In corporate loan underwriting, collateral acts as a safety net for lenders, reducing the risk of loss, and making sure that the lender can recover their funds if a borrower defaults.
Typically, the size of the loan a lender provides ranges from 70% to 90% of the collateral’s value. This significant margin shows the importance of accurate collateral valuation.
In this scenario, a proper valuation builds trust, promotes fair terms, and supports a secure, balanced lending relationship that benefits both the lender and the borrower.
But how is the collateral valued? Let’s take a closer look.
What Is Collateral Value in Corporate Loans?
Collateral value refers to the monetary worth of assets pledged by a borrower to secure a loan. These assets may include real estate, inventory, machinery, accounts receivable, or intellectual property.
The valuation determines how much financial security the collateral provides to the lender. A well-assessed collateral ensures that, even in the worst-case scenario, the lender can recover the loan amount by liquidating the pledged assets.
The type of collateral plays a key role in its valuation and loan terms. For instance, marketable securities are often the most valuable collateral due to their liquidity.
Real estate ranks next, followed by accounts receivable, inventory, fixed assets, and blanket liens. So, each type comes with its own risks and impact on lending decisions.
Importance of Collateral Valuation in Underwriting
Collateral valuation plays an important role in credit risk management during the underwriting process. It ensures that lenders and borrowers are on the same page about the value of pledged assets.
Here’s why it matters:
- Risk Mitigation: Proper valuation ensures the loan is backed by sufficient assets, minimising potential losses.
- Borrowing Costs: Loans secured with high-value collateral often come with lower interest rates. According to research, secured loans typically cost 23 basis points less than unsecured loans.
- Regulatory Compliance: Lenders must adhere to legal requirements, and regulatory compliance ensuring fair practices in asset-backed lending.
- Loan Approval Decisions: Accurate valuations influence the lender’s decision on loan amounts and terms.
- Trust Building: For borrowers, a clear and accurate valuation builds trust by ensuring they aren’t over-pledging their assets, while lenders gain confidence in the loan’s security.
The Reserve Bank of India (RBI) regulates collateral valuation practices. For instance, it mandates that the LTV ratio for gold loans must not exceed 75%, ensuring that borrowers do not over-leverage and lenders are adequately secured.
Understanding Loan-to-Value (LTV) Ratios
The Loan-to-Value (LTV) ratio is a key metric in corporate loan underwriting. It compares the loan amount to the appraised value of the collateral.
For example, a ₹500,000 loan secured by assets valued at ₹625,000 gives an LTV of 80%. Lower LTV ratios reduce the lender’s risk, making the loan more secure. Many lenders prefer an LTV of 70-80%, depending on the asset type and industry.
- The different types of collateral also impact LTV ratios.
- Real estate typically has a lower risk of depreciation, making it easier to justify higher LTV ratios, whereas assets like machinery or inventory might lose value more quickly, leading to lower LTV thresholds.
- Seasonal assets, such as agricultural goods, may also lead to lower LTV ratios due to their fluctuating value throughout the year.
- The RBI prescribes specific LTV ratios depending on the asset type. For example, for loans against gold, the LTV ratio must not exceed 75%, while for loans secured by shares, NBFCs are restricted to an LTV of 50%.
Valuation Strategies Used in Corporate Loan Underwriting
Lenders use several strategies to assess the value of collateral:
1. Asset-Based Valuation Techniques
This strategy evaluates an asset’s current worth by considering its replacement cost minus depreciation. For physical assets like machinery, the lender calculates how much it would cost to replace the asset and subtracts depreciation.
For example, a machine costing ₹10 crore with 20% depreciation would be valued at ₹8 crore.
Depreciation rates can vary by industry. For example, manufacturing equipment might lose 10-15% of its value each year, so lenders must adjust valuations based on age and condition.
2. Market Comparison Methods
Also known as the market approach, this method compares the collateral to similar assets recently sold.
For example, if a commercial property sold for ₹16 crore and is similar to the collateral, the lender might use that as a benchmark. This approach is common for real estate and vehicle valuations.
3. Income Approach to Valuation
This method calculates the asset’s value based on its ability to generate future income. For example, a rental property of ₹50,000 annually may be valued using a capitalisation rate of 10%, resulting in a value of ₹500,000.
The income approach formula used to determine the market value of a property is as follows:
Market Value = Net Operating Income (NOI) ÷ Market Capitalisation Rate
Lifecycle of Collateral Management: An Outline
Managing collateral effectively involves several stages called the lending lifecycle management:
1. Eligibility Assessment
The first stage involves determining whether the proposed collateral meets the lender’s criteria. The lender evaluates the asset’s liquidity, legal status, ownership, and potential to cover the loan in case of default.
For example, real estate or machinery might be accepted, but a lender may refuse highly volatile assets such as certain stocks. In some cases, the lender might require the collateral to be insured or have a minimum market value.
2. Booking and Documentation
Once the collateral is deemed eligible, it must be officially recorded. This step includes gathering all necessary documentation, such as asset appraisals, ownership titles, and agreements.
The lender should abide by compliance with legal and regulatory requirements, such as registering liens or other legal claims on the collateral.
3. Maintenance and Monitoring of Collateral
Collateral management is an ongoing process. Lenders frequently monitor the value of the collateral, especially for long-term loans where asset values may fluctuate.
For instance, if the value of real estate declines due to market conditions, the lender may adjust the loan-to-value (LTV) ratio or request additional collateral.
In May 2024, the RBI imposed restrictions on certain NBFCs for regulatory breaches in collateral monitoring and loan practices. This action underscores the importance of regular collateral reassessment
4. Perfection of Collateral Rights
Perfection refers to the legal steps a lender takes to solidify their claim to the collateral.
This often involves registering liens or securing titles, ensuring the lender’s rights take precedence over other creditors in case of default. A perfected lien gives the lender the legal right to seize the collateral if necessary.
Throughout these stages, effective collateral management ensures that lenders are protected from potential risks and can maintain a sound lending portfolio. Regular reassessment, clear documentation, and legal safeguards are required to reduce risk for both parties involved.
Final Note
Collateral valuation is all about managing risks, securing loans, and fostering trust between lenders and borrowers. By understanding valuation strategies, lenders can make informed decisions while borrowers can optimise their financing options.
In this context, Finezza’s cloud-based Loan Management System enhances the entire loan lifecycle by providing a streamlined process that incorporates advanced features to support both lenders and borrowers effectively.
Some of its key features include:
- Multi-Loan Types: Supports various loan types including Tenure Loans, OD Loans, Revolving Credit, Equipment Loans, and Loans against Property.
- Flexible Repayment Frequencies: Options for daily, weekly, fortnightly, and monthly repayments, and moratoriums on principal and interest.
- Multi-Disbursement: Allows for both single and multiple disbursement schedules.
- Flexible Payments Module: Supports various payment methods including NACH, eNACH, cheques, online payments, and UPI.
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