Collateral management is not very popular in the microfinance sector. This is due to the fact that, the loan sizes are small and clients are largely expected to be in groups. Where individual methodology is applied, other methods of collateralisation – receivables or inventories from clients are used instead of fixed assets. Collateral management is common in the mainstream banks and other big financial institutions. They have the resources, expertise and systems to monitor and manage collaterals for their clients.
On the whole, MFIs that take collateral also experience large defaults on their loans. This is due to three main factors: –
- The MFIs do not have the expertise in managing collaterals
- Poor clients assume that their collateral is in lieu of the loan repayments
- Collaterals do not sell quickly to defray debts for the needed liquidity – thereby leading to MFIs stacking their cash in fixed assets which eventually lead to capital adequacy problems.
While it is a requirement for all individual loans in Ghana to provide some form of collateral, it is not a requirement in Myanmar in the microfinance sector. In fact, it is illegal, under the Financial Regulatory Department’s (FRD’s) directives, for the MFI to demand collateral. It is only the banks that can require collateral and not the microfinance institutions.
Nonetheless, we shall look at the collateral issues as applied mainly in the banking sector.
What is known as “collateral” is the set of assets, in the form of securities or cash given as security by the debtor to the creditor in order to hedge the credit risk of the financial transactions negotiated between two parties. In case of default by the debtor, the creditor is entitled to retain the assets given as collateral in order to compensate the financial loss suffered.
The use of giving collateral, or “collateralising” operations, has undergone constant development in recent years and the financial crisis of 2007-2008, of course, resulted in even greater development. The implementation of the Basel II agreements, which reduce the capital requirement for operations covered by collateral, also contributes to the interest in this practice. The management of available collateral, which can be used as security for a debt, thus becomes a strategic issue for the actors.
In contrast, the organized markets and the associated clearing-houses, by concentrating the reciprocal exposures of the actors, allow to reduce these collateral requirements (even if some collateral is required to contribute to the compensation, it takes less than what would be needed to cover the same volumes negotiated in a bilateral agreement!).
The transfer of collateral is a common practice in Over the Counter (OTC) markets. Over-the-counter (OTC) or off-exchange trading is done directly between two parties, without the supervision of an exchange. It is contrasted with exchange trading, which occurs via exchanges. The best known collateralised transactions are the repos or repurchase agreements, which are cash loans secured by securities. Securities lending and borrowing are loans of securities backed by cash or securities collateral. In the OTC derivatives market (swaps, credit derivatives), securing transactions by collateral has also become widespread.
The rules for the management of collateral are then usually defined in a bilateral agreement (framework agreement) signed by both parties prior to the start of negotiations. The agreement stipulates a number of elements that will be detailed below: the types of assets transferred as collateral, the rules for valuing these assets, the thresholds of margin calls, whether the collateral received may be reused (“rehypothecation”), etc.
Participation to clearing
The organized markets of securities or derivatives generally run in conjunction with a clearing-house. The clearing-house replaces the participants, becoming the buyer for all sellers, and the seller for all buyers (novation mechanism). Thus it assumes the counterparty risk in their stead. To hedge against this risk, it will ask for security deposits, therefore for collateral, whose value will be calculated according to the positions opened by the participant. The daily re-evaluation of these positions based on market prices leads to margin calls.
Refinancing operations of the central bank
Commercial banks can find funding from the central bank of their country of residence. Within the Eurosystem, as indeed in most countries, these loans are only granted by the central bank against collateral given as security. Credit institutions may also give as collateral credit claims on non-financial debtors (corporates), which roughly corresponds to the old abandoned practice of “discounting”. Here too, specific rules define the eligibility of such mobilized claims.
Choice of the assets offered as collateral
The collateral can either be negotiable securities or cash – private claims used as part of the refinancing of credit institutions of the Eurosystem is a very specific case, although widely used in this context.
In the United States, “performance bonds” are also widely used. A performance bond is a document issued by a bank or insurance company for a third-party whereby the institution commits to cover the debts of the latter in case of failure, usually up to a maximum amount.
When it comes to negotiable securities, these are generally chosen among a pool of low-risk securities (government securities or coming from issuers rated triple-A by the credit rating agencies). They must also be liquid enough to enable the creditor, in case of default, to easily recover his debt by selling them on the market. In order to avoid unnecessary complications, it is preferred to avoid using securities coming to maturity or that pay a coupon during the lifetime of the hedged transaction. It is also good practice to avoid using collateral whose market value is closely related to the valuation of the contract covered (double default risk).
When it comes to cash, it is usually remunerated by the creditor at the market rate.
The different ways to transfer collateral
The collateral may be transferred in full ownership from the debtor to the creditor against the commitment by the latter to return the same quantity of the same security or the same amount of cash at the maturity of the debt. In this case, the creditor can possibly (depending on the agreement previously negotiated) reuse this collateral as security in other transactions. If the collateral is received in the form of cash, the creditor will obviously invest it since he usually agrees to remunerate the debtor in this case.
The collateral may also be pledged. In this case, the delivered securities remain the property of the debtor, who may dispose of them at will, even if it means bringing another security ins its stead to keep covering his debt. When securities are dematerialised, they are registered in an account of financial instruments which is itself pledged for the benefit of the creditor.
The collateral can be transferred directly from the debtor to the creditor who is its custodian until the maturity of the debt covered. It can also be managed by a trusted third party. This is called “tri-party collateral”. This practice is widespread in the repo market; it is called in this case “tri-party repo”. Indeed, the tasks related to collateral management are a burden, which explains that some institutions prefer to reduce their back-office workload by outsourcing this activity.
Collateral management patterns
The collateral may be linked to the contract, that is to say, that each transaction is guaranteed individually by one or several lines of securities. Conversely, each line of securities transferred as collateral is bound to a single transaction. The problem with this management method is its lack of flexibility whenever there exist several outstanding transactions between both parties. For example, if the debtor has given the same security twice, for two different operations, and wants his security back, then two substitutions of collateral will be needed (one per transaction).
The collateral can also be managed in a pool. In this case, the debtor provides the creditor with a pool of assets whose aggregate value shall cover all outstanding transactions. This way, substitution of collateral is easier.
Calculation of exposure
Of course, the commitments of both parties in bilateral negotiations are most frequently reciprocal, so that each party is exposed to a default of the other. In this case, the agreement should define whether the exposure calculations provide a netting of commitments or not.
- If netting is allowed, then only the party whose exposure is negative (its liabilities exceed its debts) must post collateral to the other one, to the extent of the difference. This practice is prevalent in the OTC derivatives market.
- If netting is not allowed, then each party shall deliver collateral to the other one up to its gross exposure. This second method obviously requires more collateral. This is the basic scheme of a repo, where the collateral remains associated with the cash loan transaction.
- An intermediate solution is to systematically deliver collateral during the introduction of each new contract and to always return it at maturity, for an amount equal to the market value of the contract. Only daily variations of contracts and collateral via margin calls are then being made on a net basis.
Valuation of collateral and of transactions
At regular intervals, usually every day, the stock of collateral must be revalued, as well as the stock of contracts (on the OTC market) or open positions (in organized markets) that the collateral is supposed to cover.
The open contracts are valued at their market value or Mark to Market (MTM). Depending on the type of contract, the valuation takes into account the characteristics of the negotiated transaction (nominal value, rate…) as well as the observed market prices. The valuation may be affected by a margin, usually above 100%, that is to say, the value of the contract will be overestimated in order to demand more collateral. This valuation determines the exposure, in other terms the loss the contract holder is exposed to in the event of the counterparty default.
Similarly, the collateral is valued at its market price. The collateral value may be affected by a discount or haircut, that is to say, that it will be valued at a price less than its theoretical market value, again in order to demand more collateral. The haircut can depend on the nature of the collateral. Cash will have a haircut of zero because such collateral is the safest and easiest to liquidate in case of default. Depending on the nature of the issuer, the size of the haircut for securities will vary.
The margin or the discount (haircut) is of course specified in the framework agreement which binds both parties. Both mechanisms are intended to offer a safety margin to the creditor, in order to take into account possible fluctuations in the value of collateral between two margin calls. They are rarely used simultaneously.
On the OTC market, each party revalues all outstanding transactions and the stock of collateral given or received, then both parties compare their results. Obviously, there is often disagreement, which may come from differences in the selected price source, or from errors in the stock of contracts. A reconciliation of open positions of both sides may be necessary. This processing is highly demanding on technical and human resources, hence the need to resort to a third-party (tri-party repo).
In organized markets, open positions are valued by the clearing-house for its direct members. A widely used method is the SPAN method (Standard Portfolio ANalysis) developed by the CME (Chicago Mercantile Exchange) and used by many clearing-houses including LCH.
Regarding central banks, their refinancing operations and the associated collateral are obviously revalued by the central bank itself.
Security deposits and margin calls
The “initial margin” is a security deposit that designates the initial amount of collateral used to cover a new position. A threshold can be defined: open positions will be covered only once their value has exceeded this threshold.
Margin calls denote the flow of collateral exchanged with each revaluation of the stock. Again, to avoid unnecessary expenses, a threshold is set below which the exchange will not occur.
Substitution of collateral
The debtor may ask to recover all or part of a line of securities deposited as collateral. In this case, he will have to replace the returned collateral by another asset of equal value.
In general, it is preferred to avoid giving as collateral a security that may be subject to a corporate action (e.g. payment of a dividend) during the time of the deposit. Should this happen, however, the usage is to return the proceeds of the corporate action to the original owner of the security.
As stated in the introduction of this article, collateral management should as much as possible be avoided by the MFI since they do not have the system in place to take care of them. But if an MFI does, it must have the structures and the personnel in place to manage it effectively. MFIs are strongly advised to avoid the SME Loans, loan sizes that are big enough to call for collaterals. With this, they will be able to manage their portfolios in a very effective manner.
In the next publication, we shall look at some definitions in relation to the collateral management and we shall look at the example of Ghana’s Collateral Registry system.