Commercial Credit Analysis: Collateral

Collateral is the security given to the bank as a safeguard for the facility/ facilities advanced. This is effectively the Bank’s insurance that should there be a default, the bank has something to fall back on to either recover in part or full the amount advanced.

It is important for a prospective borrower to realise that there is no such thing as a standard collateral. The nature of the collateral, the amount and the percentage of the facility advanced that it covers will vary from borrower to borrower and from bank to bank.

However, there are some standard collaterals.

  • The collateral sought for an overdraft and working capital facilities is the hypothecation of book debts and stocks. The amount advanced will be usually a percentage of the total value – the percentage held back being known in banking connotation as the margin. This is an additional safeguard for a bank as often when goods are sold in a hurry – a quick, forced or distress sale the real, fair value is not realized. The margin on stocks is usually between 25% and 40% and this depends on the company and the industry it operates in. This means that if the total value of stocks held are Rs. 100,000, the amount that the Bank would permit the borrower to draw on an overdraft (if the margin is 25%) is Rs. 75,000. This is known as the drawing power. In regard to debtors the margin is usually higher and can be as high as 50%. In calculating the drawing power banks will insist on a debtors’ aging list and debts over 90 days are excluded from the calculation.
  • If funds have been advanced to purchase machinery or some other fixed asset, the asset purchased is usually hypothecated/ mortgaged to the Bank.
  • In regard to unfunded facilities such as the issuance of a guarantee or a letter of credit, banks usually ask for a cash collateral or margin money. This varies from nil to 20% of the value of the facility – the amount depending on the intrinsic strength of the borrower and the need of the borrower for the facility.
  • Additional collateral are often sought by banks in the form of shares of good blue chip companies for additional comfort.
  • Banks, often ask too, in case the borrowing company is part of a larger  entity (a subsidiary or an associate company or a branch of a multinational), for a guarantee or at worst a letter of comfort from the parent company as additional comfort. This is more for a moral commitment than for any other as it often is difficult to hold the parent down on this or take it to court.
  • In regard to guarantees as collateral, banks ask for the personal guarantees of directors too. In the case of private limited companies, directors often give their personal guarantees supported (at times) by a statement of their net worth. Directors of public limited companies have also been known to give guarantees. This is not common though as these directors often submit that the company is a legal entity in its own right with several thousand shareholders. The directors often are paid employees. In such a circumstance they argue that there is no reason why they should be personally committed to pay all the debts of the company.

In order to be able to enforce on the collateral, banks will insist on their being registered. This is to lay claim to their right and to put on notice any subsequent lender that the particular asset has already been hypothecated/ mortgaged.

In some cases the asset (such as stocks are already hypothecated ) to another lender. In these cases the new lending bank would seek a pari passu charge with the other lender/ lenders. This is to make the new lending bank’s rights equal to that of the banks who have already got the assets as collateral.

Banks will always check whether the collateral’s value fluctuates widely as in the case of shares. If it does periodic valuations will be insisted upon and topping up may be required from time to time if there is a deterioration in value. In cases where the collateral is at the clients’ premises like stocks or machinery, periodic collateral checks will be undertaken by banks to satisfy itself on the existence and the value of the collateral.

A borrower must always remember collaterals are viewed by bankers as additional comfort and they would never, unless forced to do so and until after every other method has failed, seek to enforce their right as that could affect the viability of the concern.