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Collateral Valuation: Credit Risk: Extent of collateral & Performance indicators for collateral

Earlier we defined collateral in general. However, the basic definition of collateral can be extended to include other elements of the pledged asset, such as asset proceeds, which is elaborated below. We also briefly review some of the performance indicators for collateral with regard to its impact on the timely repayment of outstanding debt.

Extent of Collateral

The definition of collateral will extend, usually with additional clauses within the security agreement, to the following:

i. Proceeds

This refers to the proceeds of the asset pledged. This means that when there is security interest in an asset then this security interest will also extend to the proceeds from that asset.

ii. Supporting obligation

These include guarantees and letters of credit rights that support the collateral. Again this means that when a security interest in an asset is created then this security interest will also extend to any supporting obligation of that asset.

iii. After-acquired property

Applicable collateral may extend to the future property of the borrower if the security agreement includes a clause to the effect.

iv. Future advances

Sometimes it may be possible to secure future advances with the same security interest. Again in order for this to take effect an appropriate clause must be included to the security agreement.

v. Transfer of assets

When the assets pledged as collateral by a particular borrower are assumed by another person, the obligations of the borrower are automatically passed on to the buyer of the assets and they become bound by the security agreement as if they were the borrower.

Performance indicators for collateral

In order to assess whether a particular form of collateral is more effective in ensuring that loans are repaid on time and that default events are minimized, the lender may monitor some of the following performance indicators of collateral:

  • Repayment rate
  • Transaction costs incurred in appraising, selecting, perfecting, and realizing the collateral

In this post we have covered how the meaning of collateral in a security agreement can be extended to include other aspects of the collateral asset. We have also looked at how a lender may be able to assess whether a collateral is performing as it should, i.e. mitigating credit and default risk. In the next section we will consider the role that collateral plays in financial intermediation.

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