For those who have obtained credit facilities from banks or financial institutions (FI) they must have at one point raised the question that we intend to discuss in this article.
It is likely that somehow borrowers have managed to obtain misinformation from friends, the public or the lender. There has been a misunderstanding by many borrowers that as long as they have “collateral” they deserve that legal right to obtain credit facilities from the bank. I refer to this as a misunderstanding because banks/FI do not lend against the collateral; rather lending is based on the viability of the business/project to be financed.
In the process of credit risk assessment the primary repayment source of a credit facility is the cash flow from the business to be financed or from other pre-identified source of cash flow. The cash flow is what is considered as primary collateral. Banks and FI will then ask for the collateral as a secondary source of repayment to be called for only when the primary source of repayment has failed. I am deliberately putting in Italics the words legal right because in one of my coming articles I will discuss the question of whether obtaining credit from a Bank/FI is the borrower’s legal right or a privilege. For purposes of today’s discussions itis my pleasure to share my views and understanding on why Banks/FI demand collateral.
First, it is important to define collateral.What are the qualities of good collateral and finally address the pertinent question: why do banks ask for collateral?
Collateral can be defined in many ways. I have chosen the easy to understand definition which is: Collateral is a property or other asset that a borrower offers as a way for a lender to secure the loan extended to the borrower. If the borrower defaults in making the promised loan repayments, the lender can seize the collateral in order to settle the outstanding loan plus any interest accrued and therefore minimize or avoid the credit losses. The property or asset can either be owned by the borrower or a third party who is willing to assume the responsibility of the loan repayment in the event of a failure to repay by the ultimate borrower. In this regard the third party is referred to as the Guarantor.
In order to qualify as good collateral there are minimum aspects that need to be satisfied to the lender and not the borrower. These aspects are:
- The value of the collateral must be sufficient, easy to determine and stable or preferably appreciating. It has to be sufficient to cover the entire loan amount plus a certain margin to address possible value decline resulting from market changes. This is why lenders will in most cases accept discounted value of the property/asset as opposed to the face value. In case of land and building and immovable assets offered as collateral there will be the Market Value and the Forced Sale Value (FSV) of that property; these values are determined by professional property valuers. The lender will consider the FSV and yet discount it in line with the bank’s internal credit policy.
- The ownership of the property/asset must be documentary evidenced, legally verified, transferable with no encumbrances (not attached). The document evidencing the property must be issued by legally known authorities; the lender must verify the legality of the document through a search from the issuing office. Transferability is in relation to the ownership and not the possession of the asset. Take an example of a mortgage (charge of a land and building)—the possession of the asset remains with the borrower while the title ownership is transferred to the lender once the mortgage is perfected.
- The asset must be easily converted into cash in case of a need. The longer it takes to realize cash from the sale of that asset the less attractive it is to qualify as good collateral.
Having addressed these key qualities of good collateral let us look at why banks ask for collateral. There has also been a misunderstanding that banks do demand collateral in order to solely meet regulatory requirements. This is incorrect because banks are allowed to lend unsecured loans up to a maximum of 5% of their core capital. It is the prerogative of the lender to decide whether or not to demand collateral bearing in mind the existing regulatory requirements.
- The primary security for any lender is the cash flow; it is the primary means of settling the loan. Other forms of collateral are demanded to support the cash flow. The other types of security are considered to be the second way out (secondary means for a loan repayment).
- Collateral is required in order to obtain the borrower’s commitment to the business or activity being financed. There is no scientific way of validating such a commitment; however, by putting forward the collateral there is an element of the borrower’s sacrifice, value foregone through offering an asset/property as a collateral.
- Collateral is required in order to instil a sense of confidence on the part of the borrower. It is very important that the borrower is self-assured with the success of the business/activity being financed. The collateral helps to keep the borrower on his/her toes to ensure such a success.
- Finally the collateral is required in order to meet the regulatory requirements. Banks are among the highly regulated businesses; they are intermediaries linking depositors and borrowers. Regulators are therefore keen to ensure that banks remain stable with well-protected interests of both the depositors and borrowers.
I hope the above has shed some light in addressing our key question. It should be noted that banks are not obliged to extend credit simply because collateral is being offered to secure the credit. In fact on the bank’s check-list for loan requirements, collateral is at the bottom of the list of requirements.
In a few cases where banks have mistakenly offered credit based on the collateral, these credits have been defaulted and its recovery has been very painful both to theborrower as well as to the banks.
Also to be noted is that sale of properties is not part of banks’ core business.In this regard when banks have to sell mortgaged properties they have to engage independent professionals in that field at the expense of the borrower. To avoid this it is important to ensure that collateral remainsa secondary means of loan repayment. The business/activity to be financed must evidence availability of future cash flow to repay the loan.
Gasper Njuuis a career banker, currently practicing as an independent Consultant in Banking, Finance and Investment.
