Property Rights, Collateral, Creditor Rights and Financial Development

Abstract

This article reviews aspects of law and practice in relation to financial development, especially in emerging market and transition economies. It sets out the core importance of property rights in such development, and examines how those rights are linked to the functioning of collateral and insolvency mechanisms. In particular, it examines discrete aspects of the creation and treatment of secured creditor interests, processes for insolvency, and the functional relationship between these related elements of law. Several preconditions are necessary for a market-orientated financial system or national economy to develop and function effectively.2 Those relating to financial sector development rest on three principles: the first, institutional and legal; the second, largely legal; and the third, related mainly to policy: • First, a market economy and a market-based financial system cannot be sustained if certain institutional and legal supports are not in place, notably through the operation of a governance system that establishes property rights and provides for the consistent enforcement of contracts and dispute resolution. It is also important to provide for the development of human capital. • On the basis of these institutional foundations, a number of legal underpinnings must be available for a market-based financial system to function. These include the availability of collateral (supporting secured transactions), a system of law for both the establishment and dissolution of corporate bodies, and a supportive system of taxation. To maintain such effectiveness, national and sub-national governance should also provide more widely for the rule of law, which is taken to be transparent and non-discriminatory, in addition to establishing specific property rights, enforcing contracts and allowing for dispute resolution. • Third, a financial sector functions most effectively in the context of appropriate macroeconomic policies. These policies, while largely outside legal and institutional concerns, operate best in the context of an appropriately designed and transparent institutional framework. No sophisticated market economy or market-based financial system can exist without these prerequisites, regardless of indigenous or acquired national characteristics or the form manifested by that system. In this context, this article looks at the relationships of economic development with governance, property rights, provisions for the deployment of collateral and the creation of secured financial transactions, and creditor rights and their interaction with insolvency. The issues of policy and principle raised in this article have been debated in official and legal circles at intervals, most notably since the socio-economic and financial shocks associated with the 1997–98 Asian crisis. It is now generally accepted that the form and practice of law influences economic behaviour. In particular, institutional quality is often an important determinant of credit creation and flows of capital, both within the sectors of a national economy and in cross-border savings and investment. Factors such as any jurisdiction’s legal origins, the nature of the acquisition or founding of law, and details of its application and enforcement may be seen in features of governance, economic systems and structure, commercial culture, corporate behaviour, and financing patterns, as well as affecting broader variables such as changes in national output and income distribution. At the same time, the efficiency and consistency of the law’s operation form part of institutional costs, so that no assessment can ignore the organisation and management of legal systems. This is especially valid in the context of creditor claims and corporate recovery. In general, the main objective of the reform of laws governing security and creditor rights will be to influence behaviour through changes in transaction costs.