Assessing Infrastructure for Intermediation: Legal Framework and Credit Information Systems

1. Assessing Infrastructure for Intermediation: Legal Framework and Credit Information Systems Thorsten Beck

2. 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

3. Legal framework

4. 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

5. Private Credit and Creditor Rights

6. Private Credit and contract enforcement

7. Legal framework - overview • Financial sector legislation • Corporate sector framework • Collateral and creditor rights • Insolvency framework • Judicial system

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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)

15. Legal framework: Cross-country comparisons Source: Doing Business project, http:\\rru.worldbank.org\doingbusiness

16. Credit information systems

17. 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

18. Private Credit and Credit Information Sharing

19. Credit information systems - overview • Institutions and sources of information • Public vs. private registries • Elements of a robust credit registry system

20. 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)

21. Information in credit reports • The heart of the credit report is the detailed payment history it provides • Positive payment history empowers good borrowers, creates reputation collateral • Negative 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

22. Public vs. Private Credit Registries

23. 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

24. 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

25. 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.)

26. 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?

27. Institutional Arrangements for Private Credit Registries

28. 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

29. 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

30. 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

31. 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

32. 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?

33. 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

34. 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.)