From a legal standpoint, collateral is defined as the general protection that the legal system gives to individuals in exercising their contract rights –and, more specifically, this means it gives the lender or creditor to execute his claims for recovery of loans from the borrower or debtor. The establishment of collateral within a legal relations aims to secure the lender’s right to recover, coercively if necessary, the material value established in a loan transaction.
A collateral is a deposit, a pledge, a mortgage and, ultimately, anything that can serve as a guarantee and may ensure the compliance with an obligation or promise. Legally, collateral is synonymous with security and it is precisely this that interests the lender or the active subject of an obligation: that the performance of a loan obligation be ensured so that his right is not merely illusory and nominal. Legally, the different manifestations of collateral can be distinguished into three forms: First, the asset leaves the owner’s material possession and passes into the power of a third party or of the lender, empowering the latter to sell that asset if the obligation is not duly fulfilled. Second, the collateral consists of assets that do not leave their owner’s possession, but the lender can demand their sale if the obligation fails to be performed. Third, the lender acquires the right to get the benefit of the fruits of the asset that has been offered as collateral or to receive a part of the benefits to pay off the loan, either by transfer of the asset to the lender’s possession, or by depositing it into the hands of a third party or by leaving it in the owner’s possession.
Economic Aspects of Collateral
- Nature of the Loan.
Loan transactions are characterized by their intertemporal nature. The transaction begins when the borrower applies for the loan, continues with his acceptance as credit subject, is followed by the loan disbursement, and concludes when the lender collects the loan amount with the corresponding interest charges. Throughout the entire process, there is an element of trust that makes the transaction possible. The interpersonal trust that should exist between lender and borrower for the granting of a loan, demands the existence of a considerable amount of information between these two agents. Nonetheless, to acquire that information is costly and imperfect. This means that the lender does not have full and exact information on the borrower’s capacity or willingness to pay and to obtain this knowledge will be prohibitively expensive. The problem of imperfect information appears in the three phases of the loan process: in the borrower selection, at the incentive stage to properly use and repay the loan, and in the recovery of due loans. In their selection, lenders do not know the probability of non-repayment of each subject who applies for a loan. Once the credit has been granted, it is difficult and costly for the lender to ensure that the borrowers will take actions that favour the payment of their loans; this is the incentive stage. Finally, in the event of a default, it is costly to determine if this was due to situations outside the borrower’s control or whether it was the result of a deliberate action.
- The Role of Collateral in Imperfect Information.
It is in this context that collateral appears as a factor that helps to solve the problems created by imperfect information. In the case of borrower selection, given the difficulties of the lender in determining the repayment capacity, collateral emerges as a visible element that is linked to that capacity. Normally, the larger the value of the collateral, the greater the expected payment capacity. In this way, collateral acts, in the selection of borrowers, as an element that discriminates against small producers because of their difficulties in providing collateral; whenever they are able to do so, the value of their collateral is not very large.
In the incentive phase, collateral acts as a mechanism that indirectly influences the borrower’s behaviour in taking actions that are favorable to loan repayment. The more valuable the collateral of a loan, the more willing the borrower will be to take actions that are conducive to repayment of his debt. In the loan recovery phase, the threat of loss of collateral is a mechanism that directly influences the timely repayment of the loan. As in the previous cases, the value of the collateral is positively related to the loan recovery.
- Characteristics of Loan Collateral.
In ideal terms, a collateral should fulfill the following five basic attributes: The better an asset complies with these characteristics, the greater will be its capacity to serve as collateral.
- Be appropriable.
Generally, private formal credit institutions require collateral that secures loans in accordance with the five. Nonetheless, for other types of loans, assets that meet only some of these five requisites can act still efficiently as collateral. Of these, the condition that is essential is the feeling of loss that is associated with the establishment of a collateral.
- Be salable or have the possibility of being converted into cash to cover the loan transaction.
This means that a market for that asset should exist, which allows its valuation. It is important not only for setting the price for a collateral, but also because, in the event of loan default, the lender generally does not need to remain permanently in the possession of the asset, but he can sell it to recover the loan value.
- Cause a feeling of, or constitute a, loss to the borrower.
Feeling of loss refers to the value that loss of the asset given as collateral represents to the borrower and it is also related to the lender’s perception of this valuation. In this context, an asset may operate as collateral, if it has a high value to the borrower and, in case the lender perceives that the borrower values significantly the loss of the asset.
- Be durable or sustainable during the contract time.
Means that in order to fulfill its function as collateral, an asset must not expire and it should keep also its value; otherwise, its expiry or wear and tear would leave the loan transaction unsecured.
- Entail transaction costs that are accessible to the borrower and directly relate to the loan amount and terms.
The expenses of formalizing assets as collateral must be accessible to the borrower. In other words, an asset that serves as security must have transaction costs that are reasonable for the borrower and also be in proportion with the loan amount; otherwise, these expenses will impede the conclusion of the loan transaction.
The many functions that a collateral must fulfil in order to secure the compliance with a loan obligation, mean that a single asset may not be able to fulfil all of them. It is for this reason that for most transactions a lender requires several assets to ensure fulfillment of all of these functions. Furthermore, appropriability, marketability, valuation and transaction costs to the borrower are all characteristics which are institutionally and socially determined. This means that the quality of an asset as collateral is not absolute, but depends on the economic and social context in which the loan contracts are situated. In other words, an asset that in one specific situation presents a perfect collateral, in another one may be unusable as security. Land is an example of this. It is a highly valued collateral in case of private land ownership together with a legal and social system that enables land transfer and given the existence of a land market. However, in case there is no private property system and the legal and social systems do not support the transfer of land, then it will be difficult that it can serve as loan security.
- Collateral and Interest Rate.
Collateral has a relative close relationship with interest rates, inasmuch as both interest rate and collateral value have a positive effect on the expected income of lenders. In that sense, a high interest rate and low collateral value can provide an expected income similar to that of a low interest rate and a high collateral value. Along this same line of reasoning, several investigations demonstrate ceteris paribus, mathematically and empirically, that the larger the collateral a borrower can provide, the lower the interest rate will tend to be. In that context, the collateral value is not an exogenous variable to a loan contract, but is internally determined by the level of the interest rate and the security value. It is important to note here the valuation that a lender assigns to a collateral: to the extent that the lender assigns it a value significantly below that given by the borrower or the market, the interest rate needs to be substantially higher. In such a case, considering that high transaction costs of an asset have a negative effect on the lender’s valuation of that asset as collateral, higher collateral transaction costs will be related to higher interest rates. This explains why in the presence of imperfect information, higher interest rates will be observed for loans in situations where there are problems of using an asset as collateral.
- Collateral and Loan Duration.
The need for loan information varies according to the duration of the loan payback period. When these periods are longer, there will be a greater likelihood of something happening that will affect the borrower’s repayment capacity. Consequently, lenders will demand more information from borrowers when the payback periods of loans are longer. However, it is expensive for the lender to obtain information. One way of offsetting greater information needs for long-term loans and of minimizing risks, is to demand more valuable collateral. As a result, investment loans, which are generally long-term loans, require more valuable collateral than short-term loans. This is a serious limitation for small producers who need to capitalize or replace equipment, but have problems in establishing the collateral that is demanded for such long-term credit. This is one of the reasons why both commercial and development bank loan portfolios for small producers are basically short-term
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