By Rebecca McReynolds, Chazen Global Insights,
How legal systems block access to credit in emerging market countries
It’s been well documented that small businesses in emerging markets have trouble securing traditional bank financing. What hasn’t been very clear is why, says Mauricio Larrain, an assistant professor with the Columbia Business School. In a recent Chazen Institute-supported paper, “How Collateral Laws Shape Lending and Sectoral Activity,” Larrain and his co-authors quantify for the first time how weak collateral laws restrict access to credit and stifle a country’s economic development.
Business loans are typically secured using the debtor’s assets as collateral, but not all collateral is created equal. Collateral is usually broken into two categories — “immovable’ assets, such as land or buildings; and “movable” assets, such as equipment, accounts receivable, or inventory. According to the World Bank, banks in emerging markets usually won’t accept movable assets as collateral, Larrain notes.
To trace the source of this reluctance, Larrain, along with Charles W. Calomiris of Columbia Business School, and José Liberti and Jason Sturgess, both with DePaul University, studied data from a major international bank to track secured business loans to small and medium-sized businesses across 12 emerging-market countries.
By using data from a single source, the authors were able to make side-by-side comparisons of the liquidation value of all of the assets pledged as collateral across the entire spectrum. “This allowed us to construct comparable LTV (loan-to-value) ratios for loans collateralized by different types of assets — something that the previous literature has been unable to do,” the authors explain.
Connecting the Dots
The next step was to understand how each country in the study treats assets as collateral. Most countries create a clear path for collecting on immovable assets in the event of default, Larrain says. In many emerging market countries, though, creditors have to go to court to secure the right to take ownership of a movable asset, which can take months or even years. “By the time the bank can recover that asset, it has lost a lot of value, which makes banks reluctant to make loans against that type of collateral,” Larrain says.
The analysis showed a clear connection between the strength of laws protecting creditors’ rights to movables and the bank’s willingness to lend against those assets. The LTVs for loans collateralized with movable assets were 27.6 percent higher in countries with strong collateral laws than similar loans in countries with weaker laws.
Further, the authors show that the inability to use movable assets as collateral has slowed economic development in emerging markets because smaller companies, which typically depend on movable collateral to secure bank loans, can’t get financing.
The High Cost of Weak Laws
To illustrate their point, the authors compared the credit market in Slovakia, which has implemented stronger movable collateral laws, and the Czech Republic, which has not reformed its laws. Because the countries were combined until 1993, have similar industrial bases, and both joined the European Union in 2004, it makes sense to assume that their credit markets would be similar.
Instead, Larrain’s research found that the LTVs for movable assets jumped 20 percent, relative to immovable assets after Slovakia’s legal reforms. LTVs in the Czech Republic didn’t change. “Overall, our results show that collateralization laws that discourage the use of movable assets as collateral limit the ability of businesses to raise financing and create distortions that favor immovable based business production,’ the authors conclude.
That bias stunts the traditional trajectory of economic development, which usually moves from agricultural to industrial to service-based economies. Without the ability to borrow against their movable assets, new sectors can’t find traction to grow, Larrain says. “Manufacturing is one of the industries that gets hit the hardest because it is very machinery-intensive,” he adds.
That creates a chicken-and-egg dilemma for emerging market countries. Without stronger collateral laws, it’s hard for a domestic manufacturing sector develop. But without the demand, there is little pressure for countries to change their legal systems. “You enter a vicious circle,” Larrain says.