Providers and users of credit data

What is the financial market structure? How concentrated is the banking / financial sector?

What are the main financial sector products? Are banks lending to a broad spectrum of the population? Do

they offer varied products & services? What are the most important non-bank sources of

finance? How are these changing? In the real sectors of the economy, what are the most

important sources of financial services and credit? Are there special industry credit services?

What role does microfinance play?

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Institutional Arrangements for Private Credit Registries

Institutional Type

Pros Cons

Private firm w/ no bank ownership

All types of data, independence

No automatic access to data

Private firm w/ bank ownership

All types of data, Special access to bank data

Independence may be questioned

Bank association Access to bank data, integrity

Only bank data, only bank access

Chamber of Commerce

Retail & non-bank data, broad cover, historical record

No bank data, Limited funds for modernization

Commercial & credit insurance firms

In-depth data on commercial sector

Limited coverage, High cost per entry

Industry-specific databases

In-depth data on single sector

Lmtd. Scope – can’t cross -check data

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Quality of the Data Collected

Collect both positive & negative information Maintain data for a reasonable time frame – 5

years minimum Do not delete negative data when debt is repaid Data should be inaccessible after a certain amount of

time

Credit reports should not include highly sensitive information such as political or religious affiliation, etc….

Other identifying information, such as gender, should be evaluated more carefully

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Quality of the Data Distributed Integrity and transparency are paramount

Special standing of any group, including owners or government, will discourage participation

Open system preferable, reciprocity not necessary

Access to more detailed information preferable Loans described individually, not aggregates Institutions providing credit identified

Restrictions to prevent “cherry-picking” Distribution reflects privacy considerations

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Legal framework for credit reporting

Legal framework should encourage information sharing among lenders Provide legal clarity regarding acceptable

information sharing practices Consideration of privacy issues important

Broad privacy or data protection laws may unduly limit credit reporting – balance privacy with economic impact of limiting access to data

Competition policy aspects of credit information

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Legal framework for credit reporting:Consumer protection

Borrowers should have access to their own data

Notice of adverse actions based on report Record who has accessed data as part of

report Consumer-friendly procedures in place to

challenge erroneous information in reasonable time frame

Clearly established privacy policy

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Regulatory framework for credit reporting

Regulatory framework usually weaker than legal framework in developing countries

Regulatory framework with enforcement Can, and do, regulators effectively enforce

laws and regulations, via: Audits Lawsuits Fines Reviewing industry codes of conduct

Do consumers have the ability to bring complaints outside the judicial system?

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Use of credit information for bank supervision

Supervisors include financial institutions’ use of credit information as part of inspections, both on- and off-site

Use data from PCRs to identify large problem borrowers, to fine-tune regulations and in analytical work to identify risk-categories of borrowers

Require publicly (government) owned financial institutions to provide data to legitimate credit reporting firms, associations

Encourage all financial institutions to participate in credit reporting

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Consumer Outreach and Education

Readily available information on managing credit and on the rights & responsibilities of borrowers regarding credit reporting Printed materials at appropriate level, language

(internet, banks, retailers, government offices can all provide access)

Radio or television public service ads Role of industry in providing consumer assistance Outreach to lenders on importance of credit

information Outreach to other interested parties (judges,

microfinance institutions, etc.)