Supporting the development of the microfinance industry has been a key item on multilateral and bilateral donors’ agenda for expanding access to finance. Microfinance institutions, through innovations in lending technologies, have created profitable financial services for the poor and underserved, greatly expanding access to credit. Many of these institutions have become key players in the financial sector (such as BRI Indonesia, ProCredit Bank in Albania, and Banco Solidario, or BancoSol, in Bolivia). In many low- and middle-income countries these lenders compete for the same clients as commercial banks and have even become licensed commercial banks themselves.
Microfinance institutions have achieved all that in environments with poor legal frameworks, including those for secured lending. Yet it would be a mistake to assume that they would not benefit from reforms in the legal framework for secured transactions. Although microfinance institutions rely on substitutes for collateral (peer pressure, access to repeat loans, innovative—and sometimes illegal—enforcement mechanisms), reforming collateral laws may have a greater effect on them than on conventional banks. The reason? The movable property and fixtures that reform newly permits borrowers to use as collateral tend to be a better match for the property owned by microfinance clients, who do not own real estate on the same scale as borrowers from the formal sector. Indeed, anecdotal evidence suggests that in some countries that have undertaken secured transactions reform, the initial uptake in using the system for registering secu- rity interests was bigger among microfinance institutions than among com- mercial banks.8 And microfinance institutions—like all other lenders—will provide larger loans (relative to cash flow), lower interest rates, and longer maturities for loans secured by property than for unsecured loans (see the discussion of BancoSol in chapter 1).
Microfinance institutions would also benefit from the effect of the reform on unsecured lending. Gathering information about unsecured borrowers can be expensive and difficult, but lenders and sellers on credit often do so anyway in the course of dealing with their clients over the years. The information they acquire can be quite valuable, allowing them to make unsecured loans and extend unsecured credit inexpensively and profitably. But fully realizing the value of this information requires a reformed system for secured transactions that permits refinancing the portfolios of unsecured loans that microfinance lenders hold.
Inability to refinance such portfolios has limited the expansion of small, pioneering unsecured lenders, including solidarity-group lenders. But where a framework for secured transactions supports securitization, permitting the refinancing of small unsecured loans by businesses that do not take deposits, it reduces the cost of unsecured lending and promotes the development of non- bank competition. In the United States, for example, large finance companies such as American Express, Diners Club, and MBNA make unsecured loans, then use portfolios of these loans as collateral for their own loans and issues of com- mercial paper. The consequences for nonbank competition are clear: as noted, while in most developing countries nonbank credit amounts to about 5 percent of total credit, in the United States it amounts to about 60 percent of the total.
NOTES
1. Heywood Fleisig and Nuria de la Peña, “Should the Bank and the Fund Support the Reform of Secured Transactions?” CEAL Issues Brief (Center for the Economic Analysis of Law, Washington, D.C., 2003).
2. Only rarely will a bank make a local currency loan at a lower interest rate to a private borrower than to the government. The local government’s ability to tax and to print local currency means that government debt denominated in local currency will typically have a lower risk and therefore a lower interest rate.
3. E. Gerald Corrigan, formerly president of the Federal Reserve Bank of New York and now a managing director of Goldman Sachs, discusses the links between the legal system and bank supervision and regulation clearly and accessibly in an arti- cle on Latin America and the Caribbean, stating that “the region’s credit problems . . . will not [emphasis in original] be solved simply by improved supervisory poli- cies and practices” (“Building Effective Banking Systems in Latin America and the
Caribbean: Tactics and Strategy,” IFM-107 (Inter-American Development Bank, Washington, D.C., 1997, p. 14). While the article focuses on Latin America, it applies equally well to bank supervision and regulation in all developing countries. 4. See chapter 3 for a detailed discussion of the legal roots of this problem. 5. Equity finance theoretically could replace debt finance: the two are interchange- able at the margin. Consequently, it could be argued that a viable project that is not financed with borrowing would be financed by equity investment. If that were the case, a poor framework for secured lending would only shift the balance of financing away from debt and toward equity. In that view a defective system of secured transactions would have no overall economic cost: either debt or equity would eventually finance all profitable projects. This argument appears only in the legal literature, not in the economics literature, and appears to have been first sug- gested by Alan Schwartz, in “The Continuing Puzzle of Secured Debt” (Vanderbilt Law Review 37 [October 1984]: 1051–69). This article, followed in the legal litera- ture by a long debate on its merits, rests on a subtle fallacy familiar to economists: that equality at the margin implies equality on inframarginal transactions. By the same false logic one could claim to show that since imported and domestically produced goods are equal in price at the margin, no incentive for trade exists; or that because the rate of return on the marginal project equals the interest rate, no profit would arise from positive investment.
6. From 2000 to mid-2005 U.S. business invested $1.1 trillion a year on average. Average annual stock issues amounted to about $120 billion, a little over 10 percent of the total; average annual borrowing from the financial sector amounted to $425 billion, about 40 percent of the total. See U.S. Federal Reserve System, Board of Governors, Flow of Funds Accounts of the United States: Flows and Outstandings, Second Quarter 2005, Federal Reserve Statistical Release Z.1 (Washington, D.C., 2005), p. 17.
7. Donors, especially the International Finance Corporation through its Private Enterprise Partnerships, have strongly supported reforms of leasing laws. The part- nerships have worked on such reforms in Kazakhstan, the Kyrgyz Republic, FYR Macedonia, and Ukraine and are now expanding to several countries in Africa. 8. This is based on conversations with stakeholders in Albania and Bosnia and Herzegovina.