Loan Security
Category: Financial Risk Management
In this training module up to now, our main focus has been on how we might establish if our customer has repayment capacity for any existing or proposed loans. This must always be the primary focus of a lending banker as we wish to limit our overall risk by extending loans only to those customers we feel should be in a position to pay us back.
However, to properly assess repayment capacity we have to examine a huge amount of detail, both financial, as in this module, and non-financial such as Management, Competition etc. Then, even after the most detailed analysis, there can never be any certainty about repayment capacity. When assessing credit risk, and the repayment of loans, we are considering the future, and the future is always uncertain.
It is because of all this uncertainty, banks generally try to reduce their risk from any individual customer by taking Security from that customer. The purpose of the Security is to provide us with a secondary source of repayment if our primary source, normal trading income, is insufficient.
It is important to stress at the outset that the level of Security should never be the principal factor in deciding whether or not a particular loan will be granted. Many banks have found this to their cost over the years. Enforcing security is not always straightforward and it is always preferable to have loans repaid in the normal manner.
Characteristics of Good Security
The type of security we take will depend to a large extent on what is available from the customer. Also, our preferences may be determined by the legal system in our particular country because, ultimately, the effective realisation of security will depend, to a large extent, on the ease with which the legal system allows enforcement of the particular security held.
However, no matter what security we take, next shows the three factors we need to test in order to determine how effective it is likely to be.
Tests of effective security:
— Value
— Realisability
— Title
Value is clearly important. If we do not get repaid from normal trading, we hope that the value of our security will be sufficient, after costs of realisation, to at least cover the full debt. Our problem when taking security is that the only value that is of practical importance is the realisable value at the time we seek to recover our debt. Unfortunately, the value of security can often fluctuate considerably and this makes it difficult for us to make an accurate assessment of how well it covers our risk into the future.
Realisability is a key requirement. Security is of absolutely no practical value if it cannot be realised by the bank. While some forms of security are relatively simple to realise, many require complex legal action and banks often overestimate their ability to realise security in advance.
Title to the security is essential if the bank must be able to get good before realisation, and this in turn depends on the customer having good title and the ability to transfer this to the bank. It is not unknown for banks to find out too late that there are legal complications over ownership of the security provided.
From an overall risk point of view, it is recommended that the lending banker is cautious and prudent when assessing the value of security. It needs to be examined very carefully if the bank is likely to have to rely on the security for repayment. Lending against the perceived value of security is highly dangerous.
Perhaps the most effective use of security is as a means of concentrating the efforts of owners/managers on repayment of loans in the normal course, rather than surrendering the assets given as security.
We will now look at some of the more common forms of security taken by banks. We will look at them under the headings next.
Common types of security:
— Real Estate
— Company Assets / Debentures
— Guarantees / Letters of Comfort
— Assignments
Real Estate
Real Estate or Property is a very common form of security taken by banks. The bank seeks some form of legal charge over the property which allows it, in the event of default, to sell the property and apply the proceeds against the debt. As property is generally good at maintaining its value, the attractions for the bank are obvious.
There are a large number of different types of premises which may be taken as security. These are shown next.
Types of real estate:
— Residential Housing
— Investment Properties
— Retail Premises
— Industrial Buildings
— Agricultural Land
— Land for Building
— Tenanted Property
Each of these types of real estate may have particular points for the banker to bear in mind when considering them as security. In addition, when considering them all for our principal tests of Value, Realisability and Title the banker will need to subject them all to scrutiny under a number of headings. Next shows the sort of checklist that might be used.
Real estate checklist:
— Location
— Type of Land (agricultural, commercial, industrial)
— Government Regulations (e.g. Planning Permission)
— Occupants of Property / Rights of Residence
— Maintenance Costs
— Saleability
Many imposing properties are of little value because of location, legal problems, specialist use etc.
Debentures / Company Assets
When a bank is extending a range of credit facility to a company, financing both its fixed and current assets, it is logical that the bank might seek security over all of the assets of the company, perhaps by means of a debenture. The taking of such security will depend significantly on the laws of the particular country. These will not only affect the bank’s ability to take a debenture, but also the effectiveness of the security in the event of loan default.
In theory, the bank having a hold over all of the assets of the company and being in a position to sell them and apply the proceeds against borrowings, is good, but the reality is often different. The value of the assets may be severely diminished in a break-up situation. Also, there may often be formidable legal obstacles to enforcing the security.
Certainly, where security of this nature is envisaged, it is essential that detailed agreements are entered into between bank and customer, and that very good legal advice is sought in taking the security.
Guarantees and Letters of Comfort
Next, let us consider Guarantees and Letters of Comfort. These are very common forms of security because often the borrowing entity itself does not have sufficient assets to secure its loans. Typically, for instance, a bank may ask the owners of a company to guarantee its borrowings. This give the bank recourse to the personal assets of the owners in addition to the assets of the company. It certainly helps to concentrate the minds of the owners/managers on efforts to repay debts in the normal course from trading.
A similar form of security taken from multinational companies in respect of borrowings by a local subsidiary is a Letter of Comfort. Many multinational companies have a policy of never providing letters of guarantee but they will issue a letter acknowledging they are aware of subsidiary indebtedness and affirming that it is their policy to ensure that their subsidiaries meet their obligations in full. Such a letter probably has limited legal standing but banks take them as security, relying on the reputation of the multinational company.
Assignments
The final type of security mentioned earlier is Assignments. There is potentially a broad range of liquid assets that a bank may seek as security, usually by means of Assignment. The type of assets that are commonly subject to Assignment are listed in next.
Commonly assigned assets:
— Deposits / Account Balances
— Government Bonds
— Marketable Securities
-Life Assurance Policies
Because these assets generally constitute cash or can be quickly turned into cash, and because there is often a considerable degree of certainty about their value, they are particularly attractive to the banker as security.
Summary
To sum up our brief look at security, the banker must be fully aware that while good security may help to reduce credit risk it does not entirely eliminate it. Our primary concern should always be with repayment capacity of the borrower.
When taking security, next shows a number of the more important questions that need to be considered by the banker.
Security check list:
— Has the security intrinsic value?
— Is there a reasonable margin over outstanding debts?
— Has the borrower good title?
— Can the instrument be taken as security?
— Are all legal regulations complied with?
— Is the security easily realised?
— Are their other parties with prior claims (e.g. Revenue Authorities)?