MODULE NINE

THE ECONOMY OF CREDIT AND COLLECTION

After this lesson, the reader must be able to:

1. Discuss the Economic importance of credit and collection

2. Appreciate the BASEL Accord on credit

A Creditor and Debtor’s Relationship

The relationship between a creditor and a debtor is one of the most important to understand in
terms of business practices of any kind. This is because most business transactions result in some
form of debt for a given party, and even individuals outside of business practices are often debtors,
whether to a credit card company or to a bank.

Creditors are those to whom something is owed by the debtors, and therefore, the relationship
between creditors and debtors is substantially complicated by the conflicting interests of the two
parties. A creditor might be willing to seize anything and everything that he or she has to in order
to obtain adequate compensation for the debt owed to him or her by the debtor.

A debtor, on the other hand, wants to protect his or her property from being seized by a creditor
unnecessarily. A debtor cannot simply shirk the debt owed to the creditor, but the debtor does not
want that debt to result in undue action on the part of the creditor. Thus, the law attempts to serve
the interests of both parties, allowing the creditor to collect on the debts, while protecting the
debtor from undue action.

The law provides for a creditor to fall into one of two categories. Either the creditor is secured or
he or she is unsecured. An unsecured creditor is owed by the debtor, but no particular property
or asset is involved in the debt. In other words, the debtor does theoretically have to pay off the
creditor, but there is no agreed upon asset owned by the debtor which he or she must use to pay
off his or her creditor.

A secured creditor, on the other hand, has a claim on a certain asset built into the debt. This means
that the secured creditor can take that particular asset in order to ensure that the debt is paid by the
debtor. An unsecured creditor can become a secured creditor by gaining a lien against the debtor’s
property. Such liens can sometimes be obtained through a court proceeding, determining that the
creditor is owed by the debtor, and therefore, deserves a lien.

Although it may seem like the law solely lands in favor of the creditor, the law actually protects
the debtor as well. Some liens which a creditor can obtain at the time of the loan will allow the
debtor to negotiate exactly what property is at stake in the loan, thereby protecting any other
property he or she might have. The government also creates exemptions for loans, such that certain
types of property will not be seized by the creditor for any debt.
An important example of an exemption is the homestead exemption, which ensures that a creditor
cannot seize a debtor’s home unless that creditor holds the mortgage to the home. In other words,
homes are generally off-limits, except for those loans which specifically make the
debtor’s home payable to the creditor.

In any particular instance, if the debtor does not pay the debt in a fashion agreed upon in the
original formation of the debt, the primary way for the creditor to obtain payment is to take the
debtor to court. If the creditor has ample evidence, then he or she should be able to successfully
prove that he or she is owed money by the debtor and should either obtain a lien against some
property of the debtor or have a lien enforced. If, on the other hand, a debtor is trying to protect
him or herself from a creditor, the court is the primary means to do so, although in general the
burden of proof will be on the debtor. If the creditor already has a lien against certain property,
then the creditor may seize that property without needing to go to court.

What Are the Basel Accords?

The Basel Accords are a series of three sequential banking regulation agreements (Basel I, II, and
III) set by the Basel Committee on Bank Supervision (BCBS).

The Committee provides recommendations on banking and financial regulations, specifically,

concerning capital risk, market risk, and operational risk. The accords ensure that financial
institutions have enough capital on account to absorb unexpected losses.

KEY TAKEAWAYS

 The Basel Accords refer to a series of three international banking regulatory meetings that
established capital requirements and risk measurements for global banks.
 The accords are designed to ensure that financial institutions maintain enough capital on
account to meet their obligations and also absorb unexpected losses.
 The latest accord, Basel III, was agreed upon in November 2010. Basel III requires banks
to have a minimum amount of common equity and a minimum liquidity ratio.

Understanding the Basel Accords

The Basel Accords were developed over several years beginning in the 1980s. The BCBS was
founded in 1974 as a forum for regular cooperation between its member countries on banking
supervisory matters. The BCBS describes its original aim as the enhancement of "financial stability
by improving supervisory knowhow and the quality of banking supervision worldwide." Later, the
BCBS turned its attention to monitoring and ensuring the capital adequacy of banks and the
banking system.

The Basel I accord was originally organized by central bankers from the G10 countries, who were
at that time working toward building new international financial structures to replace the recently
collapsed Bretton Woods system.

The meetings are named "Basel Accords" since the BCBS is headquartered in the offices of
the Bank for International Settlements (BIS) located in Basel, Switzerland. Member countries
include Australia, Argentina, Belgium, Canada, Brazil, China, France, Hong Kong, Italy,
Germany, Indonesia, India, Korea, the United States, the United Kingdom, Luxembourg, Japan,
Mexico, Russia, Saudi Arabia, Switzerland, Sweden, the Netherlands, Singapore, South Africa,
Turkey, and Spain.

Basel I
The first Basel Accord, known as Basel I, was issued in 1988 and focused on the capital adequacy
of financial institutions. The capital adequacy risk (the risk that an unexpected loss would hurt a
financial institution), categorizes the assets of financial institutions into five risk categories—0%,
10%, 20%, 50%, and 100%.

Under Basel I, banks that operate internationally must maintain capital (Tier 1 and Tier 2) equal
to at least 8% of their risk-weighted assets. This ensures banks hold a certain amount of capital to
meet obligations.

For example, if a bank has risk-weighted assets of $100 million, it is required to maintain capital
of at least $8 million. Tier 1 capital is the most liquid and primary funding source of the bank, and
tier 2 capital includes less liquid hybrid capital instruments, loan-loss, and revaluation reserves as
well as undisclosed reserves.

Basel II
The second Basel Accord, called the Revised Capital Framework but better known as Basel II,
served as an update of the original accord. It focused on three main areas: minimum capital
requirements, supervisory review of an institution's capital adequacy and internal assessment
process, and the effective use of disclosure as a lever to strengthen market discipline and encourage
sound banking practices including supervisory review. Together, these areas of focus are known
as the three pillars.

Basel II divided the eligible regulatory capital of a bank from two into three tiers. The higher the
tier, the less subordinated securities a bank is allowed to include in it. Each tier must be of a certain
minimum percentage of the total regulatory capital and is used as a numerator in the calculation of
regulatory capital ratios.

The new tier 3 capital is defined as tertiary capital, which many banks hold to support their market
risk, commodities risk, and foreign currency risk, derived from trading activities. Tier 3 capital
includes a greater variety of debt than tier 1 and tier 2 capital but is of a much lower quality than
either of the two. Under the Basel III accords, tier 3 capital was subsequently rescinded.

Basel III
In the wake of the Lehman Brothers collapse of 2008 and the ensuing financial crisis, the BCBS
decided to update and strengthen the Accords. The BCBS considered poor governance and risk
management, inappropriate incentive structures, and an overleveraged banking industry as reasons
for the collapse. In November 2010, an agreement was reached regarding the overall design of the
capital and liquidity reform package. This agreement is now known as Basel III.
Basel III is a continuation of the three pillars along with additional requirements and safeguards.
For example, Basel III requires banks to have a minimum amount of common equity and
a minimum liquidity ratio. Basel III also includes additional requirements for what the Accord
calls "systemically important banks," or those financial institutions that are considered "too big to
fail." In doing so, it got rid of tier 3 capital considerations.

The terms of Basel III were eventually finalized in December 2017. However, its implementation
has been delayed, due to the impact of COVID-19, and the reforms are now expected to take effect
in January 2023.