Internationally driven secured transactions law reforms and globally harmonized prudential regulation set the normative premises sustaining the creation of credit in modern economies. Under the auspices and the guidance of international organizations, such as the European Bank for Reconstruction and Development (EBRD), the United Nations Commission on International Trade Law (UNCITRAL), and the World Bank Group, a growing number of jurisdictions have embarked – or are embarking – upon substantial legal reforms to facilitate access to credit and financial inclusion through the establishment of modern regimes for security rights in movable property. The underlying assumption motivating these efforts is that more credit, at a lower cost, is extended to small businesses and individuals when their assets could be used as collateral, thus ensuring preferential treatment over unsecured creditors. Simultaneously, the capital requirements enshrined in the Basel Capital Accords – designed and promoted by the Basel Committee on Banking Supervision – have been implemented in numerous legal systems to ensure both the solvency of individual banks and the stability of the financial system as a whole. Such regulatory standards impose on banks a minimum ratio of own funds (such as shareholders’ equity) to borrowed funds (typically deposits). In practice, for each loan banks calculate a risk-weighted capital charge, which is a fraction of regulatory capital reflecting the level of risk associated with that loan. The riskier the loan, the higher is the related capital charge. These two branches of law intersect when banks secure the repayment of loans with collateral. Yet, from a regulatory perspective, security rights in most types of movable property are hardly considered to offer sufficient protection.
An inconsistency, if not a fully-fledged paradox, surfaces in the international and national legal frameworks governing the creation of credit: core legal devices designed by private law rules to reduce credit risk are likely to be considered, under capital requirements, inapt to curb credit risk, and thus their effect is equated to unsecured credit. At first blush, the different treatment of collateral may appear symptomatic of a clash between broad policy objectives, namely economic growth and financial stability. This view, however, appears to be ill-equipped to grasp the complexity of the problem, given that stability is a precondition for economic growth and development.
In a recent article, we argue that the tension between secured transactions law and capital requirements is more profound than a mere balancing exercise between policies and is rooted in their different operational logics. To advance this argument, the article offers an analysis of the regulatory treatment of the most common security instruments involving movable property. The provisions of the model laws elaborated by the EBRD and UNCITRAL, together with different national regimes when departing from those international standards, are measured against the requisites that collateralized transactions must satisfy in order to benefit from reduced capital charges, pursuant to the Second Basel Capital Accord (Basel II) and the finalized Third Basel Capital Accord (Basel III). Specific attention is given to the legal regimes and the regulatory framework of the EU, where secured transactions laws are disharmonized while capital requirements are harmonized.
Our research showed that the concomitant and uncoordinated application of these two branches of law leads to far-reaching and largely unintended consequences. Regardless of the quality of the legal regime for security rights, under the current regulatory framework, taking movable property as collateral to finance small businesses is likely to be significantly more capital intensive than other forms of credit protections, such as credit derivatives, or other forms of exposures, such as loans to financial institutions or sovereign entities. Thus, everything else being equal, a bank has higher incentives to extend credit, say, to a leasing company – which, in turn, could finance small businesses against collateral – than lending directly to small businesses. Given that a change in the law pertaining to secured transactions does not entail, per se, a change in the regulatory treatment of credit protections for bank loans, financial institutions that are not subject to the Basel Accords, such as leasing and factoring companies, are likely to benefit more from secured transactions law reforms than banks.
This effect could be problematic for several reasons explored in our research and expanded in a companion article focusing on the legal and regulatory incentives affecting the creation of credit. First, credit provided outside the banking system tends to be more expensive than credit products offered by banks. It follows that, by adopting a modernized and simplified legal regime for taking security rights in collateral, access to credit may be broadened but its costs are likely to increase. Second, from a prudential perspective, diverting asset-based financing outside the banking system does not mean that individual banks and the financial system are insulated from risks. It simply means that risk is outside the purview of prudential supervisors. Although non-bank institutions contribute to sustain the real economy and promote growth, they are easily affected by cyclical changes in the value of collateral and are prone to liquidity shortages, as well as defaults. More profoundly, regulated banks even if they do not provide loans are still part of the equation, as they provide (directly or indirectly) funds, eg, by acquiring loans originated by non-banks.
Our article is part of a new body of research on inclusive and prudent access to credit. In light of the key findings of this research, we have proposed a set of possible solutions to coordinate and reconcile secured transactions laws and capital requirements at the national level, through the implementation of a broader regulatory strategy, and at the international level, by advocating at the UNCITRAL 50th Anniversary Congress for enhanced coordination (p. 166) among various international organizations and, in particular, between the Basel Committee on Banking Supervision and UNCITRAL.
Giuliano G. Castellano is Associate Professor at the University of Warwick, School of Law.
Marek Dubovec is Executive Director at NatLaw, Professor of Practice at the James E. Rogers College of Law and, from June 2018 onwards, Visiting Fellow at the University of Warwick, School of Law.