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Category: Risk Management in Banking

Collaterals are assets that the lender seizes and sells if the borrower fails to perform his debt obligations. The original credit risk turns into a recovery risk plus an asset value risk. Collateral is also an incentive for the borrower to fulfil debt obligations effectively, mitigating moral hazard in lending. Should he fail in his obligation, the borrower loses if the value of the collateral is higher than debt.

Collateral Risks

The existence of collateral minimizes credit risk if the collateral can easily be taken over and sold at some significant value. Collateralization is a widespread and common way to mitigate credit risk. There are many types of collaterals:

• Real assets, from houses for mortgages to aircraft and commodities in other business lines.

• Securities, mainly for market transactions, the most common example being that of repos.

• Commodities, when a cargo is financed, or in oil and gas financing.

• Receivables from a pool of assets in securitization, when credit card or mortgage receivables are securitized. Pools of assets include bonds and loans as well as structures used to sell these types of assets in the market.

• Margin borrowing.

Specialized finance makes wide usage of collaterals. In some cases, these are tangible assets. Assets financing is collateral-based, whether assets are ships, aircraft or assets of a corporation. In many other cases, there are intangible collaterals. Corporate acquisitions (Leveraged Buy-Outs, LBOs) or project finance pledge the cash flows from assets. Nevertheless, future cash flows are uncertain. Covenants help in structuring the transactions to minimize the risks. The collateralized assets are subject to a number of risks:

• Accessibility risk, since it might be difficult to effectively seize the collateral.

• Integrity risk, the risk of damage to the collateral.

• Legal risk, which is the risk of disputes arising from the various laws at play in international transactions.

• Valuation risk, since the liquidation value of a collateral depends on the existence of a secondary market and the price volatility of such a market.

Legal Risk

Legal risk results from the risk of dispute to access the collateral. In addition, the collateral in international transactions is subject to a number of laws, such as that of the lender, of the borrower, of the place where the collateral is located and the law of the contract.

The Ability to Physically Access the Collateral

Legal access to the collateral is one issue. Physical access might be another, since accessing the collateral might be straightforward or very difficult. With cash collateral or securities, the collateral is posted with a custodian, or the lender, and access is not an issue. When physical collateral is planes or ships, access might be an issue, because these assets can be moved away from their usual location. The case of aircraft is the best illustration. Aircrafts can be seized in airports where legal procedures can be enforced. When planes fly only within a foreign country using local airports, they might be impossible to find and seize. Flying through international airports is an important aspect of risk in such a case. Real estate is the opposite case. By definition, it stays where it is built and there is no physical access issue. Also, it is common to hide away collateralized inventories and equipment in distressed firms since everyone knows that these assets will be taken away. Although this is illegal, the risk always exists.

Integrity Risk

Collateral might be damaged, either through normal deterioration because of a lack of maintenance, or deliberately. Whenever equipment has valuable parts, there is an incentive to move them away once it is known that all equipment will be seized.

Price Risk

The collateral has a liquidation value, which is subject to price risk. Price risk for liquid assets is market-driven, since there are various periods to consider before liquidation can be effective:

• The grace period allowed for lenders before recognizing default of payment.

• The time to work out legal procedures as they are needed. With market transactions, the securities posted as collateral are readily available once a breach in the obligations of the lender has occurred.

• The time to liquidate the collateral depends on market liquidity. It is more difficult to sell large blocks of securities than small quantities. For large blocks, there might be an additional delay because it is worthwhile to sell slowly rather than selling fast and triggering a significant price decline.

The level of posted collateral depends on these factors. Whenever there is a secondary market, the time required to sell allows the price to deviate adversely because of market movements. Even after a worst-case adverse move of liquidation value, the collateral should still absorb the loss under default. Both market liquidity and price volatility are important parameters to define the adequate amount of securities pledged as collateral. Cash liquidation value is risk-free, at least in the local currency. Typical assets subject to measurable price risk include: securities, commodities, oil and gas, aircraft and ships, real estate, standardized equipment.

Market Collateral Transactions

Many transactions use market instruments as collateral, since they are liquid assets easy to sell and since their price is continuously observed. Individuals holding portfolios of securities have margin accounts, which they can use to borrow a fraction of their holdings. Financial institutions or funds can pledge the securities that they hold. Inter-bank transactions require pledging liquid collaterals. Broker financing and margin calls in futures markets are also collateral-based. Brokers pledge their securities. Margin calls in organized futures markets are set to absorb 1-day market volatility, 1 day being the minimum period between two successive adjustments.

The main collateral risk in such cases is price risk, since only liquid assets are generally eligible for collateralization. The principle is to set up a collateral, whose value is higher than the borrowers debt. In the event where the collateral value falls below a preset threshold, the lender can sell the securities to reduce the debt or to get repaid in the event of default.

In order to maintain a safety cushion between collateral and debt value, given that the collateral value moves constantly, there are rules triggering the sale of securities. In some cases, the collateral value is much higher than the debt value at inception. It is typical to borrow no more than 50% of the value of securities held by individuals. In other cases, the collateral value to debt value ratio is smaller. Various rules serve to keep collateral above debt when its value changes. A common rule is to post an additional amount of collateral when the existing security value falls below a threshold level. The excess of collateral value over debt value depends on the delay between the collateral deficiency event and all necessary corrective actions. This delay includes the minimum time required to notify deficiency to the borrower, plus some time to post additional collateral, plus the delay for selling the pledged securities under no corrective action. The difference between collateral and debt value (haircut in percentage terms) also depends on the securities price volatilities. The longer the delay and the larger the volatility, the larger the potential downside move of the collateral value under adverse conditions. Since the final value of the collateral at the time of the sale of securities should be above the debt, the required collateral increases with both delay and securities volatilities. The next chapter expands this simple model, determining the minimum value of pledged securities given volatilities and total period before sale.

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