Collateral is an asset that is used as a pledge against various financial operations such as the granting of a loan or issuing of a bond. The credit rating and good behavior of the collateral determine its quality of support.
A Little More on What is Collateral
The collateral is analyzed to assess its operation qualification. When the securities markets were developing, the collateral included mainly mortgage loans, but over time as the financial markets evolved, the variety of assets increased to include others that can be used as either backup or collateral.
In repo operations, collateral is very common. This is because these operations necessarily lead to collateral in financial markets. A repo operation has an exchange between two counterparts. For one, a fixed-income asset is delivered in the form of a bond or a letter while for the other it is delivered as cash to ensure that in a given period the opposite operation is carried out where a fixed-income asset is returned on one side and cash plus interest on the other.
Collateralization agreements are found in the financial derivatives markets, and they protect against the possible default of the counterparty of any of its obligations in a derivative transaction. By using a legal document, these agreements are used to standardize the mechanism of credit risk mitigation and define the deliverable assets to seal the obligation.
The different types of collateral include
- Loans. There are personal loans and loans with real collateral.
- Collection rights. These result from the transactions carried out with individuals and companies who have deferred payment.
- Exploitation rights. These are incomes which are in the form of royalties and fees among others.
- Contracts of services. These are the contracts to supply services such as electricity and gas although they are not in the precise amounts.
Some of the factors that are used to analyze if the quality of coverage of the collateral is desirable 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.
Since repos is mostly used by banks and other companies in obtaining liquidity and is significant for the proper functioning of the bond market, it contains the most common examples of collateral. In a repo, one part has debt securities which are usually risk-free bonds and also requires liquidity. The other part possesses excess liquidity and will thus trade it for the bonds at an interest rate or a ‘repo price.’
This transaction has the same logic as that of the mortgage where the person who makes the loan can secure his position by executing an asset. The collateral to risk-free bonds is limited to maintain the stability of the value serving as collateral.
The US T-bills or the German Bund 10-year bond are usually used as a general rule. In double buy-sell operations, the collateral guarantee appears, and it favors the execution of the transaction of investment-financing and reduces the interest rates concerning them to a riskless operation.
Such guarantees may be the Treasury Bills, Bonds or State Obligations or issuers who are not the state. As they guarantee the transactions, they generate lower interest rates compared to those of the interbank deposit market for that same term.
Mortgage-Backed securities in the US present another collateral example. A Series of ABS bonds are issued, and they pay investors an interest rate that comes together with the payments of the mortgages and then discounts a commission that is for the bank and also for the special vehicle which is created to ensure the off-balance-sheet titration of the bank.
References for Collateral
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, Jiménez, 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 loan‐to‐value 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.