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Collateral Valuation: Credit Risk: Collateral and Collateral Law

Earlier we considered how collateral helps with financial intermediation. However the extent to which it can help or play its role is dependent of the collateral law applicable. The next section covers what is meant by collateral law and what facets of collateral would normally be impacted by collateral law. It also compares the effectiveness of modern collateral law systems against the restrictions of unreformed traditional systems.

Impediments to financial intermediation and impacts on credit risk management

Most countries do not have a specific collateral law in place. Collateral tends to be addressed under dispositions in private (e.g. contract law, property law, commercial law, judicial law such as bankruptcy law) and penal law (e.g. usury prohibitions). These laws directly or indirectly impact collateral, in particular how the lender and borrower in the contract would:

  • Select or specify an asset to serve as collateral (i.e. the creation of security interest)
  • Verify the ownership of the asset and the ability to determine whether another lend has a prior claim to the pledged asset (i.e. the perfection of security interest), and
  • In the event of default realize the pledged assets to cover loan losses (i.e. the enforcement of security interest)

Under modern collateral law systems collateral is any asset that would generate future cash flows either directly or indirectly that would be used to pay off part or whole of an outstanding loan amount on default. There would also be no restrictions on borrowers and/ or lenders who may be allowed to create a security interest in that collateral.

If collateral law were effective as is envisaged by these modern systems it could lead to:

  • a widening of collateral asset base,
  • a broadening of the financial sector by making credit more accessible, and
  • an increased level of financial security due to lower default rates or minimum default losses

Under-reformed collateral law systems on the other hand place restrictions on

  • the types of assets that could be considered as collateral,
  • the lenders and borrowers that would qualify for collateral agreements, and
  • the enforceability of security interests such as lengthy judicial procedures, requirements that limit or exclude direct action of the lender against the borrower, exemptions of certain parts of the asset pledged (e.g. real estate) from repossession

In the latter case inadequate collateral law in terms of being able to verify or enforce security interest would mean that lenders would focus only on those potential borrowers where this issue would not arise or impose prohibitive risk premiums to account for higher transactions costs associated with specifying, verifying and realizing collateral. This would serve as a barrier to receiving/ granting credit.

In this post we have reviewed what constitutes collateral law and the differences in various systems of the law. In the next section we will look at the role collateral valuation plays in credit risk management.

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