Collateral Valuation: Credit Risk: Role of collateral in Financial Intermediation

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Financial intermediation refers to the channeling of funds from those who have money (the lender) to those that do not have sufficient money to carry out a desired activitiy (the borrower). Collateral plays a very important role in this process. In this post we will look at the benefits of collateral to the lender and borrower and how it promotes and enhances the financial intermediation process. We also consider the situations where collateral is not easily available and the resultant impact on the financial intermediation process and the economy as a whole.

Collateral helps to align the interests of the lenders and the borrowers and in doing so promotes investment in the economy and subsequently increased output levels. When there is insufficient collateral available, the resultant social costs to the economy are higher interest payments, reduced volume of investment and lower production levels. If collateral were not available lenders would be more cautious in their transactions. They would lend only to a limited segment of borrowers or charge higher risk premiums from more risky ones. A result of this could be that a large number of loans may not be concluded. Those concluded would be issued with higher interest rates to account for higher costs per loan as well as the greater risk associated with unsecured debt. This could eventually dampen investment in the economy and subsequently lead to lower production levels.

Also there could arise situations for the lender when the customer has met all other conditions for the loan except the one on collateral. In such instances the lender would either be forced to reject the application or assume the risk of an under-collateralized borrower. This could imply higher costs to the lender in terms of establishing and enforcing less than optimal collateral.

Situations of insufficient collateral usually arise when there exist:

  • a suboptimal distribution of assets among the population,
  • an inappropriate legal or regulatory framework which imposes restrictions on the use of some classes of assets as collateral and/ or where real estate/ property registries are not transparent,
  • monetary particularly interest rate policies that restrict the lenders ability to charge risk premiums from under-collateralized borrowers by imposing interest rate ceilings on the interest rates that lenders can charge from these borrowers
  • faulty risk assessments of borrowers by lenders which lead to them impose unrealistically high collateral requirements on the borrowers

With collateral the lender can maximize the likelihood of being repaid and minimize default losses. As mentioned earlier it serves as a screening tool for the lender, ensuring that his borrower pool is comprised of people who are conscientious about repaying their debt in a timely fashion. It can also reduce his transaction costs, particularly in the case of quality collateral being pledged, as he can save on the number of reviews that would otherwise be needed for loan application processing.

For the borrower collateral ensures that he will not take unnecessary risk with the money lent. This is because he knows that if he defaults on payments the lender has the right to seize the asset that he has pledged. It allows him to monetize his illiquid assets to raise funds by allowing these assets to serve as collateral against credit. Hence it allows him greater access to credit. By minimizing the risk of losses for the lender in the eventuality of a default, collateral could mean reduced cost of credit for the borrower.

In this section we have considered how important collateral is not only to the lenders and buyers to a transaction but also to the whole economy in general. In the next post we will look at the various aspects of collateral law and how it promotes or impedes financial intermediation.