What is Quality of Collateral?

What is Quality of Collateral?

Alternatively, quality of collateral refers to how well a lender can collect on the economic benefits of assets used to secure a loan in case the borrower defaults.

Quality of collateral is related to the overall condition of a certain asset that a company or an individual wants to put as collateral when borrowing funds from a lender (e.g., bank). Collateral secures the lender’s funds if the borrower faces bankruptcy. Alternatively, quality of collateral refers to how well a lender can collect on the economic benefits of assets used to secure a loan in case the borrower defaults.

The overall condition of an asset includes:

  • Physical condition (for tangible assets)
  • Estimation of the asset’s liquidation value
  • Liquidity (the extent of the asset’s ability to be converted into cash within one fiscal year or less than a 12-month period)
  • Magnitude and nature of the asset (scale and type)

*Note that since different types of assets can be pledged as collateral, the criteria and methods for assessing the collateral’s quality vary.

Studies on Quality of Collateral

 According to a study on collateral quality and loan default risk in the transition economy of Vietnam, the researchers, after analysis of 2,296 internal loan accounts in the country, conclude that a high-quality collateral not only implies a more credible borrower but also stipulates a stable proper behavior while using the loan, such as making repayment installments on time and overall excellent borrower’s commitment to the repay the debt.

Therefore, it enables banks to mitigate risks of adverse borrower’s selection and the problem of moral hazard. A moral hazard occurs when one party starts to be involved in risky activities knowing that the other party will incur the associated costs if the risks arise.

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Quality of Collateral and Probability of Default

Quality of collateral tests are performed to get a deep understanding of whether the underlying asset of collateral meets all the lender’s criteria.

Stable companies with a low probability of default will typically pledge strong collaterals (high-quality assets), thus making the loans cheaper because they bear a lower interest rate. Therefore, there is a straight correlation between the quality of collateral and its value. 

The value or quality of assets is a very crucial indicator of potential credit risk a lender will bear by initiating loans. Therefore, credit analysts pay a lot of attention to the accurate value estimation of an asset and, thus, its quality.