Collateral security is an ASSET which a BORROWER is required to store with, or vow to, a LENDER as a state of acquiring a LOAN, which can be auctions off if the advance isn’t reimbursed.
Insurance is a benefit that a bank acknowledges as security for a credit. In the event that the borrower defaults on the credit installments, the loan specialist can hold onto the security and exchange it to recover the misfortunes.
A form of secondary protection sometimes required by a bank and intended to guarantee a borrower’s performance on a debt obligation. The primary security on a substantial business loan is typically the thing that is being financed, such as a factory, company car or shipment, but secondary or collateral security might also be requested by a bank to help assure that the loan will be repaid.
Four types of collateral security you can give for getting credit facilities are 1. Personal Guarantee 2. Maturity 3. Covenants 4. Menu Pricing!
The majority of credit extended to small businesses is secured (Berger and Udell 1995). Bankers try to reduce the perceived risk of lending to small and new businesses by insisting on collateral to cover their investment.
Collateral can be loosely defined as an asset that is pledged to the bank to cover any losses the bank might incur if the business is not able to repay what it owes to the bank. It can be divided into inside and outside collateral.
Inside collateral refers to the assets owned by the firm. It creates a claim of the lender on a specific asset owned by the firm. This means that in case of liquidation, proceeds will be applied first to repayment of the secured lender’s debt and other lenders will be paid out of the remaining funds.
Sometimes, when the value of the underlying asset is huge and the first loan taken is minuscule in comparison, a second loan can be taken from another lender and a second charge can be created on the asset. This way a sort of a creditor priority can be created.
Outside collateral involves pledging assets not owned by the firm. It is usually owned by the entrepreneur or close family members of the entrepreneur. The unhealthy trend in bank lending to SSIs in India is that many bankers insist on some sort of outside collateral. Usually, a personal asset such as a home or jewellery is pledged as collateral. In case the bank is unsure of the resale value of some of the inside collateral, it may insist on outside collateral equal to more than the total amount of debt being given.
It has been shown that banks use outside collateral to protect themselves from a wrong assessment of the business. Many argue that using outside collateral can serve as an incentive to succeed as it effectively exposes more of the entrepreneur’s wealth to the losses of the venture (Boor, Thakor and Udell 1991).
1. Personal Guarantee:
When an entrepreneur extends a personal guarantee to a business, it conveys a claim on all personal assets of the entrepreneur. It gives lender recourse to all the personal assets of the entrepreneur in case of any shortfall in the loan’s repayment, whereas outside collateral is limited to the specific asset pledged.
An important distinction between outside collateral and personal guarantee is that outside collateral signifies significant control over specific assets. For example, if a house is placed as collateral, then the borrower cannot sell off the house without the permission of the lender.
In the case of personal guarantee, the lender is free to use or dispose of the entrepreneur’s assets as the lender wishes. So, a lender is not sure if the guarantor will have any assets at all when it is time to settle the claim.
Often, the guarantor is not the entrepreneur but someone else. For example, the banker may believe that it is much more meaningful to take a personal guarantee from the father of the entrepreneur rather than from an entrepreneur who has invested all his/her money into his/her business.
There are some alternative methods that can be used by banks to reduce the risk they are exposed to by lending to new and small businesses. They are not widely followed but have the potential to replace the overwhelming emphasis placed by banks on collateral security.
Debt contracts with very short maturities allow a bank to limit the period of exposure and at the end of the period the bank has an opportunity to reassess the creditworthiness of the venture. This can be very effectively used while issuing credit limits.
Debt covenants are commitments from borrowers regarding certain actions or activities. These can be promises to meet certain financial goals and performance targets or to engage in or refrain from certain specific activities. A banker may prohibit a lender from engaging in speculative activity by stocking up more-than-required inventory when the cost is perceived to be low. It must be kept in mind that a covenant can only be based on something that is mutually observable and verifiable ((Hart and Moore 1989 Sharpe 1990).
4. Menu Pricing:
Many have argued that it may be possible to increase payouts for riskier lending by innovatively using menu pricing. Kantanas (1987) and Berkovitch and Greenbaum (1991) have suggested that lenders can utilize menu pricing on loans by offering alternative contacts that differ in terms of upfront fees, penalties, and interest rates.
Practically, many bankers realize its usefulness in dealing with marginally riskier lending but find no rationale in using this to justify extending very risky loans.