In lending agreements, collateral is a borrower’s pledge of specific property to a lender to secure repayment of loan.
The collateral serves as a protection for a lender against possible default of a borrower – failure to pay either principal or periodical interest or both – under the terms of the loan agreement.
If a borrower defaults, s/he forfeits the collateral pledged as collateral and the lender becomes the owner of the collateral.
Naturally the lenders prefer a good collateral and the attributes of a good collateral will include
Highly liquid and easy Marketability
The security should be easily convertible to cash. This is possible only when it is freely traded in the market place.
The value of the security should be easily ascertainable. Availability and transparency of pricing is a must to verify the value at periodic intervals.
Stability of value
The market value of the security should not fluctuate very widely to ensure that available margin is not eroded
The security should be easily transferable to the lender’s name and such ownership should be legally transferable.
Normally the following types of securities are accepted in a collateral arrangement
- Liquid security
- Government securities
- Gilt edged securities
- Stock exchange securities
- Blue chip security
With a good collateral and associated documentation and other managerial prescriptions, one may be able to manage the following risks normally associated with collaterals
- Credit risk
- Price risk
- Modeling risk
- Liquidity risk
- Legal risk
- Perfection risk
- Re-characterization risk
- Priority risk
- Enforcement risk
- Concentration risk
- Settlement risk
- Value at risk
However one may have to provide for operational risk management requirements additionally.