Advanced Credit Risk Analysis and Management

23

Collaterals and Covenants

In the previous chapter, we have discussed how collaterals can help in improving LGD as well as RAROC. In this chapter, we will examine the various collateral securities available and the different ways of taking security and we will discuss the importance of financial and non-financial covenant.

A creditor can take the security in many forms, which can be broadly divided into two groups.

23.1 TANGIBLE SECURITY

Tangible securities are, as the name implies, tangible – physical, real and in some kind of material form. They are the material assets of the borrower held in the creditor's name or possession and in most cases they can be realized or sold at the creditor's discretion if the customer fails to settle the credit obtained. Some of the major tangible securities are as follows.

23.1.1 Deposits (with Banks, Financial Institutions, etc.)

Cash deposits are a very satisfactory form of security. Such deposits do not depreciate in value and in case of default the creditor can realize the security without much hassle, legal issues or expense. For example, the chairman of a company may place a cash deposit in an account in his own name to secure a credit extended to the company. If the cash deposits are with a third party, before disbursing the credit, a confirmation should be obtained that a lien over the deposit has been recorded and that the deposit funds will be freely transferred if required.

23.1.2 Stock and Shares

Shares quoted on a stock exchange ...