Just as important as the existence of sufficient collateral sources is, it is also essential that collateral valuation methods are accurate. In this post we consider how collateral valuation impacts capital and profits.
Valuing collateral accurately ensures a more enhanced form of credit risk management. Collateral value is used in the estimation of loss given default (LGD). If collateral was not valued correctly a larger loan loss on default than expected could lead to a significant drain on the bank’s equity capital. A more accurate valuation process could mean that the bank would be able to reduce it LGD estimate and subsequently reduce the risk margin it sets in its prices (interest rates charged).
More specifically LGD is estimated from the default amount-weighted average loss rate during a certain time period, where the loss rate is a function of the rate of recovery which in turn is a function of exposure at default, recoveries of loss amounts and costs associated with collection. In order for the loss rate to be minimum, the recovery rate associated with loan losses should be maximized. This means that a greater amount should be recovered on default and it should happen at a faster rate (which translates to a lower cost of collection).
An inaccurate collateral valuation process means that the estimate for the recovery rate is out of whack from reality as a lower amount is recovered at default as well as a longer time is taken to recover the amount. This leads to depletion of capital, because of larger losses and costs of collection, and subsequently to lower profits. The latter is true because higher write offs than initially expected mean that the LGD estimate for the future will be higher, leading to a higher provisioning requirement and a lower profit margin.
We have seen how collateral valuation affects the estimates of the Loss Given Default (LGD) parameter and hence the credit risk capital charge and profits of the bank. In the next section we will look at some of the general principles of valuing collateral.