- February 8, 2024
Over-collateralization in Loan Transactions
Availability of credit and at competitive prices are major factors that promote the growth of businesses. Two of the main problems that face Ghana’s small and medium-scale enterprises arethe unavailability of credit and the cost of credit. A critical look at this problem reveals that it is not primarily unavailability but rather, the conditions for accessing available credit that most entities are unable to meet. In particular, the requirements for businesses to provide comfort to financial institutions on their ability to repay the loan and acceptable collateral as a fallback measure in the event that they are unable to repay.
We will take a look at the issues relating particularly to collateral arrangements from both the perspective of borrowers and lenders.
Funding of Businesses
Businesses require capital for their operations to generate income. Capital is provided in two main ways – through the resources of the business owner or by borrowing from relatives, friends, business associates or financial institutions. Financial institutions lend money to make money. Two factors primarily determine the ability of businesses to obtain credit from financial institutions – first, the legal capacity of the entity and second, its creditworthiness.
For a business to be credit-worthy, it must demonstrate its ability to repay the loan given. It can do this by showing that there are potential future receivables that will be available to repay the loan. A business must demonstrate that:
Lenders will look at the whole business cycle of the entity to conclude on the above factors. Assessing the operations of the business including its potential income is, therefore, key to the ability of the business to secure credit. This will also include looking at the borrower’s previous financial statements to determine the past financial performance of the business. In spite of the borrower’s ability to meet the above conditions, there are events that could happen in the future which may affect the above factors. Lenders, therefore, want a fallback measure to recover loanswhere such future events occur. This introduces the issue of collateral. Typically, if lenders are assured of the above position, the issue of collateral may not arise.
Collateral generally covers fallback guarantees and securities available to a lender in the event the borrower defaults in repaying the loan as agreed under the loan agreement. Collateral or security interest may generally cover:
Collateral is a fallback measure. Lenders do not grant a loan primarily with a view to enforce the fallback measure (collateral). Lenders must, therefore, require and obtain any of the above collateral only after assessing that there are potential risks to the operations of the business which may affect the future receivables that will be used for the repayment of the loan.
Imagine you have a house valued at Ghc150,000. You have applied to the bank for a loan of GHc10,000 for your company and the bank has requested the house as collateral. In addition, the bank has asked that you provide a personal guarantee in the event the company is unable to pay. Then, for good measure, the bank has asked that you pledge your shares in the company as collateral. This situation is the over-collateralization situation. Another example may be where on an application for a personal car loan, the financial institution requires a guarantee from your employer, your salary to be passed through the financial institution with charge over the account, a charge over the car, assigning proceeds from comprehensive insurance over the car, and taking life insurance with proceeds assigned to the financial institution. This is after the usual requirement for the borrower to pay upfront 10 – 25% of the cost of the car. The situation can be compared to intending to kill a fly with a sledge-hammer. From the borrower’s perspective, that is problematic. The issue of over-collateralization has been one of the silent factors discouraging businesses from accessing credit.
Whilst financial institutions may see it as fully underwriting all possible risk, this adds to the cost of credit particularly since the security documents must be stamped and perfected. The cost of stamping is 0.5% of the secured amount for the principal security, and 0.25% of the secured amount for each additional security. It does not matter if all the security are included in the same document. This must be a problem for the financial institution itself as it makes the institution less competitive. Such cost, together with the interest charged, processing and other applicable fees make the cost of obtaining a loan prohibitive for businesses. This feeds into the narrative of high cost of lending. In order to be competitive, financial institutions must be mindful of the type of security and number of securities to take as a fallback position in the event of default of the borrower. A number of ways are suggested below for consideration by financial institutions.
Any of the suggestions below must be implemented within the context of assessing the potential risks that the collateral is to cover. In order to avoid over-collateralization, the following can be implemented:
The suggestions above are not exhaustive and must be implemented within the specific context of the risk exposure the financial institution intends to cover.
It is important for businesses, especially small and medium–scale enterprises, to always assess the cost of borrowing prior to entering into any financial transaction. A business must check its financial health and ensure that repayment of loans will not have the potential to cripple the business. Where security is required, the business must ensure that the security provided is commensurate with the loan amount plus interest. As much as possible, businesses should attempt to negotiate fair collateral packages rather than settling for over-collateralized loans out of desperation for a loan. Financial institutions should have policies on requirements for collateral and nature of security to take. This will feed into the competitiveness of financial institutions.
Many businesses require financing for growth and financial institutions also need to provide these credit facilities in order to grow. Although lending and borrowing may seem like an everyday transaction and fairly straightforward, it is particularly important for lenders to aim at reducing credit cost while providing financing to businesses. This will make loans more accessible for all types of businesses and will ultimately contribute to business and financial growth for both lenders and borrowers. A win-win for all.