It’s the institutions!
A long academic tradition connects institutional development and quality to the socioeconomic strength of nations in the long term. This is, in fact, one of those few theses capable of arousing an enormous degree of agreement among social scientists. In defining the meaning of “good institutions”, two basic concepts stand out: (1) full and free inclusion and participation of all society in the political process and markets and (2) broad guarantee of property rights.
It doesn’t come as a surprise. Economic development cannot take hold when small groups—military or economically powerful—capture the state and direct it for their own benefit and/or when the fruits of personal effort can be easily expropriated by others (government or otherwise). An entrepreneur who anticipates the possibility that another will steal from him an invention that takes time and resources to set up will invest much less than he would like.
A worker who suspects that his bank will make irresponsible decisions with his money will keep his funds under his bed or send them abroad (or he will consume everything, given the risk of saving). Consequently, the bank will have few resources to finance the invention of the entrepreneur in the aforementioned paragraph, and the economy will again grow less.
Credit market and its problems
An economy with a poor credit market will miss many investment opportunities and grow less. The bad news is that dynamics in this market are particularly complicated by the fact that exchanges involve events taking place at different points in time. The financial intermediary captures funds that can be withdrawn by depositors at any time, and lends them to someone who signs a commitment to repay them in the future. Often a very distant future (the mortgage on a house, for example, can be 20 years). Acquiring a loan is very different, therefore, from acquiring goods on the cash market – you go to the store, try on the pants, feel if they are tight, examine the fabric, pay and end the transaction – where everything takes place in the here and now. .
Another serious problem that afflicts the credit market much more than the pants market is that the borrower (“buyer”) knows much better than the financial intermediary (“the seller”) the risks inherent in their own projects, and knows also better than anyone their real willingness to repay (something the bank obviously tries to infer, but manages only incompletely). The bank, in turn, understands this logic and will think twice before lending to new borrowers, especially if the legal apparatus that obliges the latter to honor its contracts does not work well. Loans with guarantees serve to minimize this problem: the bank does not know the borrower’s predisposition to repay and the risks of the projects, but this will matter less if it can recover a portion of the assigned funds by taking possession, in the event of default, of a pre-agreed guarantee – it can be the property or car purchased with financing, the machinery purchased by the entrepreneur, bills payable from customers, etc. The problem, of course, is that depending on the legal apparatus, the same guarantee can be worth more or less.
In developed countries, the recovery rate of contractual guarantees ranges between 80% and 90%. In countries such as Turkey and Brazil, this figure does not even reach 15%. This is not innocuous: the lower chance of recovery translates into higher cost of credit. Bill 4,188, authored by the Executive, aims to improve the quality of the guarantees framework and, in our opinion, the suggestions presented there actually contribute to this improvement. But we don’t expect a miraculous impact. For an essential reason: the PL provides for the creation of IGGs (Guarantee Management Institutions). But what we see as the biggest obstacle to the development of the credit market is not the internal organization of the sector (banks vs IGGs), but the interaction with the legal system.
PL 4.188/21 – Guarantee Framework: what does it do?
Essentially, it creates the legal figure of IGGs, which will be able to manage collateral just like banks do today. Currently, when someone looks for the bank, it evaluates the value of the guarantee and, based on it, offers loan conditions. With IGGs, competition grows, as the borrower can hire the IGG service, have their guarantee guaranteed it (and no longer by your bank, if you want) and based on this assessment knock on the doors of several credit institutions and analyze your options. In this sense, the idea bears some resemblance to open banking: in it, the individual or legal entity wanders around with its history of being a good payer and forcing banks to compete with each other to sell you the loan at the lowest possible rate.
In addition, the proposal increases the efficiency of contracts with real estate guarantees, as it proposes:
- that a given property can be given as collateral for more than one loan (the difficulty would be a property as collateral for loans in different banks, but for the same property the measure is obviously beneficial and should not give rise to legal turmoil);
- that reductions in the debt balance make room for new operations with the property as collateral (which makes sense, because as the debt balance drops, the owner starts to have more personal equity in the property);
- that family properties can be pledged when they are offered as loan guarantees (a measure that makes sense, but may face legal difficulties a posteriori).