Credit Creation: Reconciling Legal and Regulatory Incentives
CREDIT CREATION: RECONCILING LEGAL AND REGULATORY INCENTIVES
0 Associate Professor at the University of Warwick School of Law, Research Associate at École polytechnique (i3-CRG, CNRS, Paris-Saclay), J.D. Bocconi University, Law School, Ph.D. (Law) University of Turin, Ph.D. (Economics) École polytechnique. I gratefully acknowledge the support of the Economic and Social Research Council (ESRC) via the University of Warwick Impact Acceleration Account (ES/M500434/1). A version of this paper was presented at the Asian Institute of International Financial Law (AIIFL) of the University of Hong Kong, Faculty of Law in
As international organizations adopt new legal standards to promote access to credit through the modernization of national regimes governing security interests in personal property, the lack of coordination with regulatory standards for banking institutions thwarts the effectiveness of these efforts. Banking regulation, which generally views collateral with favor, displays a strong skepticism towards transactions collateralized with personal property, which constitute the borrowing base of small and medium-sized enterprises (SMEs) in developed and developing economies alike. In recognizing the relevance of the issue during its Fiftieth Commission Session, the United Nations Commission on International Trade Law (UNCITRAL) agreed that its Working Group VI should undertake future work that results in a text to include specific guidance to national regulatory authorities on capital requirements.1 The aim would be to coordinate the implementation of the UNCITRAL Model Law on Secured Transactions (Model Law)2 with the requirements enshrined in the Basel Accords issued by the Basel Committee on Banking Supervision (BCBS).3 If UNCITRAL lives up to its promises, the future text would assist national 1. See Rep. of the U.N. Comm'n on Int'l Trade Law (UNCITRAL), Fiftieth session (3-21 July 2017), ¶¶ 222-223, U.N. Doc. A/72/17, Supplement No. 17 (2017). One objective would be to indicate how capital regulation could be adjusted within the discretion granted by international capital standards. For further details, see infra note 6 and accompanying text.
regulators in adapting their domestic regulatory environment so that security
interests in personal property could serve more effectively as credit protection
under the Basel Accords. The initiative is timely and relevant to fostering access
to credit. In most jurisdictions—including all Member States of the European
Union and the United States—banking activities are regulated through
legislation transposing the First Basel Accord (Basel I) and the Second Basel
Accord (Basel II),4 whereas the Third Basel Accord (Basel III) has been finalized
and is entering into the implementation phase.5 Hence, the establishment of a
regulatory environment that incentivizes banks to extend loans secured with
personal property, while in compliance with the Basel Accords, is essential to
ensure the effectiveness of secured transactions law reforms.6
Although efforts at the national level are commendable, this article shows
that coordination between secured transactions law and prudential regulation,
particularly capital requirements, should be addressed at the highest level of the
lawmaking process—notably, when international soft-laws are defined. On one
hand, international legal standards guiding secured transactions law reforms have
been developed under the assumption that there is a substantial equivalence
among different sources of credit and, therefore, all lenders—be they commercial
banks or non-banking institutions—operate under similar sets of incentives and
constraints.7 On the other hand, international capital requirements have been
designed and applied across the world without acknowledging the potential
reduction of risk that a modern secured transactions law regime would provide.
As demonstrated in this article, both approaches perpetuate a lack of
coordination between two fundamental pillars of the legal and economic
4. In the U.S., Basel Accords for saving associations regulated by the Office of Thrift Supervision
(OTS) are codified at 12 C.F.R. §§ 567.1–567.12 (2017). For institutions supervised by the Federal
Deposit Insurance Corporation (FDIC), Basel II and certain elements of Basel III are consolidated and
codified at 12 C.F.R. pt. 324 (2017). In the E.U. they are consolidated in: Directive 2013/36/EU, of the
European Parliament and of the Council of 26 June 2013 on Access to the Activity of Credit Institutions
and the Prudential Supervision of Credit Institutions and Investment Firms, Amending Directive
2002/87/EC and Repealing Directives 2006/48/EC and 2006/49/EC, 2013 O.J. (L 176) 338 and Council
Regulation 575/2013, of the European Parliament and of the Council of 26 June 2013 on Prudential
Requirements for Credit Institutions and Investment Firms and Amending Regulation 648/2012, 2013
O.J. (L 176) 1 [hereinafter CRR]. These provisions apply to all banks operating in the European single
5. BASEL COMMITTEE ON BANKING SUPERVISION, BASEL III: FINALISING POST-CRISIS
REFORMS (2017) [hereinafter BASEL III].
6. Elsewhere, we indicated that, to ensure coordination at the national level between secured
transactions law and capital requirements, a regulatory strategy is necessary. See Giuliano G. Castellano
& Marek Dubovec, Bridging the Gap: The Regulatory Dimension of Secured Transactions Law Reforms,
UNIFORM L. REV. (forthcoming 2018) (noting that national regulators should, inter alia, stimulate the
development of sound risk management practices, incentivize the creation of transparent and liquid
secondary markets, and adopt specific regulatory measures to incentivize secured lending for small
7. See, e.g., UNCITRAL, LEGISLATIVE GUIDE ON SECURED TRANSACTIONS, ¶ 52, U.N. Sales
No. E.09.V.12 (2010) [hereinafter UNCITRAL LGST] (noting that secured transactions laws are
“designed to apply equally to a wide range of credit providers: financial institutions and other lenders”).
The assumption influenced all UNCITRAL texts, including the Model Law.
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framework sustaining credit creation. To advance this argument, the different
functions and mechanisms underpinning secured transactions law and capital
requirements are isolated, and a holistic understanding of the legal and
regulatory rules governing the supply of credit is put forward.
This article is structured as follows. Part II, following this introduction,
presents the essential roles of secured transactions laws and capital requirements
in supporting the creation of credit through the management of credit risk. The
conditions for security interests in personal property to reduce regulatory capital
under the Basel Accords are tested against modern secured transactions laws.
Particular attention is given to the rules governing priority and enforcement
under the Model Law and Article 9 of the Uniform Commercial Code (U.C.C.
9). References to selected European legal systems and to the Canadian Personal
Property Security Acts (PPSAs) are offered to enrich the analysis. Part III further
expands on the regulatory treatment of collateral and identifies the incentives
created by the Basel Accords for banks to deploy different credit protections,
focusing on security interests in personal property and credit derivatives. In
addition, the analysis under Part III explains how the lack of coordination
between secured transactions law and capital requirements stimulates the
creation of credit outside the banking system and examines the larger
consequences of this phenomenon. Concluding remarks then follow.
CURBING CREDIT RISK: DIFFERENT VIEWS OF THE CATHEDRAL
Secured transactions law and prudential regulation are essential pillars of the
legal architecture that sustains the creation and distribution of credit. Secured
transactions law, by granting preferential treatment to secured creditors vis-à-vis
other creditors and competing claimants, such as the insolvency trustee, is a
critical element supporting lending activities and promoting access to credit in
general.8 Prudential regulation, through its micro and macro dimensions, aims at
ensuring the solvency of individual banks and the stability of the banking system
as a whole, thus sustaining the supply of credit.9 More profoundly and drawing
from a growing body of influential legal scholarship, these two sets of rules not
only sustain credit creation but should be understood as constitutive components
of credit markets.10 An agreement that grants a creditor a preferential right over
8. See, e.g., Grant Gilmore, The Secured Transactions Article of the Commercial Code, 16 LAW &
CONTEMP. PROBS., Winter 1951, at 27, 29 (highlighting the relevance of secured transactions law for
small and medium-sized businesses); Roy Goode, Security in Cross-Border Transactions, 33 TEX. INT’L
L.J. 47, 47–48 (1998) (noting the increased dependence on security devices in international lending).
9. The relationship between financial stability and economic growth has been convincingly
highlighted by ANAT ADMATI & MARTIN HELLWIG, THE BANKERS’ NEW CLOTHES: WHAT’S WRONG
WITH BANKING AND WHAT TO DO ABOUT IT 5 (2013). For further considerations on the connection
between financial stability and access to credit policies, see Giuliano Castellano & Marek Dubovec,
Global Regulatory Standards and Secured Transactions Law Reforms: At the Crossroad between Access
to Credit and Financial Stability, 41 FORDHAM INT’L L. J. (forthcoming 2018). For an introduction to
capital regulation, see JOHN ARMOUR ET AL., PRINCIPLES OF FINANCIAL REGULATION ch.14 (2016).
10. Through different analytical lenses, various scholars have reconsidered the relationship between
a debtor’s asset requires a legal regime that recognizes its validity and
enforceability between the two parties, as well as against third parties. Rules for
creation (or attachment), perfection, priority, and enforcement of security
interests in personal property serve this purpose, and if non-existent or outdated,
this form of secured credit would not develop or flourish in the economy. In a
similar vein, the regulatory framework influences and is influenced by the
behaviors of economic agents, indicating that the very existence of financial
markets without any sort of legal, accounting, and regulatory structures is hardly
imaginable.11 Prudential regulation, through capital requirements that are
routinely adjusted to reflect changing market dynamics, lays the foundation for a
banking system designed to support the creation of purchasing power and thus,
to fund the “real economy,” affecting the production and commerce of good and
services.12 Hence, a coordinated interaction—or the lack thereof—between
secured transactions law and capital requirements shapes the credit market by
affecting and being affected by the behaviors of its core participants, banks and
At the heart of the intertwined relationship between legal rules and the
market’s dynamics for credit creation is risk management.13 Legal and regulatory
norms are constitutive elements of markets, as they allow economic agents to
minimize the uncertainties related to their investments.14 In this respect, both
secured transactions law and capital requirements represent mechanisms to
mitigate potential losses associated with lending activities; simply put, they are
both concerned with curbing credit risk. However, they approach credit risk in
substantially different fashions that eventually fail to reconcile.
financial markets and legal rules. See generally Iman Anabtawi & Steven L. Schwarcz, Regulating
ExPost: How Law Can Address the Inevitability of Financial Failure, 92 TEX. L. REV. 75 (2013) (providing
a system-wide perspective to explain the interaction between financial regulation, markets, and firms);
Julia Black, Reconceiving Financial Markets—From the Economic to the Social, 13 J. CORP. L. STUD. 401
(2013) (advancing an alternative and enriched conception of financial markets); Katharina Pistor, A
Legal Theory of Finance, 41 J. COMP. ECON. 315 (2013) (developing a “Legal Theory of Finance,”
holding that financial markets are legally constructed, occupying a hybrid space between public and
11. In this respect, Professor Black notes: “Whilst legal rules may not automatically dictate
behaviour in markets (if they did regulators, would be out of work), regulative rules, both non-legal and
legal, play a role in providing scripts, processes and routines that influence, and are influenced by,
individual behaviour.” Black, supra note 10, at 416.
12. See infra note 32 and accompanying text.
13. See Black, supra note 10, at 417 (indicating how legal, regulatory and accounting rules shape
market practices also by determining how risk is allocated, transferred, and ultimately priced); Pistor,
supra note 10, at 318 (noting how the emergence of the global market for credit derivatives to manage
credit risk reveals the role of the law in shaping markets).
14. New institutional economics noted that markets and legal rules have developed to reduce
uncertainty. See generally DOUGLASS NORTH, INSTITUTIONS, INSTITUTIONAL CHANGE AND
ECONOMIC PERFORMANCE (1990); Oliver Williamson, The Theory of the Firm as Governance Structure:
From Choice to Contract, 16 J. ECON. PERSP. 171 (1985).
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A. The Perspectives of Secured Transactions Laws
The benefits sought by secured transactions laws—and their reforms—stem
from the ability of security interests to confer an effective device to manage credit
risk.15 To this end, personal property secured transactions laws typically provide
for: (i) the creation of security interests without unnecessary formalities; (ii) the
perfection of security interests primarily through a streamlined filing process; (iii)
clear priority rules; and (iv) effective enforcement procedures.16 Each of these
elements is critical to equip creditors with a device to manage credit risk and,
therefore, facilitate access to credit. Hence, legal rules are intended to design a
system where credit risk is not solely expression of the creditworthiness of a
borrower, as collateral offers an alternative method of repayment. However, the
conditions under which personal property serves effectively as an alternative
repayment method depend on national laws.
From a comparative and international perspective, secured transactions law
is a heterogeneous and dynamic field of law. Its ancient origins and constant
developments have resulted in a variety of nationally defined approaches and
legal categories. Initiatives to harmonize this field are a relatively recent
phenomenon and stem from the need to rationalize the maze of domestic legal
rules in order to facilitate cross-border transactions.17 In a similar vein, legal
reforms at the national level aim at equipping creditors with a more agile and
effective set of rules, embodied in a single statute. Not surprisingly, simplification
was also a key motivating factor driving the U.C.C. 9 pioneering reform of
personal property security law—as noted by Karl Llewellyn, one of its primary
proponents and drafters.18
15. See Giuliano G. Castellano, Reforming Non-Possessory Secured Transactions Laws: A New
Strategy?, 78 MOD. L. REV. 611 (2015) (noting that new strategies for legal reforms can be identified
when the management of credit risk is understood as the core economic function performed by secured
16. For a comprehensive analysis of how U.S. secured transactions law addresses attachment,
perfection, priority, and enforcement of security interests, see generally STEVEN L. HARRIS & CHARLES
W. MOONEY, JR., SECURITY INTERESTS IN PERSONAL PROPERTY: CASES, PROBLEMS AND MATERIALS
(6th ed. 2016); in Canada, see RONALD C.C. CUMING, CATHERINE WALSH & RODERICK J. WOOD,
PERSONAL PROPERTY SECURITY LAW (2005); under English law, see SIR ROY GOODE, GOODE AND
GULLIFER ON LEGAL PROBLEMS OF CREDIT AND SECURITY (Louise Gullifer ed., 6th ed. 2017).
Secured transactions laws might not necessarily address cohesively these four fundamental tenets, and
different regimes for attachment, perfection, priority and enforcement might apply to different security
devices. This is typically the case for legal systems adhering to a formalist understanding of security
interests. See infra notes 21–22. Special rules might also apply to specific classes of financing transactions;
typically this is the case for security rights in intellectual property. See, e.g., Andrea Tosato, Secured
Transactions and IP Licenses: Comparative Observations and Reform Suggestions, 81 LAW & CONTEMP.
PROBS., no. 1, 2018, at 155.
17. UNCITRAL adopted the Model Law in 2016. However, the process of harmonization and
modernization started much earlier with noteworthy regional initiatives. See, e.g., Frédérique Dahan,
Law Reform in Central and Eastern Europe: The ‘Transplantation’ of Secured Transactions Laws, 2 EUR.
J.L. REFORM 369 (2000).
18. K. N. Llewellyn, Problems of Codifying Security Law, 13 LAW & CONTEMP. PROBS., Autumn
1948, at 687, 690.
The novelty of this reform was to embrace a unitary and functional approach,
whereby different consensual arrangements that serve the common purpose of
enhancing the satisfaction of obligations from the disposal of personal property
were subjected to common sets of attachment, perfection, priority, and
enforcement rules. U.C.C. 9 has played a pivotal role in influencing both national
law reforms and international legal standards. Notably, UNCITRAL as well as
the Canadian PPSAs,19 but also Australia and New Zealand, followed this
approach and re-fashioned different forms of security instruments under a single
category, known as “security rights” according to the terminology of the Model
Law or “security interests” under the PPSAs.20
The functional approach is opposed to the formalistic understanding of
security interests and could be encountered in both civil law countries, such as
France, Italy, and Germany, and common law jurisdictions, such as England and
Wales.21 Pursuant to the formalistic approach, the characterization and legal
treatment of a security interest depends on its legal nature, rather than on its
economic effects. As a result, a variety of consensual security devices coexist and,
depending on their legal nature, different rules concerning attachment,
perfection, priority, and enforcement apply. Moreover, security interests that
facilitate the extension of credit to finance the acquisition of specific assets
(purchase money financing) typically escape the purview of secured transactions
law, strictly considered, and are regulated by general property and contract law.
An example of this is found in the German fiduciary transfer of ownership or
retention of title arrangements commonly deployed in the legal systems of
Regardless of the different instruments and national approaches, modern
secured transactions laws have been implemented and reformed under the
assumption that a security interest over any collateral offers an alternative
method of repayment and, thus, reduces credit risk. Secured transactions laws
contain mandatory rules but leave most aspects of the bargain to the parties.
Asset-based lending practices, such as the methods for valuing the collateral
or the level of acquired or transferred risk, fall outside the scope of legal regimes
concerned with the establishment of security interests in personal property.
Rather, secured transactions laws equip creditors and debtors with the tools to
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conduct their assessments of risk exposures while exercising their contractual
freedom. Secured transactions law also performs a regulatory function, broadly
intended, as it defines the limits to party autonomy with the intent of protecting
the debtor and third parties affected by the security interest. These limitations
may be general or specific. Generally, the concept of “commercial
reasonableness” dictates in which manner the parties must discharge their
obligations and exercise their rights, such as when choosing the appropriate
method and manner for disposal of the collateral.23 As an example of a specific
limitation, debtors and secured creditors cannot choose which law will govern the
perfection and priority of the security interest.24 In any respect, the level of risk
that creditors assume reflects their idiosyncratic choices. Whether and, if so, to
what extent, secured transactions should also be regulated to protect financial
stability is cogently examined by another article in this symposium.25
B. The Perspective from Basel
Effective management of credit risk is also the central theme of capital
requirements that impose on banks a cushion, known as regulatory capital, for
the absorption of a reasonable amount of unexpected losses. Regulatory capital
is calculated through a capital adequacy ratio between a bank’s risk-weighted
investments—or risk-weighted assets, in reference to the accounting distinction
between assets and liabilities—and its own funds, primarily composed of
shareholders’ equity and long-term subordinated debt.26 The First Basel Accord
(Basel I) set the minimum ratio of capital to risk-weighted assets (RWA) at 8%.
In practical terms, for every loan, a bank must calculate a capital charge, a
fraction of the regulatory capital, by multiplying the amount of the loan by the
prescribed capital ratio and the corresponding RWA. Hence, the higher the
RWA coefficient, the more capital is required. With the introduction of Basel
II,27 banks have been allowed to either rely on statutorily prescribed RWA
coefficients, under the standardized approach, or adopt an internal-rating based
(IRB) approach to calculate RWAs by adopting their own estimations. In the
aftermath of the 2007–2009 financial crisis, the BCBS adopted several
amendments to Basel II, with the adoption in 2011 of the first elements of Basel
III.28 The new Accord maintained the approach of Basel II, and although the
capital ratio remained at 8%, the amount of shareholders’ equity was increased
23. CUMING, WALSH & WOOD, supra note 16, at 29; HARRIS & MOONEY, supra note 16, at 638.
24. See UNCITRAL MODEL LAW, art. 3(1).
25. Steven L. Schwarcz, Secured Transactions and Financial Stability: Regulatory Challenges, 81
LAW & CONTEMP. PROBS., no. 1, 2018, at 45.
26. See, e.g., ADMATI & HELLWIG, supra note 9, at 6; ARMOUR ET AL., supra note 9, at 290.
27. BASEL COMMITTEE ON BANKING SUPERVISION, BASEL II: INTERNATIONAL CONVERGENCE
OF CAPITAL MEASUREMENT AND CAPITAL STANDARDS: A REVISED FRAMEWORK (rev. 2006)
[hereinafter BASEL II]. For a critical examination of Basel II and its development, see DANIEL K.
TARULLO, BANKING ON BASEL: THE FUTURE OF INTERNATIONAL FINANCIAL REGULATION (2008).
28. BASEL COMMITTEE ON BANKING SUPERVISION, BASEL III: A GLOBAL REGULATORY
FRAMEWORK FOR MORE RESILIENT BANKS AND BANKING SYSTEMS (rev. 2011) [hereinafter BASEL III
and further buffers and surcharges were added.29 Given the criticisms concerning
the ability of banks to game capital requirements, further changes, particularly to
limit the use of IRB models, were discussed in different consultative documents
issued by BCBS.30 Ultimately, the consultation process led to the finalization of
Basel III, which will progressively enter into force from 2022, with full
implementation in 2027.31
The justification for capital regulation is inherent in the role played by banks,
particularly commercial banks, in creating credit. Contrary to common
explanations that banks perform an intermediary function by lending out
deposited savings, central bankers and leading economists point out that the core
economic function of banks is the creation of monetary purchasing power
through loans.32 In fact, from an aggregate perspective, each time a loan is
extended, a corresponding deposit is created; therefore, loans generate deposits
that, in turn, are the primary form of purchasing power for any given economy.33
At the individual level, however, banks acquire funds, such as deposits, in order
to expand lending and increase profits. Hence, in performing their function of
creating credit and purchasing power, banks manage a process of liquidity and
maturity transformation whereby loans (assets) are illiquid, long-term
investments, and deposits (liabilities) can be withdrawn mostly at-will.
Regulation is thus concerned with the detrimental consequences on depositors
and on the economy at large, resulting from a non-prudent management of a
29. On the main changes introduced by the first version of Basel III in 2011, see Kern Alexander,
The Role of Capital in Supporting Banking Stability, in THE OXFORD HANDBOOK OF FINANCIAL
REGULATION 335 (Niamh Moloney, Eilís Ferran & Jennifer Payne eds., 2015). Even if in practice the
level of capital may be higher, numerical examples in this article refer to 8% for simplicity.
30. These documents were informally called “Basel IV,” although they were intended to complete
Basel III, rather than present a novel accord. Of particular relevance is the proposal to amend the
standardized approach. See BASEL COMMITTEE ON BANKING SUPERVISION, SECOND CONSULTATIVE
DOCUMENT: REVISIONS TO THE STANDARDISED APPROACH FOR CREDIT RISK (2015) (issued for
consultation on March 11, 2016) [hereinafter SECOND CONSULTATIVE DOCUMENT].
31. BASEL III, supra note 5. Although further changes might be implemented, the adoption of Basel
III marks the beginning of the implementation phase for a new set of requirements to calculate credit
risk, market risk, and operational risk. In particular, new standardized and IRBs approaches are set to
enter into force on January 1, 2017. See Press Release, Basel Committee on Banking Supervision,
Governors and Heads of Supervision Finalise Basel III Reforms (Dec. 7, 2017),
32. See, e.g., ADAIR TURNER, BETWEEN DEBT AND THE DEVIL: MONEY, CREDIT, AND FIXING
GLOBAL FINANCE 137–38 (2017) (noting that early twentieth-century economists, such as Friedrich
Hayek and Joseph Schumpeter, identified the creation of deposits through loans as a key feature of the
banking system); Zoltan Jakab & Michael Kumhof, Banks Are Not Intermediaries of Loanable Funds—
And Why This Matters (Bank of Eng., Working Paper No. 529, 2015).
33. Legal contributors have embraced this notion. See MORGAN RICKS, THE MONEY PROBLEM:
RETHINKING FINANCIAL REGULATION (2016) (characterizing the relationship between banking,
financial instability, and private money creation as the “money problem”); Robert Hockett & Saule
Omarova, The Finance Franchise, 102 CORNELL L. REV. 1143, 1147 (2017) (describing the banking
system as a public-private partnership in which public actors accommodate and monetize private
liabilities); see also CHRISTINE DESAN, MAKING MONEY: COIN, CURRENCY AND THE COMING OF
CAPITALISM 398 (2014) (noting that historically, commercial banks developed to dominate the creation
of money through deposits).
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business that by nature is highly leveraged. Hence, capital requirements
modulate the aggregate quantity of credit available in the economy by controlling
the leverage of individual banks.34
Regulatory standards do not prevent banks from extending new loans; if a
bank extends a new loan, it must either increase the amount of its own funds or
reduce its exposure to credit risk. However, banks consider their own funds,
particularly equity, to be more expensive than borrowed funds, such as deposits.35
From the standpoint of individual banks, thus, capital regulation represents an
additional cost or a tax.36 In this respect, the Basel Accords incentivize banks to
diminish their exposure to credit risk to maximize their return on equity, a result
that is arithmetically achieved through lower risk-weightings.
Adding to the current literature on capital regulation, this analysis indicates
that capital requirements control the quantity of credit circulating in the economy
by binding its creation to an amount of equity that is proportionate to the level
of risk acquired by each bank. Through this prism, risk-weighting mechanisms
are the pivot steering the choices of individual banks, as they determine the costs
of funding for the extension of credit. As shown in Part III, however, the effects
of capital regulation transcend the regulated banking sector and affect the overall
supply of credit. Therefore, whether risk-weightings accurately capture the level
of risk of a given operation and how secured transactions law reforms interact
with this mechanism are critical policy matters that cannot be approached
C. The Long Road from Basel to Vienna
The ultimate test of convergence between the different approaches to credit
risk is to examine the conditions under which security interests in personal
property reduce risk-weightings and, consequently, capital charges. Broadly,
different credit risk mitigation (CRM) techniques, such as security interests or
34. See James Tobin, Commercial Banks as Creators of “Money” 2 (Cowles Found. for Research in
Econ., Discussion Paper No. 159, 1963) (also indicating reserves as one of the limits to excessive credit
creation); see also Hockett & Omarova, supra note 33, at 1161 (noting that capital regulation is not a real
limit to credit creation, because even if banks violate capital requirements, the credit already extended
cannot be cancelled retroactively).
35. See ADMATI & HELLWIG, supra note 9, at 110–11; ARMOUR ET AL., supra note 9, at 310–11
(both noting that favorable tax treatment for debt instruments and guarantees protecting deposits render
debt less expensive than equity, as the assumptions of the Modigliani-Miller theorem on corporate
finance are not satisfied).
36. See David Jones, Emerging Problems with the Basel Capital Accord: Regulatory Capital
Arbitrage and Related Issues, 24 J. BANKING & FIN. 35, 40 (2000) (noting that to reduce the cost of capital
regulation banks engage in regulatory capital arbitrage; that is, the exploitation of the “differences
between a portfolio’s true economic risks and the notions and measurements of risk implicit in regulatory
capital standards”); see also Viral Acharya et al., Capital, Contingent Capital, and Liquidity Requirements,
in REGULATING WALL STREET: THE DODD-FRANK ACT AND THE NEW ARCHITECTURE OF GLOBAL
FINANCE 143 (Viral Acharya et al. eds., 2011) (noting the role of capital regulatory arbitrage in the 2007–
2009 financial crisis); Erik F. Gerding, The Dialectics of Bank Capital: Regulation and Regulatory Capital
Arbitrage, 55 WASHBURN L.J. 357, 365 (2016) (indicating that “capital regulations and regulatory capital
arbitrage co-evolved in a dialectical manner”).
credit derivatives, are recognized in the Basel Accords to reduce the risk
exposure of an operation.37 When CRM techniques are employed, the resulting
risk-weighted capital charge should not be higher than that imposed on an
otherwise identical transaction that is not covered by a CRM.38 However, if
deemed inadequate in providing credit protection, any CRM would result in
capital charges that correspond to those applied to unsecured credit.39
In line with the general logic of capital regulation, credit protections are used
to reduce RWA coefficients to lower the cost of creating new credit. Yet, given
that any reduction in own funds is, by definition, a decrease of the cushion
insulating depositors from unexpected losses, specific regulatory conditions must
be met. In particular, a transaction collateralized with personal property is
eligible to lower capital charges only if a bank, authorized to adopt an IRB model,
has the highest priority and if the legal framework allows swift realization of the
value of the collateral on default.40 As much as these prescriptions appear to be
straightforward, their application collides with the practical functioning of
secured transactions laws. The result is that the Basel Accords are not sensitive
to the variations in risk that different legal regimes or rules may induce. To
illustrate this point, a few examples affecting priority and enforcement of security
interests in different legal systems are provided, indicating the direction that any
efforts to reconcile capital requirements and secured transactions law should
Under the Model Law, U.C.C. 9, and Saskatchewan PPSA, priority rules are
clear and predictable.41 Creditors may acquire first priority, for instance, by filing
a financing statement before a competing interest in the same collateral has been
perfected. However, attaining the same result is not as plain in other legal
systems. For instance, under English law, the particulars of a charge must be
registered with the Companies House within twenty-one days of the creation of
the charge.42 Given that the priority of a charge is determined by the date of
creation, the collateral could be encumbered by a yet-to-be-registered competing
charge that is difficult to discover. However, while this priority rule presents a
risk not associated with the priority rule of U.C.C. 9 and the PPSAs—with the
exception of the purchase money security interest in equipment that may be
37. BASEL II, supra note 27, ¶ 109; BASEL III, supra note 5, ¶ 117.
38. BASEL II, supra note 27, ¶ 113; see also SECOND CONSULTATIVE DOCUMENT, supra note 30, ¶
104; BASEL III, supra note 5, ¶ 119.
39. There are some exceptions to this rule. For past-due loans, non-eligible CRMs may also result
in lower capital charges. See BASEL II, supra note 27, ¶ 77. However, Basel III adopts a more conservative
approach, and only eligible collateral and guarantees considered eligible for CRM purposes can be
deployed to reduce capital charges. See BASEL III, supra note 5, ¶ 94. In any respect, the application of
these exceptions does not affect the regulatory treatment of security interests here examined.
40. See BASEL II, supra note 27, ¶¶ 512–15, 522; BASEL III, supra note 5, ¶¶ 286–89, 296.
41. See UNCITRAL MODEL LAW, ch. V; U.C.C Art. 9, pt. 3, subpt. 3 (2010); Saskatchewan PPSA,
42. Companies Act, 2006, ch. 46, pt. 24 § 886, (U.K.). Pursuant to § 874, failure to register within
twenty-one days renders the charge void against administrators, liquidators, and creditors of the
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perfected twenty days after delivery under U.C.C. 9-322(a)—a prudent lender
may attain the highest priority by not disbursing the credit until it is certain that
potentially registrable charges have not been registered within the
twenty-oneday window, thus perfecting a security interest that satisfies the Basel Accords
requirement of highest priority. Accordingly, an old-fashioned priority regime
may satisfy prudential expectations, but at a higher cost and delay in disbursing
Furthermore, other challenges arise when a security interest may be perfected
without any form of public notice, as it often occurs in jurisdictions adhering to
formalism.43 In this respect, jurisdictions adopting the functional approach to
security interests make it easier and less costly for banks to satisfy the first
priority requirement prescribed by the Basel Accords.
Nonetheless, the Basel Accords neither impose nor encourage the adoption
of a unitary, functionally defined approach to secured transactions. For instance,
Italian lawmakers introduced special provisions for bank loans secured with
assets of companies.44 This security device added further complexity to a
nonunitary regime already plagued by intricacies by prescribing antiquated
requirements, such as the priority being established through a non-centralized
and paper-based filing system.45 Although formally compliant with the Basel
Accords, the effectiveness of this security device in curbing credit risk is therefore
Ensuring that a security interest enjoys the highest priority against competing
(consensual) claims is, in practice, of limited relevance when non-consensual
claims are taken into account. The Basel Accords consider non-consensual claims
as the sole exception to the first priority rule for security interests in tangible
assets.46 Interestingly, such an exception is not contemplated in rules concerning
financial receivables, thus leading to question whether security interests in
financial receivables qualify as eligible credit protections only if the highest
priority, even against non-consensual claims, is attained.
The scant attention given to non-consensual claims is epitomic of a regulatory
approach that does not gauge the variety of risks associated with different
secured transactions regimes. Non-consensual claims may render the priority
ladder difficult to determine or even eviscerate the protection provided by
security interests, given that secured creditors may be left with little or no value
to recover from the collateral. To address this issue, several secured transactions
laws have extended their reach to regulate the perfection and priority of specific
non-consensual claims, such as judgement and tax liens. For instance, the
California Secretary of State Office accepts registration of notices of judgment
liens, for which the priority against competing security interests is determined by
the time of filing or perfection.47 However, in most secured transactions
regimes—including U.C.C. 9 and Canadian PPSAs—there is no provision
concerning the priority of employee claims. As a result, the spectrum of
possibilities is large and difficult to assess a priori.48 Under the Model Law,
enacting states are invited to specify in their secured transactions laws any
preferential claims affecting the priority of security interests.49 Yet, from the
point of view of capital requirements, it is irrelevant whether this solution is
adopted or, instead, an intricate nexus of non-consensual claims continues to
exist outside the secured transactions law, weakening the protection granted by
a first-priority security interest, as the same risk-weighting would apply under
either legal regime. This also means that a mere listing of preferential claims in
the secured transactions law, as suggested by the Model Law, does little to
approximate national secured transactions law to the Basel Accords because it
does not ensure the effectiveness of security interests as credit protections.
Further considerations should be advanced with respect to enforcement rules.
A security interest in personal property results in reduced capital charges only if
banks can realize the value of the collateral in a timely fashion.50 Here also,
secured transactions law may approach the pre-requisites for the deployment of
post-default remedies differently, expediting or delaying enforcement. For
instance, pursuant to Article 78(4) of the Model Law, if the secured creditor
intends to dispose of the collateral, notification must be given to the grantor and
other competing claimants.51 It is left to enacting states to determine the period
of time that creditors must wait before selling the collateral. Hence, depending
on the choice made by national lawmakers, an excessively lengthy period may
hinder the level of protection granted by security interests. Legal regimes have
opted for various approaches; for instance, the Saskatchewan PPSA establishes
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a period of at least twenty days,52 whereas U.C.C. 9 provides that notification
must be sent within a reasonable time.53 Arguably, some legal regimes following
the formalistic approach provide creditors with more effective enforcement
procedures than those commonly offered under legal regimes embracing the
functional approach. As an example, retention of title arrangements generally
allows creditors to terminate the contract, dispose of the collateral, and keep any
surplus.54 It is worth noting that these contractual arrangements—supporting
acquisition financing in most non-functional legal regimes—may require banks
to follow accounting and regulatory standards established for lease agreements.
To calculate capital charges, leases are treated as exposures collateralized by the
underlying asset, but higher capital charges apply if banks are exposed to the risk
of excessive depreciation of the leased asset.55 Hence, it is more convenient for
banks to support acquisition financing through external leasing companies, which
are not subject to capital requirements and would benefit from the protection
offered by ownership rather than classical security interests.56
From the foregoing discussion, two observations may be drawn. First, the
risk-sensitivity of the Basel Accords does not factor in the diversity of legal
regimes and rules pertaining to secured transactions. This means that the actual
protections granted by secured transactions law are not recognized by capital
requirements and, absent any form of coordination, the actual level of risk
associated with transactions collateralized with personal property is not
accurately reflected in regulatory capital. As a result, national lawmakers are not
encouraged to embark on more comprehensive reforms to facilitate access to
credit, as long as they can offer a device that formally satisfies the general
conditions stated in the Basel Accords. Second, the treatment of non-consensual
claims and different approaches to enforcement procedures reveal that secured
transactions laws are largely oblivious to the impact of security interests on the
amount of a bank’s own funds required to extend credit and shield depositors.
To address these critical issues, amendments to international legal and
regulatory standards are required. In regard to capital regulation, it is not
necessary for the Basel Accords to indicate a preference for functionalism or
formalism. It is necessary, instead, to define—in coordination with UNCITRAL
or other international organizations apt for the task—what standards for
attachment, perfection, priority, and enforcement of security interests would
better accommodate the needs of banks. Lower risk-weightings to security
interests created under those rules may be then attributed. As further explored
in the next part of this article, however, coordination requires the Basel Accords
52. Saskatchewan PPSA, supra note 20, at § 59(6).
53. U.C.C. § 9-612(a) (AM LAW. INST. & UNIF. LAW COMM’N 2010).
54. ULRICH DROBNIG & OLE BÖGER, PROPRIETARY SECURITY IN MOVABLE ASSETS 763 (2015).
55. This form of risk is known as “residual value risk,” which is “the bank’s exposure to potential
loss due to the fair value of the equipment declining below its residual estimate at lease inception.” Basel
II, supra note 27, ¶ 524; see also BASEL III, supra note 5, ¶ 299.
56. See infra note 98 and accompanying text.
to correct or at least attenuate their skepticism towards personal property
collateral and secured transactions laws to relinquish the fallacious assumption
that banks conduct their business under the same constraints and incentives as
THE STRUCTURE OF INCENTIVES IN THE CREDIT MARKET
Secured transactions law and capital requirements affect the supply side of
the credit market by modifying lending behaviors. The former, through the
protections granted to secured creditors, incentivizes lenders to extend credit in
support of the real economy. The latter, by increasing the amount of own funds
to hold against risky operations, controls the creation of credit and discourages
banks from taking excessive risks. As noted earlier, at the heart of this mechanism
lay the risk-weighted coefficients to calculate capital charges.
Against this backdrop, the regulatory coefficients attributed to different
classes of exposures and risk-mitigation techniques should reflect the actual
levels of risk taken by banks. As obvious as this observation might sound, it has
proven to be contentious. For instance, under the Basel Accords, national
policymakers have the discretion to attribute a zero percent risk-weighting to
exposures to their own central governments or to the governments of other
countries.57 In the United States, exposures to countries belonging to the
Organization for Economic Cooperation and Development (OECD) are
considered risk-free,58 whereas, in the European Union, a zero-risk coefficient is
attributed for exposures to Member States.59 Theoretically, sovereign exposures
are deemed risk-free because, in case of default, the competent central bank is
supposed to step in, servicing the debt in full. Following this reasoning, the
riskiness of a given sovereign exposure is directly linked to the ability of the
relevant central bank to live up to that commitment. However, under E.U. law,
the European Central Bank cannot finance the debts of Member States,60 nor is
57. As a general rule, Basel II relates the risk-weightings for claims on sovereign entities to official
ratings. BASEL II, supra note 27, ¶ 53. However, at national discretion, lower risk-weightings may be
attributed to exposures towards a sovereign’s own entities or central banks, thus allowing for a statutory
zero percent risk-weighting. BASEL II, supra note 27, ¶ 54. The new Basel framework left the treatment
of sovereign exposures unchanged. See BASEL III, supra note 5, ¶¶ 7–10. However, further consultations
and possibly amendments are expected in this regard.
58. A zero-risk coefficient is attributed to “[s]ecurities issued by and other direct claims on the U.S.
Government or its agencies (to the extent such securities or claims are unconditionally backed by the full
faith and credit of the United States Government) or the central government of an OECD country.” 12
C.F.R. § 567.6(a)(1)(i)(B) (2017). “Claims on, and claims guaranteed by, a qualifying securities firm that
are collateralized by cash on deposit in the savings association or by securities issued or guaranteed by
the United States Government or its agencies, or the central government of an OECD country.” §
59. CRR, supra note 4, at art. 114(4).
60. This principle is stated by the Consolidated Version of the Treaty on the Functioning of the
European Union art. 123(1), Oct. 26, 2012, 2012 O.J. (C 326) 47 [hereinafter TFEU] (prohibiting the
European Central Bank from printing money in order to finance the public debt of Member States).
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the Union liable for Member States’ commitments.61 Given that more than half
of the OECD countries are E.U. Member States, membership of either
organization does not represent a reliable proxy for determining the actual
riskiness of their commitments.
A second issue concerns the incentives that capital requirements create,
particularly vis-à-vis the deployment of different risk mitigation techniques. In
setting the conditions and the coefficients for different operations and credit
protections, regulation steers banks towards investments and techniques to
mitigate credit risk that require less capital. In this context, it is necessary to
understand to what extent security interests in personal property are more
expensive than other credit protections and whether the skeptical attitude of the
Basel Accords towards personal property collateral is justified.
A. The Incentives of Credit Protections
As a direct manifestation of the regulatory rationale underpinning capital
requirements, the Basel framework has a strong preference for highly liquid
assets. This preference transpires first and foremost from the standardized
approach, according to which the list of eligible collateral prescribed by
regulators is limited to financial collateral, such as cash deposits, gold, corporate
(and sovereign) debt securities with prescribed credit ratings, and
exchangetraded equities.62 If one of these assets secures a loan, the corresponding capital
charge is significantly reduced. In such circumstances, the risk-weight of the
counterparty is replaced by the risk-weight of the collateral subject to a floor of
20%, whereas a zero percent risk-weight could be applied in specific cases.63 A
few examples should clarify this point. For an unsecured loan of $1,000 extended
to a corporation that does not have an official credit rating, a risk-weight of 100%
applies,64 thus resulting, in this example, in a capital charge of $80.65 If the loan
was fully secured by an eligible collateral instead—say, by a bond with an
investment-grade rating66—the bank would reduce the required capital to $16,
61. TFEU, art. 125(1), often described as a no bail-out clause, given that it bars any EU institution
from “assum[ing] the commitments of central governments, regional, local or other public authorities,
other bodies governed by public law, or public undertakings of any Member State.” See generally Andreja
Lenar i , Dirk Mevis & Dóra Siklós, Tackling Sovereign Risk in European Bank (European Stability
Mechanism, Discussion Paper No. 1, 2016) (advocating for a change in the risk-weightings of sovereign
exposures in the EU).
62. BASEL II, supra note 27, ¶ 145. The same skepticism towards personal property as collateral is
maintained in the new rules. BASEL III, supra note 5, ¶ 148.
63. BASEL II, supra note 27, ¶¶ 183–85 enumerates the exceptions whereby the resulting capital
charge would be equal to zero; among these are securities issued by sovereign entities that are considered
risk-free. The same provision is contained in Basel III. BASEL III, supra note 5, ¶ 150(a); see also supra
note 57 and accompanying text.
64. BASEL II, supra note 27, ¶ 66; BASEL III, supra note 5, ¶ 39.
65. This is the result of the following calculation: $1000 (the loaned amount) x 100% (the RWA
coefficient attributed to unsecured and unrated loans) x 8% (the regulatory capital ratio).
66. BASEL II, supra note 27, ¶ 145(c); BASEL III, supra note 5, ¶ 148 (both setting the minimum
ratings for bonds used as collateral).
which is 20% of $80.67 Supposing the loan was to be fully secured by even more
liquid assets, such as a cash deposit or by securities issued by qualified sovereign
entities,68 the resulting capital charge would be zero.69
The emphasis on liquidity also emerges from other common forms of credit
protections. Unsecured undertakings offered by a third party to cover credit risk
are eligible to reduce capital charges.70 Through these mechanisms, the risk
profile of a borrower is substituted with the risk profile of the entity providing
the credit protection. Of particular relevance in this category are credit
derivatives and, specifically, credit default swaps (CDS). Under a typical CDS
contract, one party (the protection buyer) agrees to pay a fee to another party
(the protection seller) in exchange for protection against a credit event, like
default or insolvency, concerning an underlying entity (the reference entity).
Upon the occurrence of the credit event, the protection buyer may deliver the
protected asset, for example, a bond, to the protection seller who, in return, must
pay an amount equal to its face value. Alternatively, CDS contracts may establish
that the protection seller pays the protection buyer an amount equal to the
difference between the face value and the post-default value of the underlying
debt.71 Capital charges are reduced if the protection provider enjoys a lower risk
rating than the reference entity.72
Although the impact of CDS contracts on the stability of the financial system
is and has been the subject of scrupulous investigations and debates,73 their
impact on credit creation deserves further attention. The massive trading of these
instruments, at the heart of AIG’s near-collapse and JP Morgan’s massive
losses,74 has been fueled by the significant capital relief that these instruments
67. See supra note 65 (substituting 100% RWA with a 20% RWA).
68. See supra note 63.
69. This calculation assumes that the collateral is represented by cash on deposit and that there is
no currency mismatch, pursuant to BASEL II, supra note 27, ¶ 185 and BASEL III, supra note 5, ¶ 154.
70. BASEL II, supra note 27, ¶ 189; BASEL III, supra note 5, ¶¶ 191–93.
71. CDS performs the same economic function as an insurance policy underwritten by the
protection seller on the face value of a credit extended by the protection buyer to the reference entity. It
differs from an insurance contract primarily because protection buyers are not required to suffer any
actual loss to activate the protection; hence, there is no “insurable interest.” See Alberto Monti, Cutting
Across Linguistic and Regulatory Divides: On Covered Credit Default Swaps and Insurance, 17 UNIFORM
L. REV. 425 (2012); Daniel Schwarcz & Steven L. Schwarcz, Regulating Systemic Risk in Insurance, 81 U.
CHI. L. REV. 1569 (2014).
72. BASEL II, supra note 27, ¶¶ 190–94; BASEL III, supra note 5, ¶¶ 194–96 (both indicating specific
requisites concerning the obligations and the entities eligible to provide valid credit protections for
73. See Schwarcz & Schwarcz, supra note 71, at 1585–93 (highlighting the broader impact of CDS
on the financial system); see also HAL SCOTT, CONNECTEDNESS AND CONTAGION: PROTECTING THE
FINANCIAL SYSTEM FROM PANICS 30 passim (2016) (isolating the role of CDS in relation to the Lehman
and AIG cases); FIN. CRISIS INQUIRY COMM’N, THE FINANCIAL CRISIS INQUIRY REPORT 50 (2011)
(noting, inter alia, the risk of CDS contracts and the role they played in the financial crisis). For a
summary and analysis of the recent literature in the field, see Patrick Augustin et al., Credit Default
Swaps: Past, Present, and Future, 8 ANN. REV. FIN. ECON. 175–96 (2016).
74. Regarding JP Morgan, credited for having created these contracts in the 1990s, see a recent
report covering the operations of its London branch, REPORT OF JPMORGAN CHASE & CO.
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offer to banks, or the protection buyers. In fact, CDS contracts are used to shift
assets from high risk-weight categories to low risk-weight categories, regardless
of the actual risk borne by banks.75 For instance, in its 2007 annual report to the
U.S. Securities and Exchange Commission, AIG disclosed that the large majority
of CDS contracts was sold to banks for the purpose of reducing regulatory capital,
rather than effectively reducing risk.76 In an attempt to incorporate some of the
lessons from the recent financial crisis, the first amendments introduced with
Basel III comprised a new capital charge known as credit valuation adjustment,
or CVA.77 However, the CVA does not apply to credit derivatives used for risk
mitigation purposes. Hence, under the current Basel framework, CDS contracts
still offer one of the most attractive tools for banks to reduce capital charges.
The following example illustrates this point. Bank A buys a corporate bond,
hence lending $1000 to a company with 100% risk-weight.78 As explained above,
this operation results in a capital charge equal to $80. The bank, however, buys a
CDS on that bond from another regulated bank (Bank B) which is weighted at
20%.79 Bank A has effectively transferred the risk of the bond issuer to Bank B.
MANAGEMENT TASK FORCE REGARDING 2012 CIO LOSSES (2013) (presenting the result of an
investigation into a recent CDS-related scandal, the “London Whale” case, which caused a loss for JP
Morgan of no less than $6.2 billion).
75. The problem has been debated extensively. See, e.g., Viral Acharya et al., supra note 36, at 150;
Adrian Blundell-Wignall & Paul Atkinson, Thinking Beyond Basel III: Necessary Solutions for Capital
and Liquidity, 2010 OECD J.: FIN. MKT. TRENDS 1, 9, 12 (2010); Erik Gerding, Credit Derivatives,
Leverage, and Financial Regulation’s Missing Macroeconomic Dimension, 8 BERKELEY BUS. L.J. 29, 32–
36 (2011). More compelling evidence that CDS contracts are used to game capital regulation has been
offered recently by Chenyu Shan, Dragon Yongjun Tang & Hong Yan, Credit Default Swaps and Bank
Regulatory Capital (HKIMR Working Paper No. 20/2017).
76. In Form 10-K it was stated: “Approximately $379 billion (consisting of the corporate loans and
prime residential mortgages) of the $527 billion in notional exposure of AIGFP [i.e. AIG Financial
Product, a London-based subsidiary] super senior credit default swap portfolio as of December 31, 2007
represents derivatives written for financial institutions, principally in Europe, for the purpose of providing
them with regulatory capital relief rather than risk mitigation.” Am. Int’l Grp., Inc., Annual Report (Form
10-K) (Feb. 28, 2008) (emphasis added).
77. BASEL III (2011), supra note 28, ¶ 14 (CVA covers the risk of mark-to-market risk—that is,
possible losses resulting when financial instruments held by a financial institution are valued at the
current market value, and their value falls because of the deterioration in the creditworthiness of
78. According to BASEL II, supra note 27, ¶ 66, corporate claims rated between BBB+ and
BBcorrespond to a 100% risk-weighting. BASEL III, supra note 5, ¶ 39, further differentiates, attributing to
corporate exposures rated between BBB+ and BBB– a 75% risk-weighting and to those between BB+
and BB– a 100% risk-weighting.
79. BASEL II, supra note 27, ¶¶ 60–64 introduced two approaches from which national regulators
may choose. The first approach, adopted in the European Union, reflects the credit rating attributed to
the bank itself. See CRR, art. 119. The other approach is based on the rating of the central government
where the bank is incorporated and has been adopted in the U.S. for saving associations. See 12 C.F.R. §
567.6(a)(1)(ii)(Q) (2017). Basel III introduces a new schema under the standardized method to
determine capital charges for exposure to banks. For exposures to banks incorporated in jurisdictions
allowing the use of official ratings for regulatory purposes, such ratings are used to determine RWAs
pursuant to BASEL III, supra note 5, ¶¶ 18–20. For exposures to banks that are unrated, Basel III
introduces the standardized credit risk assessment approach, or SCRA, whereby banks are graded in
three main categories of risks depending on their capacity to meet financial commitments. BASEL III,
supra note 5, ¶¶ 21–31.
LAW AND CONTEMPORARY PROBLEMS [Vol. 81:63
Therefore, instead of applying the original risk-weight of 100%, Bank A will
apply a risk-weight of 20%, reducing the original capital charge from $80 to $16.
Cumulatively, however, the regulatory capital of Bank A and Bank B should
reflect the riskiness of the original corporate bond. However, Bank B may
transfer the risk outside the banking system by purchasing coverage from an
insurance company on the potential losses resulting from the transaction with
Bank A. As a result, the risk associated with the corporate bond is moved outside
the purview of banking (capital) regulation, and neither Bank A nor Bank B
reflects the actual riskiness of the original operation in their respective regulatory
capital.80 Even if the insurance company—which, in this example, bears the risk—
may offer adequate protection, this mechanism loosens the tie between credit
creation and the level of capitalization of banks.
When credit derivatives are deployed, new credit is extended with little or no
regulatory costs, in terms of the lender’s own funds. The incentives to adopt these
instruments are therefore extremely high, especially when compared to the
capital relief that results from other credit protections. Through a CDS, an
unsecured loan may require the same amount of the lender’s own funds that is
required for a loan secured by, say, a Treasury bond issued by the U.S.
The question is, then, whether security interests in personal property offer
sufficiently attractive capital relief and, thus, whether the current regulatory
framework encourages asset-based lending. The answer to that question is
painfully banal: given that tangible assets and receivables are not included in the
list of eligible credit protections, they cannot be used for credit risk mitigation
purposes when banks adopt the standardized approach. Therefore, regardless of
the improvements offered by a modern secured transactions law, the
standardized approach requires banks to apply the same risk-weight attributed
to unsecured credit to transactions collateralized by personal property.
Banks authorized to use IRBs may, at least theoretically, consider personal
property collateral as eligible credit protection. To this end, IRB institutions must
fulfil specific requisites.81 In addition to legal requirements, according to which a
bank must enjoy first priority and the right to enforce a security interest swiftly,82
the bank must demonstrate that, for each asset, there is a sufficiently developed
secondary market where prices are publicly available and collateral could be
easily liquidated post-default.83 Regarding security interests in receivables, banks
are required to ascertain the credit risk of the receivable and its correlation with
80. Blundell-Wignall & Atkinson, supra note 75, at 12 (noting that through this mechanism “there
is little point in defining an ex-ante risk bucket of company bond as 100% risk-weighted”).
81. For an analysis of the requisites set in the Basel framework in this respect, see Castellano &
Dubovec, supra note 6.
82. See supra Part II
83. BASEL II, supra note 27, ¶¶ 521–22. BASEL III, supra note 5, ¶¶ 295–96, by and large reiterates
these core requisites, with one notable difference: national regulators lost the discretionary power to
compile a list of collateral that are automatically considered to meet the market conditions to be
considered as eligible collateral.
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the debtor’s ability to pay.84 Reliable data must feed the IRB models to calculate
the amount of one’s own funds necessary to absorb unexpected losses. Therefore,
the process to reduce the risk-weights of an exposure through security interests
in personal property requires banks to invest considerable resources.
The disproportionate effect that this approach has on SMEs is partially
attenuated by the introduction of a special class of exposure. If loans to
individuals and small businesses meet the criteria of the regulatory retail portfolio,
they are pooled and treated as a single exposure subject to a risk-weight of 75%.85
To qualify for this treatment, the availability of collateral is immaterial, again
disregarding the reduction in credit risk offered by security interests in personal
property.86 Nonetheless, the solution does not appear to provide adequate
incentives to support the needs of SMEs that are increasingly seeking financing
outside the banking system.87
From the above, several incongruences surface. First, regulators consider
personal property difficult to evaluate and prone to depreciation because their
value is deemed to be excessively correlated with the ability of borrowers to repay
loans and affected by the cyclical movements of the economy.88 Although
theoretically sound, the argument appears at odds with the regulatory treatment
of CDS as credit risk mitigation techniques. Despite the fact that credit
derivatives are prone to deterioration—resulting precisely from their correlation
to the creditworthiness of protection sellers—the regulatory framework still
induces banks to use CDS for the purpose of reducing capital charges. Second,
security interests in personal property might reduce regulatory capital only under
the most sophisticated approaches available for risk-weighting purposes.89
84. See BASEL II, supra note 27, ¶¶ 516–20; see also BASEL III, supra note 5, ¶¶ 290–94 (establishing
specific risk management procedures). For instance, both BASEL II, ¶ 516 and BASEL III, ¶ 290, provide
that “[w]here the bank relies on the borrower to ascertain the credit risk of the customers, the bank must
review the borrower’s credit policy to ascertain its soundness and credibility.” On correlation risk, both
BASEL II, ¶ 519 and BASEL III, ¶ 293 state “[t]he receivables pledged by a borrower should be diversified
and not be unduly correlated with the borrower.”
85. BASEL II, supra note 27, ¶ 69. The BCBS, within the current Basel IV debate, proposed to apply
a lower risk of 85% for direct exposures to corporate SMEs, while retaining the current regime for
regulatory retail exposures. See SECOND CONSULTATIVE DOCUMENT, supra note 30, at Annex 1, ¶ 37.
Such a proposal has been codified in Basel III, under which exposures to SMEs could receive an 85%
risk-weighting or, if certain conditions are met, could be included in the regulatory retail portfolio. BASEL
III, supra note 5, ¶ 43.
86. BASEL II, supra note 27, ¶ 70 requires that the claim of an individual or a small business take
the form of revolving credits, lines of credit (for example, credit cards and overdrafts), personal loans
and leases, including auto loans and leases, student and educational loans, and personal finance loans.
The entire portfolio should be sufficiently diversified and individual claims should not exceed 1 million
euros. While retaining these general principles, BASEL III, supra note 5, ¶¶ 55-58, introduces significant
changes, allowing for lower risk-weightings in considerations of the repayment history of, say, credit
LAW AND CONTEMPORARY PROBLEMS [Vol. 81:63
Gathering data and applying the IRB approaches are resource-intensive
activities. Conversely, relying on standardized risk-weights is undoubtedly more
cost-effective. Within this regulatory framework, loans secured with personal
property are more expensive in terms of capital and therefore discouraged,
leaving the credit needs of SMEs unmet.
B. The Uneven Incentives and Their Consequences
It could be argued that the regulatory preference towards highly liquid
collateral is justified by the necessity of imposing a limit on the ability to create
credit. At the core of this argument lies the idea that excess credit—and
corresponding excess debt—is detrimental to the stability of the financial
system.90 However, the regulatory skepticism towards personal property does not
limit the creation of credit. Empirical evidence indicates that credit and
indebtedness have expanded without a corresponding increase of capital or a
corresponding reduction of the overall level of risk circulating in the banking
sector.91 As just discussed, banks are incentivized to use other, less transparent,
credit protections to support the extension of credit, with the sole purpose of
reducing regulatory capital, whereas asset-based lending is pushed outside the
banking system. Although the problem primarily concerns how the Basel
Accords have been engineered, a holistic perspective indicates that secured
transactions laws have relevant responsibilities for promoting the extension of
credit outside the banking system.
International efforts to modernize and harmonize secured transactions laws
have been undertaken under the flawed assumption that the credit supply is
homogeneously affected by legal rules. UNCITRAL, in fact, developed its texts
dealing with secured transactions by taking as one of its key policy objectives the
“equal treatment of diverse sources of credit.”92 The underlying belief is that
there are no conflicts with or limitations imposed by banking regulation and,
accordingly, that a modern legal regime governing secured transactions equally
benefits banks and non-bank lenders. Aside from the considerations on the
priority and enforcement of security interests, examined above, frictions between
the Model Law and the Basel Accords also emerge in other aspects—for instance,
concerning the description of collateral in security agreements.93 More
transactions law reforms also requires promotion of the use of IRB models).
90. On this point, convincing arguments are offered by ADMATI & HELLWIG, supra note 9 and
TURNER, supra note 32.
91. In the decade prior to the 2007–2009 financial crisis, the International Monetary Fund (IMF)
noted that the overall assets of ten of the largest banks in the United States and Europe doubled, whereas
their risk-weighted assets increased by only one-third. See IMF, Containing Systemic Risks and Restoring
Financial Soundness, Global Financial Stability Report 31 (Apr. 2008). The global levels of debt have
expanded since the financial crisis. See BANK FOR INT’L SETTLEMENTS (BIS), 87TH ANNUAL REPORT 8
92. See UNCITRAL LGST, supra note 7.
93. Compare BASEL II, supra note 27, ¶ 522, and BASEL III, supra note 5, ¶ 296 (both establishing
that “[t]he loan agreement must include detailed descriptions of the collateral”), with UNCITRAL
MODEL LAW, supra note 2, at art. 9(2) (allowing for a description “that indicates that the encumbered
No. 1 2018]
profoundly, absent any form of coordination with international capital
requirements, the effect of secured transactions law reforms remains curtailed.
Legal and regulatory incentives affect the supply side of the credit market
unevenly. Secured transactions law applies to any lender, whereas capital
requirements concern only the formal banking system. Given that capital
requirements induce banks to invest in operations that are less capital-intensive
than asset-based lending to SMEs, non-banking institutions such as leasing and
factoring companies fill the void. The expansion of commercial lending activities
outside the banking system and the growth of “shadow banking activities”94
corroborate these observations.95 This trend is bolstered by legal reforms
designed to promote access to credit through secured transactions. As the Basel
Accords disregard the quality of the legal framework governing secured
transactions, ceteris paribus, the benefits sought through reforms will be unevenly
distributed among the suppliers of credit, with non-banking institutions enjoying
a larger share. Although the availability of credit outside the banking system is
not per se a negative phenomenon, larger policy implications should be
When non-banking institutions extend new credit in the form of loans,
purchases of accounts receivable, or deferred payments for the acquisition of
equipment, the amount of deposits increase, given that loans are normally
credited to borrowers’ bank accounts. As deposits represent purchasing power
created through loans,96 the credit extended outside the banking system increases
the general purchasing power without being subject to the risk controls
associated with the creation of new loans. For banks, this is akin to free lunch, as
new deposits are available without requiring a corresponding loan, and they can
be invested in other operations, which is more profitable and less
capitalintensive than commercial lending.97 This mechanism may offer new liquidity and
facilitate credit expansion, reaching borrowers normally excluded from the
traditional banking system. However, the cost of funding for non-bank lenders is
significantly higher. Therefore, the availability of credit may increase, but not at
a lower cost.
assets consist of all the grantor’s movable assets, or of all the grantor’s movable assets within a generic
94. In this article, shadow banking activities are only those activities of intermediation related to
commercial lending that occur outside the regulated banking system. See Fin. Stability Bd., Shadow
Banking: Strengthening Oversight and Regulation 1 (2011). For a more complete analysis of the
phenomenon, see Dan Awrey, Law and Finance in the Chinese Shadow Banking System, 48 CORNELL
INT’L L.J. 1 (2015) (applying the “Legal Theory of Finance” to explain the development of shadow
banking activities in the People’s Republic of China), and Steven Schwarcz, The Governance Structure
of Shadow Banking: Rethinking Assumptions about Limited Liability, 90 NOTRE DAME L. REV. 1 (2014).
95. See supra note 87 and accompanying text. On the retraction of the largest U.S. banks from small
business financing, see Brian S. Chen, Samuel G. Hanson & Jeremy C. Stein, The Decline of Big-Bank
Lending to Small Business: Dynamic Impacts on Local Credit and Labor Markets (Harvard Bus. Sch.,
Working Paper, 2017).
96. See supra note 32 and accompanying text.
97. See IMF, supra note 91 (indicating that banks tend to reduce commercial loans while increasing
investments in securities).
LAW AND CONTEMPORARY PROBLEMS [Vol. 81:63
Furthermore, the largest leasing companies in Europe and the United States
finance their secured loans through bank loans or are directly affiliated with
banks.98 It is precisely the connection with the banking system that renders
shadow banking activities, within the process of credit creation, potentially
harmful for the stability of the financial system.99 When banks engage in
assetbased lending via non-banking institutions, not only new purchasing power
(through deposits) is created, but banks also de facto participate in the creation
of new credit. However, a corresponding increment of own funds—that is
proportionate to the riskiness of the operation—does not occur.
In general terms, the involvement of non-banking institutions in the extension
of credit represents an important source of liquidity and funding to support the
production and consumption of goods and services. Yet, when sustained by
secured transactions law reforms implemented to foster access to credit, a steady
retraction of banks from asset-backed lending requires rethinking the approach
to secured credit. Secured transactions laws and their reform should not be
developed in a vacuum, as their interactions with capital requirements could be
detrimental to a sustainable creation of credit. In the same vein, capital
requirements that aim at managing risks cannot disregard the impact of different
rules and regimes governing credit on the riskiness of banks and the creation of
Secured transactions law and capital requirements shape the supply of credit
by affecting the behaviors of its participants. Notwithstanding the importance of
ensuring adequate protection against credit risk to promote both access to credit
and financial stability, the legal and regulatory frameworks appear to be
concerned with different approaches to mitigating credit risk. Secured
transactions law, on the one hand, has progressively expanded to consider all
kinds of personal property that may be encumbered by a security interest as
reducing credit risk; capital requirements, on the other hand, consider security
interests to reduce the credit risk only when specific statutory criteria are met.
These criteria are stricter than the criteria imposed on other credit protections,
such as credit derivatives, which affect banks’ appetite for different kinds of
98. See Dilek Bülbül, Felix Noth & Marcel Tyrell, Why Do Banks Provide Leasing?, 46 J. FIN. SERV.
RES. 137 (2014) (noting that the role of banks in providing leasing services has progressively expanded);
see also Manmohan Singh & James Aitken, The (sizable) Role of Rehypothecation in the Shadow Banking
System (IMF, Working Paper No. 10/172, 2010).
99. See Hockett & Omarova, supra note 33, at 1183 (convincingly demonstrating that securitization
and other forms of shadow banking activities have the effect of “amplifying” bank lending). The risks
posed by the connection between the shadow banking and traditional banking activities are commonly
considered a primary policy concern. See supra note 94; see also Yingmao Tang, Shadow Banking or
“Bank’s Shadow”: Reconceptualizing Global Shadow Banking Regulation, in RECONCEPTUALISING
GLOBAL FINANCE AND ITS REGULATION 326 (Ross P. Buckley, Emilios Avgouleas & Douglas W.
Arner eds., 2016) (noting the connection between banks and non-bank entities in the Chinese context).
CREDIT CREATION 85
investments. Yet, efforts to modernize and harmonize secured transactions laws
are undertaken under the untested assumptions that legal frameworks facilitating
the use of personal property as collateral would stimulate bank loans and that
non-banking institutions are always in competition with banks.
The lack of coordination between these two sets of legal and regulatory rules
have larger consequences than their narrowly understood perimeters, as it affects
the creation of credit and purchasing power in a given economic system.
Countries that were led to believe that reforms of secured transactions laws
would facilitate access to bank credit might not see their hopes fulfilled, as
reformed legal frameworks for secured transactions lay the foundations for
nonbank lenders to expand their activities. To promote a prudent extension of
secured credit also through the banking system, coordination between secured
transactions law and capital requirements is of essence. In particular, capital
requirements should abandon the skepticism towards personal property and
recognize that secured transactions law rules may bolster the protection offered
to creditors. For this to occur, however, secured transactions law should be
geared to accommodate the specific needs of banking activities and achieve an
effective reduction of credit risk reflected in lower capital charges. In other
words, promoting access to credit and preserving financial stability should be
considered as complementary objectives.
19. In this article, the PPSA of Saskatchewan, infra note 20 , is used as a reference. For an account of the fundamental features of different PPSAs, see Hugh Beale, An Outline of a Typical PPSA Scheme, in SECURED TRANSACTIONS LAW REFORM: PRINCIPLES, POLICIES AND PRACTICE 7 (Louise Gullifer & Orkun Akseli eds., 2016 ). On the reception of U.C.C. 9 in Canada, see Catherine Walsh, Transplanting Article 9: The Canadian PPSA Experience, in SECURED TRANSACTIONS LAW REFORM: PRINCIPLES, POLICIES, AND PRACTICE 49 (Louise Gullifer & Orkun Akseli eds., 2016 ).
20. Canadian PPSAs have expanded this approach to include long-term true leases, which is not the case for U.C.C. 9 or the UNCITRAL Model Law . See Saskatchewan Personal Property Security Act , 1993 , P- 6 .2 R.S.S. ( 1995 ) (Can .) [hereinafter Saskatchewan PPSA].
21. For a critical assessment of the differences between these two approaches , see Michael G. Bridge et al., Formalism , Functionalism, and Understanding the Law of Secured Transactions, 44 MCGILL L .J. 567 , 648 , 661 - 64 ( 1999 ).
22. See Castellano, supra note 15 , at 615.
43. Typically , security interests created by retention of title or fiduciary transfer of ownership do not condition perfection on registration . See Castellano, supra note 15 , at 616.
44. This specific security interest is regulated by article 46 of the Italian Consolidated Law on Banking (Testo Unico Bancario) . Decreto Legislativo , 1 settembre 1993, n. 385 (It.), as most recently amended by Decreto Legislativo, 1 aprile 2016 , n. 72 (It.).
45. See Giuliano G. Castellano , Reverse Engineering the Law: Reforming Secured Transactions Law in Italy, in INTERNATIONAL AND COMPARATIVE SECURED TRANSACTIONS LAW 313 (Spiros Bazinas & Orkun Akseli eds., 2017 ) (presenting a possible strategy to implement the UNCITRAL Model Law in the Italian context ).
46. BASEL II, supra note 27, ¶ 522 (referring to n. 94); BASEL III, supra note 5, ¶ 296 (referring to n. 31).
47. See CAL. CODE CIV . P. § 697 .590(b).
48. On the treatment of employee claims in Canada, see ANTHONY J. DUGGAN & JACOB S. ZIEGEL, SECURED TRANSACTIONS IN PERSONAL PROPERTY: CASES, TEXT, AND MATERIALS 418 (6th ed. 2013 ) (noting that provincial and federal legislation provides employees with a lien on the asset of the employer). For selected European jurisdictions, see Federico M. Mucciarelli, Employee Insolvency Priorities and Employment Protection in France, Germany, and the United Kingdom, 44 J.L. & SOC 'Y 255 ( 2017 ). In general, see José M. Garrido, No Two Snowflakes are the Same: The Distributional Question in International Bankruptcies, 46 TEX . INT'L L.J . 459 ( 2011 ).
49. UNCITRAL MODEL LAW , art . 34 .
50. For financial receivables and physical collateral, see, respectively , BASEL II, supra note 27, ¶¶ 515 , 522 (referring to ¶¶ 509 - 10 ). These principles have been maintained with the recent reforms . See BASEL III, supra note 5 , ¶¶ 289 , 296 .
51. Notice is not required when the collateral is perishable, “may decline in value speedily or is of a kind sold on a recognized market.” UNCITRAL MODEL LAW, art . 78 ( 8 ).
87. See , e.g., Trends in the External Financing Structure of Euro Area Non-financial Corporations , at 29, ECB Economic Bulletin (European Central Bank , Frankfurt, Germany) ( Aug. 4 , 2016 ).
88. See , e.g., David Clementi, Deputy Governor , Bank of Eng., Speech at the Financial Services Authority Conference: Risk Sensitivity and the New Basel Accord (Apr. 10 , 2001 ).
89. See Castellano & Dubovec, supra note 6 (indicating that the strategy to render effective secured