Importance of collateral for bank loans

Importance of collateral for bank loans

Importance of collateral for bank loans

Banks lend money to the public for various purposes like buying or building a house, buying consumer goods like TV, music system, etc. Banks also finance businesses, both manufacturing and service. Apart from all this, they also provide personal loans to members of the public.

This service provided by banks, namely financing or more commonly called lending, is fraught with several inherent risks. Loan defaults can occur for more than one reason, including causes beyond the borrowers’ control, such as in the event of floods or tsunamis, which may destroy the borrower’s assets, in addition to making him unable to resume his business immediately. The most serious risk for banks in the lending process is the risk of non-payment of the loan by the borrower. Imagine a situation in which none of the borrowers of the Banks repays the loans used by them! This could lead to the collapse of the banking industry!

The current wave of bank failures in America and elsewhere is largely due to borrower defaults. While in an ideal situation every borrower repays the credit he used from the bank, in real life this does not happen. Many times, borrowers, both individuals and institutions, fail to fulfill their repayment commitments, which affects the well-being of the lending bank. Sometimes there are even genuine reasons why borrowers default.
 
That being the case, banks invariably have norms and procedures they follow before parting with a borrower’s money. Banks review and evaluate loan proposals in terms of their viability and feasibility, both technically and financially, before deciding to grant a loan. Each loan is assessed individually to establish the reliability of the proposal and only then a decision is made to grant a loan. Obtaining collateral for loans is one of the guarantees that banks exercise to secure their interests. Among the various safeguards followed by banks to protect their interests in the lending process is obtaining collateral for the loan provided by them.
 
Definition of security: Security, in relation to a loan advanced by a bank to a borrower, means an asset of any kind or description having certain qualities, among which a monetary value, which may be held by the bank in the event of default and is applied to repayment of the loan.
 
Having granted the loan to the borrower, the Bank would naturally want to ensure that the loan is repaid with the interest on it. This means that the bank would like to secure the loan. This is done by creating a charge against the asset financed by the Bank. The type of charge created depends on the nature of the loan and the collateral.
 
There are basically two types of securities available to banks to secure a loan. They are primary security and collateral security.

Primary security refers to the asset created directly by the bank’s funding. For example, when a bank finances the purchase of a home, the home is the primary security. Likewise, a car purchased with the help of a bank loan is the primary security for that loan. The bank creates a charge against this primary collateral to secure its loan. This fee gives the bank the legal authority to dispose of the asset and apply the proceeds from it to the amount of the defaulted loan.
 
Collateral Collateral refers to certain additional collateral received from the Bank to secure the loan. For example, say a bank financed the purchase of machinery by a pharmaceutical company. This machine will be the primary collateral for this loan. In addition, the Bank may obtain collateral in the form of a factory building owned by the company as additional collateral. This will protect the bank’s interests in the event that the primary security is not of sufficient value to liquidate the loan. Sometimes, due to adverse market conditions, the value of the primary security is reduced, exposing the bank to a higher risk than it originally anticipated.
 
In addition, loans can be secured by personal security of the borrower. The receipt of the borrower’s personal security allows the Bank to take action against the borrower and his personal property to recover the loan.
 
Once the bank secures its loans with adequate collateral, the possibility of default is reduced and even in case of default, the amount of loss it is likely to incur is less than otherwise.

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