Collateral Management in Finance

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Collateral management is the procedure used by financial institutions to reduce credit risk when they make unsecured financial transactions. Collateral management systems used to play a subsidiary role in financial circles, however, in the last twenty or so years, it has rapidly evolved due to the stratospheric application of cutting-edge technology, greater financial industry competition, increased leverage, the securitisation of asset pools, and counter party risk from the broad application of derivatives. To that end, it has become mainstream practise, and interrelated and complex functions such as: credit risk, repossessions, multilateral collateral, collateral outsourcing, collateral arbitrage, and counter party credit limits, are all now encompassed under the umbrella of collateral management. In over the counter financial transactions, the banking industry predominantly utilises collateral as a form of bilateral insurance, and this method is regarded as the most efficient for mitigating market risk and credit risk for transactions related to securities.

What are the differtent types of collateral?

The collateral management process allows various forms of collateral. This includes: securities which are usually high level government notes or bonds, stocks and shares, cash, freehold residential and commercial property, leases, works of art such as valuable paintings and antiques, precious metals such as gold, diamonds, and valuable jewellery, etc.

Managing collateral

When a collateral management process is functioning at an optimum level, the lending organisation actively rebalances its financial exposure to the loans it has given out, by demanding or releasing collateral to or from the borrower, according to fluctuations in the market, (for example, a fall or surge in house prices). This way, it actively rebalances its exposure, and strives to offset any potential losses. If the collateral management system is effective, the re-evaluations are made frequently in order to determine the collateral “Fair Value” which the lender could, if necessary, recover.

What happens if the borrow is unable to pay back the loan?

There is a legal agreement in the collateral management systems process, and the collateral acts as a guarantee to ensure that the money borrowed is returned on a predefined date; therefore, if the borrower defaults and is unable to fulfil this part of the contract, and does not pay the money when due, then this is legally classed as a default, and the lender has the legal power to dispose of and sell the collateral, so that the sum borrowed can be recouped.

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