Collateral Valuation: Credit Risk: Definition and Types
We start this course by looking at the definition of collateral, the characteristics that should be present in an asset pledged as collateral, and the various categories and types of collateral usually offered as security.
Collateral is an asset that is pledged by the borrower to the lender in order to protect the lender against the default of the borrower. The asset is pledged until the loan is paid back. In the event of the borrower being unable to repay the principal and interest in respect of the loan, i.e. a default, the lender has the right to seize the asset and sell it to pay off the loan or limit the overall loss from default.
There are certain desirable characteristics that an asset offered as collateral should have:
- It should be marketable
- Its value should be maintained over time
- It should be appropriable and the bank (lender) should have access to the assets pledged in comparison to the borrower’s other lenders
- the transaction costs involved in specifying the asset, verifying ownership of the asset, valuing them, enforcing security interests, etc. should be reasonable
- The borrower places value on the asset pledged and therefore is interested in paying the loan in a timely manner so as to avoid losing the asset in the event of a default. Collateral therefore helps to screen potential borrowers only attracting those borrowers who have understood the importance of repaying the loan in light of the asset pledged.
- For the borrower it should minimize the shame of having borrowed money, (i.e. the social exposure connected with the need to borrow) and there should be a limited impact on his current household and business affairs
Usually loan size is one of the main determinants of what type of collateral is taken by the bank.
i. Types of collateral
- Real estate property- building/ land
- Plant and Equipment
- Natural Reserves
- Timber to be cut
- Consumer goods
- Farm products
- Negotiable instrument
- Document of title
- Investment property
- Account (book debt)
- General Intangibles
- Deposit accounts
- Life insurance policy/health-care insurance receivable
In this post we have defined collateral and considered the various types of collateral. We have also reviewed what a lender would look for in assets pledged as collateral by the borrower. In the next post we will consider the degree to which the definition of collateral can be extended and some of the performance indicators for assessing the effectiveness of collateral.