Collateral and Credit Risk Mitigation

What are the types of collateral?

Tangible fixed assets (like land, buildings, machinery etc) are most often pledged as collateral. However, it is also common to see current assets (cash, receivables, inventory etc) used as collateral and these are the most liquid forms of collateral available. Pledged assets typically are relatively easy to value, have a reasonably liquid secondary market and are generally legally permitted to be taken as collateral and according to lender’s policies.

What are the key considerations relating to taking collateral?

The 5 key considerations a lender must take into account are

1. Identification and valuation of assets
2. Documentation
3. Perfection of security
4. Control and monitoring
5. Enforcement

Identification and valuation of assets - Lenders need to understand the legal environment and ensure that the lien will be valid, legally binding and enforceable.The due diligence process enables lenders to identify which assets are appropriate for the purpose of taking collateral. Regarding valuation, it is important to find out if these assets have a value outside of the business, as well as the ability to dispose of a pledged asset in a stressed scenario and also form a view on the liquidity of the asset. Valuation can either be based on book value, market value, or net realisable value. The most prudent valuation method is net realisable value.

Documentation and Perfection of security - The documentation involves the registration and notarisation of the collateral and this is very important for lenders to follow as per the governing law. To perfect their security and lenders need to check that the registration process has been accurately completed, otherwise the collateral might be void.

Control and Monitoring of security - Assets pledged as collateral must be monitored regularly to ensure continued visibility, existence. Lenders have to monitor the condition and support regular maintenance of the asset. Frequency of the monitoring process depends on the nature of the asset, the volatility of its valuation, the legal environment and internal policies of the lender.

Enforcement - Enforceability of collateral is often complicated and sometimes the lender might not have possession of the pledged asset. In a stress scenario, it is essential to locate the asset, ensure access and be able to identify and segregate the pledged assets. Enforceability is dependent on the governing law and jurisdiction.