Collateral management

From CEOpedia | Management online


Collateral management is a method of operating used by managers when they are dealing with collaterals. It includes monitoring, assuring and advising on collateral transactions (P.C.Harding, Ch.A.Johnson 2002,p.12). In a situation when a small or corporate bank doesn't possess the internal resources or the amount to set up its collateral management unit, it can always outsource these operations. Using the third party is recommended when each party is small (P.C.Harding, Ch.A.Johnson 2002,p.29).

The purpose of collateral management units

Collateral management units are dealing with (P.C.Harding, Ch.A.Johnson 2002,p.12):

  • recording relationships in the collateral management system
  • checking collateral received on the agreed mark to market frequency
  • conducting special collateral projects
  • asking for an initial margin if necessary
  • coping with failures in delivering securities collateral and cash margin
  • filing the agreed "haircuts" to collateral
  • coordinating collateral valuations of sundry branches
  • being involved in collateral agreement negotiation
  • rechecking the same thing whether a margin call has been given from a counterparty
  • coping with instances for collateral substitutions

Types of collateral

The two the most popular types od collaterals are bond and cash (M.Simmons 2019, p.7).

Cash collateral is usually given in British Pounds (GBP),US Dollars (USD) AND Euros (EUR). In a situation when firm's exposure is the same currency as the collateral from the counterparty, there is no foreign exchange (FX) risk. That is because there isn't any conversion to be made. Contrary, If the firm is in possession of the same USD exposure, although is given another currency as collateral, there is a risk of exposing the firm to FX currency rate movements. It might end with collateral having a lower value than the firm's exposure (M.Simmons 2019, p.7).

Bond Collateral happens when the borrower is offering his property or assets as a security measure to receive money from the lender. When the borrower id failing to give back the money, the person who lends it can retrieve it by acquiring the borrower's property or assets (M.Simmons 2019, p.7).

Examples of bonds:

  1. Fixed Rate Bond has a fixed coupon rate. It is also providing the lender with an unchanging fixed-rate throughout the bond's lifetime. Moreover, the first payment is often made one year after issuing the bond. Additionally, the price of the bond is going to change according to laws of supply and demand(M.Simmons 2019, p.10).
  2. Floating Rate Notes (FRN) is a bond, whose rates are based on a defined floating benchmark rate. The payments are made when coupon rates are changing. Some of those bonds are issued with repayment of capital at par and no payments of interest(M.Simmons 2019, p.11).
  3. Zero-Coupon Bonds is also a type of bond that is issued with repayment of the capitol at par. The most unusual feature of this band is the fact that is a non-interest-bearing bond. This type of bond is issued highly discounted from par(M.Simmons 2019, p.12).

Examples of Collateral management

  • A bank may require a borrower to provide collateral to secure a loan. Collateral is typically an asset, such as a house, a car, or other valuable property, which the borrower pledges to the lender in exchange for the loan. If the borrower defaults on the loan, the lender can take possession of the collateral and sell it to repay the loan.
  • A company may use collateral management to secure a line of credit. Collateral is typically assets owned by the company, such as inventory, accounts receivable, or real estate. The collateral is pledged to the lender to secure the loan. If the company fails to make the required payments, the lender can seize the collateral and use it to repay the loan.
  • A hedge fund may use collateral management to secure investments. The collateral is typically securities, such as stocks and bonds, which the hedge fund pledges to the lender as security for the loan. If the hedge fund fails to make the required payments, the lender can seize the collateral and sell it to repay the loan.
  • An insurance company may use collateral management to secure a reinsurance contract. The collateral is typically assets owned by the insurance company, such as cash, investments, or real estate. The collateral is pledged to the reinsurer to secure the contract. If the insurance company fails to make the required payments, the reinsurer can seize the collateral and use it to repay the loan.

Advantages of Collateral management

Below are the advantages of collateral management:

  • Collateral management allows for greater liquidity, which reduces the cost of borrowing for companies. This helps businesses to access funds quickly and efficiently, allowing them to invest in short-term projects and take advantage of market opportunities that require quick decisions.
  • Collateral management also helps to reduce risk in lending activities by providing lenders with an additional layer of security through collateral. This helps lenders to make more informed decisions and to ensure that they are not exposed to excessive risk.
  • Collateral management also provides a more comprehensive view of a company’s financial situation, as it allows lenders to analyze the collateral and other assets held by the company. This gives lenders an accurate picture of the company’s financial health, which helps them to make more informed decisions.
  • Collateral management also helps to improve transparency in the lending process, as lenders can easily access the information they need to make informed decisions. This helps to create a fairer and more efficient lending market, as lenders can assess their risk more accurately.
  • Finally, collateral management can help to reduce the amount of time required for a loan to be processed, as lenders can access the information they need quickly and easily. This helps to speed up the loan process, allowing companies to access funds quickly and efficiently.

Limitations of Collateral management

Collateral management is a financial tool used to protect parties in a financial transaction from potential losses. Although collateral management is an effective tool, there are some limitations that need to be considered. These include:

  • Lack of liquidity: Collateral management can tie up funds which can reduce liquidity, making it difficult to access funds quickly.
  • Cost: Collateral management can be expensive due to the costs associated with setting up the collateral, monitoring it and liquidating it if necessary.
  • Credit Risk: Collateral management does not provide full protection against credit risk and can expose the parties to potential losses due to defaults.
  • Complexity: Collateral management can be complex to setup, manage and monitor, and can become a bureaucratic process.
  • Legal Issues: Collateral management can be difficult to implement and enforce when there are legal issues involved in the underlying transaction.

Other approaches related to Collateral management

Financial management includes many other approaches related to collateral management. These include:

  • Risk management - this involves assessing the risks associated with collateral and determining the best strategies to manage them. This includes monitoring market conditions, analyzing creditworthiness of borrowers, and assessing the liquidity of collateral.
  • Portfolio management - this involves creating a portfolio of collateral to ensure that its value is maintained. This includes diversifying the portfolio across different asset classes, managing the portfolio’s liquidity and risk, and rebalancing the portfolio when necessary.
  • Valuation management - this involves ensuring that the collateral is accurately valued on an ongoing basis. This includes using valuation models, conducting independent appraisals, and maintaining records of collateral values.
  • Reconciliation management - this involves reconciling collateral data across multiple systems and ensuring that it is up-to-date and accurate. This includes reconciling differences in pricing, classification, and ownership.

In summary, financial management includes various approaches related to collateral management, such as risk management, portfolio management, valuation management, and reconciliation management. These approaches help to ensure that the value of collateral is maintained and that it is accurately reconciled across systems.


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References

Author: Witold Urjasz

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