The term 'collateral security' frequently resonates across the Board Rooms, Credit Committees and Credit Departments of the banks for evaluation of loan proposals. Unfortunately, ignorance and negligence to identify the risks inherent in securing bank's exposure through collateral security are the main reasons why the banks are laden with a heavy load of non-performing loans. More often than not, collateral security is erroneously thought of as the hallmark of safety and security of the money lent by the bank. As the Hall-Mark and other sensational scams have shown, collateral security is of small significance to ensure repayment of the loan money.
Collateral security is like mysterious nightly voice called nishir dak that, according to legends in rural Bangladesh, beckons people to walk in their sleep towards the source of the voice. The next morning, the legend says, their lifeless bodies are found floating in a pond or cesspool. Many a banker, like these sleep-walkers, are drowned in the cesspool of bad loans after listening to the sweet voices of fly-by-night borrowers promising to offer 'impeccable' collateral security for a credit line. The so-called 'impeccable security', usually a landed property, frequently turns out to be a product of fraud and forgery.
Fraudsters in some localities in the outskirt of Dhaka have earned notoriety for producing fictitious documents of landed property. They offer fake documents for use by the loan seekers as collateral for bank loans in exchange for a share of the booty. One interesting waterlogged location is 'satarkul' where one can literally take a dip for a 'satar' (swim) almost throughout the year. Unscrupulous borrowers sometimes join hands with dishonest elements in the banks to mortgage submerged landed property in this area as security for the loans. In time the loan turns bad, the borrower vanishes into thin air and the bank's loan recovery officers swim in the water body to locate the property that never was to begin with.
I do not, however, intend to undermine the importance of collateral security. On the contrary, if the bank is in doubt about the safety of the fund it should retain some security in order to protect itself in case of default by the borrower. What is important, however, is to remember that collateral supporting a loan may be considered only as an alternative source and not a substitute for a primary security. Primary securities are the assets like raw materials, accounts receivables, factory building and machinery created out of the credit facility extended to the borrower and are directly associated with the borrower's business.
When, however, the primary security provided by the borrower is not sufficient or it may be difficult to maintain control over this security, the lending bank may ask for an additional security which is known as collateral security. It may be provided by the borrower or a third party. The collateral security is not funded by the bank but remains pledged or mortgaged to it until the loan is repaid. It would usually be certificates of deposit, treasury bills, bonds, and stocks and other marketable securities, real estate, jewelry, vehicles, warehouses, office buildings, hotels, and shopping centres, machinery and factory equipment.
Before, however, you come to the stage of asking the potential borrower the kind of collateral security he can offer, you must address other more important issues for processing a loan application. The most important one is, of course, 'knowing your borrower'. The borrower's reputation, capacity and credit worthiness would feature prominently in your check list for evaluation of the credit risk. The bank should look to the borrower's cash flow or asset conversion as the primary source of repayment and consider collateral security as only second line of defence in the event of his loan default.
A customer who is a likely candidate for liquidation or rescheduling should be kept at the arm's length even if he offers collaterals that cannot be easily converted into cash. The credit history of the borrower is another aspect that must be thoroughly scrutinised before giving a favourable nod to the loan request. The due diligence of the borrower's capacity and integrity must be conducted with a rigour equal to that given to an unsecured loan exposure.
The next step is to establish your seniority or legal claim or priority on the assets of the borrower over other creditors. Seniority of marketable collateral securities like bills of lading and warehouse receipts may be secured by taking possession of the title documents. Seniority over non-possessory collaterals may be established by an agreement with the borrower which should better be registered with relevant government agency.
The next important element is protection of bank's interest. Protection is defined as the net realisable value of the specific assets that, upon liquidation, should be adequate to cover a risk exposure. The exposure of the bank against a loan includes principal, accrued interest, and collection costs. The key elements of protection are value of the collateral, the amount of margin retained by the bank, vulnerability of collection of value of the collateral security, marketability and insurance of assets against lost theft, fire etc.
Finally, control and monitoring of collateral is very important. The bank must be able to receive, hold, and deliver either physical assets or title documents which should be in good order. Constant monitoring of collateral is also very important. Audit programmes should be laid out to periodically inspect non-possessory assets.
Here is a story for the young bankers about the hassles they would encounter if they do not carefully examine the agreements signed with the borrower. This interesting story, which is claimed to be from real life, comes from America where, in 1970s, one bank's loan agreement routinely contained a clause that in case of the borrower's default he would deliver the collateral security to the bank. What the credit officer or the law officer failed to foresee was that the 'collateral' was a herd of 3,000 cattle. The borrower, who was unhappy with the bank, followed the delivery instructions literally. Imagine the predicament of the loan officers of the bank chasing 3,000 cows and bulls around a small town. The moral of the story is that if you are not careful you will have to do all the chasing after the borrowers, if not the cattle.
The writer is a retired banker. [email protected]
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