Before advancing loans and advances a bank should make sure that it will get the loan back in time.
Since many borrowers default in repaying loans, borrowers need to deposit assets or give guarantee as a testimony of the assurance of repayment. This asset or guarantee is called the security of credit.
The Economist defines security as;
something of value given to a lender by a borrower to support his or her intention to repay. In the case of a mortgage, the security is the property that the loan is being used to purchase.
Oxford Dictionary of Finance and Banking defines security as “an asset or assets to which a lender can have recourse if the borrower defaults on any loan repayments”.
Hence security is what the borrower puts up to guarantee repayment of the loan. It may include tangible, intangible assets or even personal guarantee.
Kinds of Securities for Bank Credit
- Personal Security: Personal security refers to the guarantee given by the borrower or by a third party in lead of pledging a tangible asset.
Since advancing loan against personal guarantee is very risky banks rarely grant loan against such security unless the borrower has special and long relationship with the bank.The character, integrity, financial solvency, and social status are important factors that are looked into before sanction of loan against personal security.
- Non-personal Security: Non-personal security refers to movable and immovable tangible properties against which loans are granted. This type of security may include land, building, commodities etc.
Non-personal security is safer than personal security. In case the borrower defaults a tangible property can be sold in the market to realize the unpaid amount.
Non-personal security can be charged in the Conn of lien, pledge, mortgage, hypothecation, or assignment.
- Collateral Security: When the lender feels the security provided by the borrower is not sufficient or it may be difficult to recover the dues smoothly, the lender may ask for additional security to be provided by the borrower himself or by others on behalf of the borrower.
In case of any default by the borrower, the collateral securities will come in hand to service and recover the loan.
Features of Good Security/ Canons of a Good Banking Security/ Conditions for Acceptable Securities
While accepting securities bankers need to consider certain factors. Otherwise the odds of getting the loan repaid will be very little and the security will not serve the intended purpose.
These factors are considered to be the essentials of an acceptable security. In what follows we discuss this factors in detail.
In case of Non-personal Security
- Acceptability: The asset accepted as security must be acceptable in the eyes of the law.
Any asset considered illegal to own or possess will put the bank in difficulty at the time of disposing of.
Moreover, the bank may face legal consequences for possession of illegal items.
- Marketability: The security must have a ready market. The bank has not taken the asset to keep it in its possession for an indefinite period but rather to sell it in the market and realize the loan amount.
Hence, no matter how valuable the asset may be it is of no use if it does not have a broad market.
- Liquidity: Liquidity refers to how quickly an asset can be converted into cash or other assets with little or no diminution in value.
Ideally a security should be liquid which will enable the banker to sell l he properly at a known price as soon as the default occurs.
- Ownership: Before accepting a security the banker must ensure the ownership of the property.
An asset which is not owned by the lender may render difficulty in getting the loan repaid. Moreover, if the title of the property is defective the lender may face problem.
- Adequacy: The value of the security must be adequate to cover the full amount of the loan. Moreover, a reasonable margin over the (loan is to be maintained. The margin is the difference between the market value of the security offered and the loan granted.
- Stability of Price: The price of the goods and commodities which are necessaries of life are relatively stable over a short period, though not necessarily over a long period.
But wide variations in the prices of luxury goods take place due to changes in demand, fashions and tastes of the people.
Bankers are generally reluctant to accept the commodities the prices of which are uncertain and fluctuate too widely and frequently.
- Documentation: The banker should see that proper documents such as mortgage deed or the pledge agreement containing all terms and conditions of the mortgage or pledge are executed.
This should be done in order to avoid all future disputes.
- Non-encumbrance: A property or asset which has already been charged against a prior loan from some other lender should be avoided as a security.
Because in that case the banker will have a secondary claim on that particular security.
- Possession: Mere ownership of an asset without its possession may lead to unwanted circumstances for the banker.
Unless the property being considered as a security is in the possession of the borrower (though he is the owner) that property should not be accepted as a security.
If goods are taken as security the banker should take the possession before advancing the loan.
- Quality: If a commodity has been used as a security it should be of good quality.
A commodity which is perishable and may deteriorate in quality or quantity with passage of time should not be accepted as security.
- Free from disabilities: A banker should disqualify securities crippled with certain disabilities like partly paid up shares, life insurance policy without surrender value and so on.
He should see before accepting that the security is free from such disabilities.
- Meld generating security: An asset which generates earnings during the period in which the loan is outstanding is a better security than those which do not and are preferred by the bankers.’
- Easy store ability and low maintenance cost: A security should not create a headache or be a burden for the banker. It must be easy to store with low maintenance cost.
In case of Personal Security
- Financial Ability: The banker must enquire into the financial condition of the guarantor.
If the guarantor does not have the financial solvency to repay the loan in case the principal debtor defaults the existence of a guarantee will be futile.
- Honesty: The ability of the guarantor to repay the loan is of use only if the guarantor also has the willingness and integrity.
So in addition to the financial solvency of the surety his honesty is of immense importance in case of personal guarantee.
- Social status: The social status of the borrower and that of the guarantor must be ensured before granting a loan.
A person who holds esteemed kudos in the society is more likely to be conscious about fulfilling his promises.