Collateral (Security Interest) - Definition
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What is Collateral?
Collateral is an asset that is used as a pledge against a financial obligation, such as a loan or bond. Generally, collateral may be repossessed by the secured entity and sold if the underlying obligation is not paid.
When is Collateral required?
Collateral is used to mitigate risk. Some common types of risks include:
- Payment delays and default and liquidity risk
- Geographical and sectoral risk diversification.
- Money flows' predictability
- The asset's legality and regulatory framework
- Additional assurances that are associated with the collateral
- Cross-collateralization where a group of assets is used so that in the case of failure of one the rest can be used to cover that asset.
Academic Research on Collateral
- Asymmetric valuations and the role of collateral in loan agreements, Chan, Y. S., & Kanatas, G. (1985). Journal of money, credit and banking, 17(1), 84-95. This paper examines the role played by collateral in the type of loan contract where the collateral is an additional asset that will be lost in the case of a default. It focuses mostly on the case where the borrower cannot take action that will change the return to the lender.
- Credit ratings, collateral, and loan characteristics: Implications for yield, John, K., Lynch, A. W., & Puri, M. (2003). The Journal of Business, 76(3), 371-409. This article investigates how collateral affects the yield of bonds and uses a big data set of public bonds to document that collateralized debt has a higher yield compared to general debt after the control for credit rating.
- Collateral, loan quality and bank risk, Berger, A. N., & Udell, G. F. (1990). Journal of Monetary Economics, 25(1), 21-42. This article presents empirical evidence that shows collateral is mostly associated with riskier borrowers, riskier loans and riskier banks.
- The loan market, collateral, and rates of interest, Barro, R. J. (1976). Journal of money, Credit and banking, 8(4), 439-456. This study creates a theoretical model in which collateral is used as a mechanism to enforce loan contracts.
- Collateral and rationing: sorting equilibria in monopolistic and competitive credit markets, Besanko, D., & Thakor, A. V. (1987). International economic review, 671-689. The main focus of this paper is finding out the role of market structure in credit allocation when there is an informational asymmetry.
- Collateral, type of lender and relationship banking as determinants of credit risk, Jimnez, G., & Saurina, J. (2004). Journal of banking & Finance, 28(9), 2191-2212. This article analyzes the determinants of the probability of default of bank loans and discusses the role of a limited set of variables while controlling for the explanatory variables.
- Incorporating collateral value uncertainty in loss given default estimates and loantovalue ratios, Jokivuolle, E., & Peura, S. (2003). European Financial Management, 9(3), 299-314. This paper presents a model of risky debt which has a collateral value that is correlated with the possibility of default. The model is used in the study of expected loss given default mainly as a function of collateral
- Collateral and competitive equilibria with moral hazard and private information, Chan, Y. S., & Thakor, A. V. (1987). The Journal of finance, 42(2), 345-363. This is an examination of the equilibrium credit contracts and allocations under differing specifications and an explanation of the economic roles of collateral under these specifications competitively.
- Loan collateral decisions and corporate borrowing costs, Booth, J. R., & Booth, L. C. (2006). Journal of Money, Credit and Banking, 67-90. This paper examines the borrowing costs' relationship with the presence of loan collateral and finds out that the presence of loan collateral increases with default risk.
- Role of collateral and personal guarantees in relationship lending: Evidence from Japan's SME loan market, Ono, A., & Uesugi, I. (2009). Journal of Money, Credit and Banking, 41(5), 935-960. This is an investigation of the determinants of the use of collateral and personal guarantees in SME loan market of Japan.
- The role of collateral in a model of debt renegotiation, Bester, H. (1994). Journal of money, credit and banking, 26(1), 72-86. This paper uses a simple model of borrowing and lending to with asymmetric information to determine how the prospect of future debt renegotiation affect the lender's security interests at the contracting date.
- Collateral pricing, Benmelech, E., & Bergman, N. K. (2009). Journal of financial Economics, 91(3), 339-360. This study uses a data set issued by US airlines to examine how collateral affects the cost of debt capital and to construct industry-specific measures of collateral deployability.