Banks select convenient loan collateral assets to secure the uninterrupted service of a loan facility. In the adverse case of a borrower in default, collateral assets provide critical last resort coverage for bank loan recovery. Nevertheless, collaterals may provide least protection when they are most needed. Recessionary economic cycle phases, unstable capital markets, liquidity constraints and financial crises amplify abrupt downward collateral value shifts. This, in turn, can result to outstanding loans being exposed to diminishing collateral values, substantially increasing the bank's asset-liability mismatch. This study proposes an integrated and flexible framework to support a preferential collateral asset selection process for lending banks. Two multi-criteria decision making methods are critically compared and evaluated, in order to gain insight into the identification, evaluation and ranking process of important quantitative and qualitative collateral selection criteria. Bank shipping finance is undertaken as an empirical case study.
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Loan collateral assets are critical complementary bank credit instruments, pledged to a bank loan, and intended to support and secure the enduring performance of a credit facility. In technical terms, ‘collateral’ refers to a lender’s right to possess the asset used as security on a borrower’s potential default or bankruptcy and implies that the lender has developed either a security interest (i.e., the bank reserves the option to liquidate the asset) or a collateral assignment (i.e., possessory right on the asset, based on which a lender can take legal action for infringement). In fact, collateral assets decrease the riskiness of a given loan, since the lender acquires a specific claim on the underlying asset without diminishing his/her general claim against the borrower.
As a bank security mechanism, collaterals are considered an important mechanism to decrease credit rationing and credibly signal borrowers’ quality (Sharpe, 1990; Rajan & Winton, 1995; Gup, 2011). In general, two types of collaterals can be distinguished (Chan & Kanatas, 1985). First, a borrower can pledge as collateral, assets that are used in a project under finance (‘inside collateral’). In case the borrower defaults, the control of the project and the ownership of the depreciated assets shift to the lender, although renegotiations may be possible (Laurin & Majnoni, 2003). Second, the borrower can pledge as collateral, assets that are not used in a project under finance (‘outside collateral’) (Berger & Udell, 1990). As an extreme case, the creditor may take title to and physical possession of the collateral asset over a debt’s maturity span. Furthermore, collateral assets can be distinguished into personal and physical types (Riles, 2011). In the former type, the provider is basically liable with his/her entire fortune. Personal collaterals include suretyship, guarantee, letter of support and collateral promise. In the latter type, the lender receives a specific security interest in certain assets of the borrower/collateral provider. Physical collaterals include real estate prenotation, mortgage, pledge of tangible assets (securities, goods and bills of exchange), security assignment and retention of title.
From a bank perspective, collateral typically refers to secured (asset-based) lending and frequently includes unilateral obligations, secured in the form of property, surety or guarantee. From a firm perspective, the ability to pledge collateral enhances a firm's debt capacity, provides outside investors the option to liquidate pledged assets against potential losses and enforces a strong disciplinary mechanism on borrowers. Therefore, the asset value in case of liquidation plays a key role in determining a firm's debt capacity. On the other hand, collateral asset value damages (depreciations), particularly during business cycle downturns, can depress investment and potentially amplify recessionary trends (Gavalas & Syriopoulos, 2014a). Empirical evidence indicates that firms are less inclined to raise debt following an exogenous collateral asset value decline (Gan, 2007), whereas collateral redeployability affects the cost of debt (Benmelech & Bergman, 2009).