Will the guarantee framework work? – 07/11/2023 – Bernardo Guimarães

Last week, Tax Reform dominated the headlines, and for good reason. But with that, the important milestone of guarantees, approved in the Senate, ended up receiving little attention.

This proposal seeks to change the rules for guarantees in the real estate credit market. If it works, it could help unlock this market. But will it?

In credit markets, promises are traded. Debtors receive money today in exchange for a promise to pay the debt with interest in the future. But how much is a promise worth?

If a debtor can offer guarantees for the payment of the debt, the pledge is worth more. If a commitment to pay $1,000 next year is worth $700 today in the absence of collateral, it would be worth $800 with a good guarantee. In other words, collateral lowers interest rates.

Of course, loan interest depends on how much competition there is in the market. But when there are guarantees, competition is generally fiercer, as it is easier for a financial institution to assess the risks involved.

One problem is that those who need credit often don’t have more than a few bucks to back it up.

One solution is to create guarantees.

Payroll credit is an example of a measure that did this, by allowing people to offer their future salary as collateral for loans. In fact, interest rates on this type of credit are much lower than in similar cases without collateral.

The framework of guarantees has a similar purpose. One proposal is to allow people to offer a property as collateral in more than one credit operation (for example, a house worth BRL 500,000 could be pledged as collateral in two loans of BRL 200,000).

Another idea is to facilitate the enforcement of guarantees.

However, in the version approved in the Senate, creditors would need to go to court to collect the assets given as collateral — the original version provided for extrajudicial collection, but this part was rejected in the Senate.

That makes a lot of difference.

Everyone knows that judicial decisions in Brazil take a long time. In a work published in 2016, in the Quarterly Journal of Economics, one of the main scientific journals in Economics, Jacopo Ponticelli and Leonardo Alencar showed that speed in judicial decisions has important effects on the credit market.

The change in the Bankruptcy Law in 2005 increased companies’ access to credit. Ponticelli and Alencar showed that this increase was much greater in municipalities with less congested courts and faster decisions.

Using appropriate statistical techniques, they are able to establish a causal relationship between greater speed in Justice and more loans and investments by companies.

Policies for the credit market should seek to increase the value of pledges. Creating guarantees goes in that direction. But guarantees offered are only valuable if they can be enforced quickly and at low cost.

Some oppose measures like this (and payroll loans) because they believe that many people, being able to offer real estate as collateral, would make bad lending decisions and end up losing their homes.

In fact, we humans have difficulty with intertemporal decisions, especially when the loan repayment will take place after a long time. This may justify regulation and limits on these markets, but it is wrong to disregard the benefits of an expansion in credit.

Changes in the possibility of offering real estate as collateral may boost the credit market. But if the legal process is costly, long and complicated, guarantees will not be effectively created.

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