In our earlier post, we discussed the creation and perfection of security interest in collateral. It is also important to properly manage collateral. In this post we discuss the two elements of collateral management.
Collateral Management broadly encompasses two risk management concepts:
- First, Credit Risk Management (CRM)
- Second, Safeguarding the enforceability of security interest
a. Credit Risk Management
In terms of CRM, collateral management is part of maintaining the Credit File of the borrower. In other words, this means
1) keeping proper records of the collateral and the collateral valuation process and
2) revaluing/ reappraising collateral regularly together with monitoring it against the credit exposure.
i. Record Keeping
Keep records of the following:
- The written appraisal, the appraisers name, address and signature, the effective date of the appraisal
- A description of the collateral (current and projected, including its use)
- The valuation method used
- The assumptions used in the valuation and for any adjustments made to the value
- A description of the source information
- A description of the analysis and supporting information
- An estimate of the value of the collateral and loan officer’s opinion of the appraisal
Revalue collateral on a regular basis and monitor it against the amount of outstanding debt. The frequency depends on:
- The type of collateral being value
- The market condition
- Passage of time
- Volatility of the local market
- Availability of financing
- Environmental contamination
- Improvements/ lack of maintenance
- Changes in zoning
- Inventory of competing properties, etc
For example, real estate revaluation usually occurs once over 6 months or annually. An on-site survey of the same, on the other hand, would happen once every 1-3 months. Valuations for farm products would occur on a weekly basis, while investment property may be subject to daily marking to market, etc.
After revaluing the collateral, update the lender’s credit/ collateral balance table. This table shows:
- By facility; the original amount of credit extended and the loan proceeds outstanding.
- By collateral; the original collateral value, the latest collateral value, a haircut applied to the value of the collateral (depending of the type of collateral and the perceived risk associated with holding that asset) and the collateral value after the haircut
- The total unsecured balance which is the total of the loans outstanding less the total collateral value after haircuts.
b. Safeguarding Enforceability
The second element of collateral management includes the dual task of safe custody and maintaining the collateral book.
i. Safe custody
To safe guard the enforceability of the security agreement keep the following items in safe custody:
- Collateral / security agreement (usually ordered by borrower name)
- Pledged goods and documents (usually ordered and kept by type)
Keep associated documents of collaterals (e.g. fire insurance on property pledged) which are subject to a limitation period or a maturity date, in order of date, to ensure that the lender takes timely and appropriate action with regard to them.
In addition, limit access to the items put in safe custody and ensure processes are in place to protect them against natural disaster.
ii. Collateral Book
Create collateral book for each type of collateral which a senior manager manages. Consequently, this allows the lender to manage the:
- Collateral inventory
- Expiration of the limitation period/ maturity dates on certain collateral so that they can take appropriate action. For example, this may include the filing of continuation papers on the expiration of limitation periods for the perfection of security interests. Or, the settlement of negotiable instruments, like promissory notes or certificates of deposits, which need to settle without delay on maturity, etc.
The collateral book should assign a number to each collateral asset / document. Then tag the asset/document with the number, the borrower’s name/ number, pledger’s name, date, etc.
The senior manager responsible for the collateral book will need to periodically check the collateral book against the physical inventory of the collateral. Also, register any collateral that he adds or removes from the inventory in the appropriate collateral book. Further, when accepting or returning collateral/ documents either issue a receipt or receive one from the borrower stating the collateral type, quantity, date and signature.
In this post we have considered collateral management with respect to credit risk management and safeguarding the enforceability of security interest in collateral. In the next post we will see how to enforce security interests when a credit risk event, such as default occurs.