Collateral

Collateral is an asset pledged by a borrower to a lender as security for a loan. If the borrower defaults, the lender has a claim on the collateral, which can be sold to recover the amount owed. Collateral reduces the risk borne by the lender and expands the borrower's access to credit.

Function

Collateral addresses the problem of information asymmetry between borrowers and lenders. Because the lender can seize the collateral in the event of default, the borrower has an incentive to repay, and the lender is protected against loss. The presence of collateral reduces the risk premium the lender demands and lowers the cost of borrowing.

The value of collateral depends on its marketability, its volatility, and the legal framework for its seizure and sale. Assets that are liquid and whose value is stable make better collateral, and jurisdictions with effective contract enforcement support the use of collateral.

Types

Collateral can take many forms. Real estate is commonly used to secure mortgages. Financial assets, including securities and deposits, are used to secure loans and repo transactions. Inventory, receivables, and equipment are used to secure business loans. Personal guarantees and third-party guarantees provide additional security.

In secured lending, the collateral is identified and the lender's claim is registered, giving the lender priority over other creditors. In unsecured lending, no specific collateral is pledged, and the lender relies on the borrower's general creditworthiness.

Margin and Haircuts

In secured financing, the lender advances less than the value of the collateral, with the difference, the haircut, providing a buffer against declines in the value of the collateral. The size of the haircut reflects the riskiness and volatility of the collateral, with riskier assets requiring larger haircuts.

Changes in the value of collateral affect borrowing capacity. When asset prices rise, collateral values increase, and borrowing capacity expands, potentially fuelling further price increases. When asset prices fall, collateral values decline, borrowing capacity contracts, and borrowers may be forced to sell assets, amplifying the decline. This mechanism, known as the financial accelerator, is central to the analysis of credit cycles.

Legal Framework

The effectiveness of collateral depends on the legal framework governing secured transactions, including the rules for creating, registering, and enforcing security interests. In jurisdictions with weak frameworks, lenders face greater difficulty in seizing and selling collateral, and credit may be less available or more costly.

Reforms to secured transactions law, including the establishment of collateral registries and the streamlining of enforcement, can improve access to credit. The design of these reforms is a central element of financial sector development and of the improvement of the business environment.

Collateral and Credit Availability

The availability of collateral affects the access to credit and the terms on which it is offered. Borrowers with collateral can obtain larger loans and lower rates, while those without collateral face higher rates or may be unable to borrow.

The relationship between collateral and credit availability is central to the analysis of credit markets. Changes in the value of collateral, driven by movements in asset prices, affect borrowing capacity and can amplify credit cycles.

Haircuts and Margin

Haircuts and margin requirements determine the amount that can be borrowed against collateral. The size of the haircut reflects the riskiness and volatility of the collateral, with riskier assets requiring larger haircuts to protect the lender.

Changes in haircuts affect borrowing capacity. During periods of stress, lenders may increase haircuts, reducing the amount that can be borrowed against a given collateral and forcing deleveraging. The use of margin and of margin calls is central to the management of risk in secured financing.

Secured Transactions Law

The legal framework governing secured transactions determines the ease with which collateral can be used and the effectiveness of the lender's claim. The framework includes the rules for creating, registering, and enforcing security interests, and the priority of claims in the event of insolvency.

Reforms to secured transactions law, including the establishment of collateral registries and the streamlining of enforcement, can improve access to credit and reduce its cost. The design of these reforms is a central element of financial sector development.

Collateral in Monetary Operations

Central banks accept collateral in their monetary operations, lending against eligible assets. The range of eligible collateral and the associated haircuts determine the reach of central bank operations and the conditions under which institutions can obtain liquidity.

The design of collateral frameworks affects the transmission of monetary policy and the functioning of markets. During periods of stress, central banks may broaden the range of eligible collateral and reduce haircuts, supporting the flow of liquidity.

See also

• Financial Asset
• Liquidity Risk
• Private Property Rights