Lanka to modernize secured transaction systems

Priyantha Fernando
Credit Information Bureau Chairman and Central Bank Deputy Governor

Access to credit is critical for economic growth and is widely considered as the engine for private sector development. In emerging market economies more than half of private sector firms have no access to credit or have very limited access.

Survey results indicate that their credit applications mostly get rejected due to insufficient collateral or unsuitable collateral.

In many cases business owners do not even bother to apply for loans as they are certain that they could not meet the stringent collateral requirements such as land and real estate often requested by banks and other formal financial sector institutions.

Going in depth to this issue, available information and case studies indicates that the availability of collateral is not the source of the problem. It is the inability of translating the capital stock of enterprises which typically constitute movable assets such as machinery, equipment or receivables. Generally, banks and other formal financial institutions heavily prefer land and real estate as collateral, but reluctant to accept movable property as collateral.

However, the good news is that wider distribution of credit could be achieved by introducing modern secured transaction law which recognizes utilization of the full value inherent in assets of a business to obtain credit.

Secured Transactions Systems

A sound legal and institutional infrastructure is critical to maximize the economic potential of movable assets (machinery and equipment, inventory, accounts receivable, cash flows, livestock) to be used as collateral in exchange for loans.

Economic analysis suggests that small and medium sized businesses in countries that have stronger secured transaction laws and secured transaction registries have greater access to credit, better ratings for financial stability, and low rates of non-performing loans and lower cost of credit.

A concurrent action when modernizing secured transaction law is to set-up a centralized registration system to record the secured transactions for the purpose of making them effective against third parties and for deciding priorities amongst various claimants over a secured property.

Lenders are permitted to register movable assets on which they finance the borrowers. When granting loans against movable assets lenders can search the registry to ascertain whether the assets have already being mortgaged to another financial institution.

Such registration systems are required to operate electronically to maintain up to-date records and provide easy accessibility so that it becomes a source of information for parties dealing with secured assets.

The encouragement of the regulator, CBSL, to financial institutions to increase their lending operations, especially to key strategic sectors such as agriculture sector and the small and medium enterprise (SME) sector, while maintaining credit risks and NPLs at healthy levels, will become far more effective if information asymmetry in the credit market is reduced.

Improvements in the Secured Transaction System are an essential ingredient for reducing such information a symmetries.

A sound secured transaction system has three main pillars. The first relates to creation of the security interest covering the kinds of movable assets that can be used as collateral and how those could be used for collateral finance.

The second consists of the methods of publicizing the security interest through registration. The third, deals with priority rules and enforcement of the security interest determining how easily creditors can recover their investment after default by debtor.

A centralized collateral registry protects secured creditors rights by providing objective information on whether assets are already subject to the security right of another creditor.

Scenario in Sri Lanka

The financial sector in Sri Lanka is dominated by banks. The rest of the formal credit market is divided among registered finance companies and specialized leasing companies.

Registered finance companies and specialized leasing companies which are usually the main vehicles for movable asset financing, only represent around 2.1 percent and 3.5 percent of the total assets respectively.

Leasing companies and finance companies do not significantly finance heavy equipment or machinery given the difficulties in protecting their rights on the assets since they cannot register their security interests in those assets anywhere.

Because of this they focus most, around 95 percent in financing vehicles.

In Sri Lanka, the concept behind security interest notice filing is not well understood and as of yet there are no registries that function as modern filing registries.

Accordingly, action has been taken to improve the secured transaction system focusing on (a) improving the legal and regulatory framework for security transactions based on standard internationally accepted practices; (b)developing electronic collateral registry; and (c) creating awareness about the concept of secured transactions among the main public and private sector stakeholders.

The Secured Transaction Act (STA) has been drafted by the Finance Ministry and is expected to be implemented during 2011.

The salient features of STA

Objective:

Promote further access to credit by recognizing collateral in movable assets.

Scope:

The Act identifies that all pledges, mortgages or obligations of movable property may be secured with any movable collateral. This exempts certain transactions such as collateral registered under the Motor Traffic Act or the Civil Aviation Authorities Act.

Nature of collaterals:

Legal rights of a debtor who register secured interests in the Secured Transaction Registry maintained at the Credit Information Bureau (CRIB) are protected above any other obligation.

Additionally any interest in collateral placed by the debtor under the secured obligations may be utilized to secure more than one obligation as well.

Authorization of the debtor:

A party who secured an obligation with movable collateral shall be entitled to file a notice with the CRIB. These notices will be valid for a period of 5 years from the date of filing of same which can be renewable.

Role of CRIB:

Under the provision of the Act, the CRIB is empowered with the responsibility of maintaining the Secured Transaction Registry, also called the Moveable Assets Registry.

Secured Transaction Registry:

The CRIB has developed “in-house” the software to file information pertaining to the secured interests and maintain the information electronically at a centralized data-base.

It is a ‘notice’ registry in which only a simple notice of the essential facts of the secured transaction, namely identity of the debtor, the identity and contact information of the secured creditor, a general or specific description of the collateral and the amount of the loan secured by collateral.

Registration requirements are kept as simple as possible to eliminate errors and to encourage use among financial institutions and their borrowers. It features an on-line access for registration and searches, register the defined types of assets as collateral.

The services provided through the registry include:

* Initial registration notices

* Continuation, amendments and termination of such notices

* Supplying searching services for current and historical records.

All services will be provided through clients, i.e., (CRIB members); Banks, Finance Companies and Leasing Companies. The CRIB members will set-up their relevant customer accounts in the Registry.

The registry IT system at CRIB performs four major functional requirements; Registration, Search, Member Access Management and a Billing Process. It is the duty of the CRIB to provide the lending institutions, at their request, information available with the STR on the availability of debt secured by collateral and its details.

The registry which has been development was tested with institutions drawn from banks, finance companies and leasing companies. It was in July, 2010, that CRIB first announced to the media regarding establishing the Secured Transaction Registry. Subsequently, several workshops were held to educate personnel from the financial sector about the development of the registry and the Secured Transaction System.

The feed-back received from them to improve the system have been incorporated in the list of ‘user requirements’ and taken into account in developing the system. Also while setting up the registration system, the CRIB has taken a view on the existing registration system for motor vehicles, registry of assets of corporate entities and decided that these registries should continue at least in the medium term and to consider integrating with new secured transaction registry as a longer term development.

Implementing the Secured Transaction Act and the establishment of a Secured Transaction Registry, Sri Lanka will be able to move to modern transaction systems aimed at expanding credit to business, particularly to the self-employed and SME’s by allowing them to use their movable property as collateral.

These reforms in the financial infrastructure would help financial institutions expand lending based on more informed and less risky decisions about taking specific types of moveable collateral, as the centralized electronic collateral registry when implemented would publicize the security interests in all types of moveable property. Currently, there is a multiplicity of registries depending on the type of assets that is secured.

Most of those are still paper based systems and are dysfunctional in terms of publicizing the information available in a timely manner for creditors to make informed decisions when securing loans with moveable assets.

Reforming this area could also improve the Sri Lanka ranking of the getting credit indicator in the World Bank Doing Business Report.

Increasing such rankings would make Sri Lanka more competitive in the region, leading to attracting more business from overseas contributing towards Foreign Direct Investments.

This modernization of the Secured Transaction Systems is a joint effort of the Central Bank, Finance Ministry, CRIB and its members.