Financial Products and Poverty Reduction in Latin America and the Caribbean

1
Financial Products and Poverty Reduction in Latin
America and the Caribbean
Debtor Enhancement Policies

• Arturo Galindo
• Research Department
• Inter-American Development Bank

Washington, D.C., September 30 October 1st, 2004
2
Rodriguez-Mezas paper

• Discusses key policy areas where possible
  intervention is needed to increase access to
  credit
• Secured transactions framework
• Backed by moveable assets
• Backed by non-moveables
• Collateral Substitutes
• Credit registries
• Alternative types of contracts
• Credit guarantee schemes

3
I will focus and present evidence for LAC on
Secured Transactions

• Well functioning secured transactions frameworks
  involve
• Efficient property registries that allow
  creditors to track the ownership and pledging of
  assets
• Clear rules and regulations that define property
  rights regarding the types of assets that could
  be pledged as collateral in credit agreements
• Enforceable rules and efficient institutions that
  allow creditors to seize collateral in an
  efficient and timely manner if the debtor
  defaults.

4
Latin America lags far behind in Creditor
Protection ...
Effective Creditor Rights
Other Emerging
OECD
LAC
Chile
Costa Rica
Uruguay
Panama
Venezuela
Trinidad and
Brazil
Jamaica
Dominican Republic
El Salvador
Peru
Ecuador
Honduras
Paraguay
México
Guatemala
Colombia
Bolivia
Argentina
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
0.40
0.45
Source Galindo and Micco (2004) based on LLSV
(1997), and WB..
5
Latin America lags far behind in Creditor
Protection (2) ...
Duration of Bankruptcy Procedures
OECD
Other Emerging
LAC
Brazil
Panama
Chile
Venezuela
Uruguay
Guatemala
Paraguay
Ecuador
Dominican Republic
Colombia
Argentina
Costa Rica
Nicaragua
Peru
Mexico
Bolivia
Jamaica
0
2
4
6
8
10
12
Source World Bank (2003)-Doing Business
Years
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What can LAC gain from increasing creditor rights
protections?

• Increase the size of credit markets
• Facilitate access to credit for particular
  sectors
• Decrease credit market volatility

7
Creditor Protection and Credit Market Breadth

• Institutions lay out the rules of the game in
  credit markets
• Laws and their enforcement determine the
  incentives of the participants in a debt contract
  and determine the extent to which insiders
  (managers) can expropriate outsiders (creditors,
  investors) who take the risk to finance projects.
• Better creditor protection increases financial
  breadth and depth by making the expropriation
  technology less efficient (LLSV)

8
Creditor Protection and Credit Market Breadth

• Creditor protection enhances the use of
  collateral
• Collateral reduces several problems derived from
  informational asymmetries
• When value of collateral is less uncertain than
  the value of the project
• Is used a signal about the quality the project
• Reduces moral hazard
• If collateral cannot be used credit rationing
  resurfaces, leading to underinvestment.

9
Creditor Protection and Credit Market Breadth
Credit/GDP vs Effective Creditor Rights
60
50
40
Panama
30
Bolivia
20
Trinidad and Tobago
Honduras
Jamaica
Credit/GDP ()
Uruguay
10
El Salvador
Chile
Brazil
0
Costa Rica
Ecuador
Dominican Republic
Peru
Venezuela
-10
Guatemala
Colombia
Belize
Argentina
-20
Mexico
-30
-40
-0.5
-0.3
-0.1
0.1
0.3
0.5
Effective Creditor Rights (Index)
Notes Variables are adjusted for the log of GDP,
average inflation rates during the 1990s, and
average real GDP growth rates during the
1990s.
Source IDB calculations
10
Creditor Protection and Access to Credit

• Better creditor protection can increase access to
  credit by small firms.
• Galindo and Micco (2004) develop a model based on
  the standard idea that it is difficult for a
  lender to enforce both a particular use for the
  credit granted (asset substitution) and the level
  of entrepreneurial effort.
• The model introduces these two type of moral
  hazard, mixing the formulation in Holmstrom and
  Tirole (1997, 1998) and Bester and Hellwig
  (1987).

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Creditor Protection and Access to Credit

• We assume that there are two kinds of
  risk-neutral agents. Borrowers face profitable
  investment opportunities, but do not have enough
  cash for financing their own projects. Banks have
  plenty of cash, but no investment opportunities.
• In the model, banks have a monitoring technology
  that forces entrepreneurs to adopt a safe
  technology that reduces the "assets substitution
  moral hazard" and increases leverage.

12
Creditor Protection and Access to Credit

• The monitoring action has a fixed cost per
  entrepreneur, and therefore is only valuable to
  be used when the entrepreneur has a high level of
  wealth that implies a high level of investment.
• The solution of the model shows that in
  equilibrium banks will not monitor the small
  borrowers (entrepreneurs with low initial wealth
  SME). This increases the moral hazard problem for
  small firms and they adopt the risky technology
  with a higher probability of bankruptcy.

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Creditor Protection and Access to Credit
Share of Bank
Share of Bank
Credit in
Share of Bank
Credit in
Small Firms
Credit in Medium
Large Firms
()
Sized Firms ()
()
Complete Sample
Mean
11.4
17.1
25.7
Standard Deviation
10.1
11.7
14.6
Developing Country Sample
Mean
10.7
17.0
26.3
Standard Deviation
9.3
11.9
14.5
Developed Country Sample
Mean
19.6
18.3
19.9
Standard Deviation
11.8
11.4
16.1
14
Creditor Protection and Access to Credit
15
Creditor Protection and Access to Credit
16
Creditor Protection and Access to Credit
17
Creditor Protection and Access to Credit

• In terms of this sample, an improvement in
  effective creditor rights from the 25th
  percentile to the 75th percentile reduces the
  access gap between large and small firms by
  almost 15 percentage points.

18
Creditor Protection and Credit Volatility

• Credit protection can also reduce the impact of
  adverse shocks over the credit cycle
• The impact of an adverse shock that increases
  credit risk can be exacerbated if creditor
  protections are low
• Low creditor protection can lead to stronger
  contractions when collateral cannot be recovered

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Creditor Protection and Credit Volatility
Credit Volatility and Effective Creditor Rights
0.3
0.2
Brasil
0.1
Mexico
Venezuela
El Salvador
Std. Dev. Of Real Credit Growth(1990-2002)
Peru
Nicaragua
Costa Rica
Uruguay
0
Argentina
Haiti
Ecuador
Colombia
Trinidad y Tobago
Paraguay
Chile
-0.1
Panama
-0.2
-0.3
-6
-4
-2
0
2
4
6
8
Effective Creditor Rights Index
Note The figure controls for foreign shocks
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Policy Implications

• Developing a system to use collateral adequately
  is crucial to increase access to financial
  services
• Strengthen the different components of a secured
  transaction framework
• Develop frameworks to incorporate movable assets
  as collateral
• Strengthen registries
• Protect creditors from a legal perspective
• Improve enforcement (creation of special courts?)
• There are guidelines for reform and experiences
  on reform (Estonia, Romania)

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Policy Implications

• Strong political will is needed to adapt the law
• Incumbents may not want to (Rajan and Zingales)
• It might be unpopular due to the fact that
  personal assets that have traditionally been
  protected, such as homes can be exposed.
• Very important to notice that there is a one to
  one correspondence between the protection of
  creditor rights and the protection of deposits.
• Banks lend mostly deposits. The ability to
  exercise a security interest on a non performing
  loans is protection for depositors.