Challenges to Enterprise-wide Collateral Management
Collateral is an asset or a right provided by a counterparty or a third-party to secure a debt obligation. It reduces the credit risk of the loan, i.e. in case of a default by the borrower, the bank has priority claim on the sale proceeds of the collateralized assets. For example, in case of a mortgage loan (e.g. home buying), the residential real estate (a piece of land and/or buildings or structures on it) serves as collateral. In case the borrower is unable to pay the interest or principal back, the bank can sell the asset and recover the outstanding amount.
Collateralization has been a primary credit risk mitigation strategy for banks worldwide. It is estimated that over 40 per cent of a typical bank’s portfolio is secured with collateral.
Most retail, wholesale and treasury transactions are usually secured through collateral. In retail banking, loans against property, vehicles and other durables are usually secured through a claim over these assets. Similarly, in wholesale lending, most facilities are backed by a charge over the company’s fixed assets (plants and machinery), credit balances or deposits or inventory. Most of the trade transactions financed by a bank are also usually secured through a charge over the goods being sold. More recently, there has been an exponential growth in treasury transactions, such as trades in forex, fixed income, equities, commodities and derivatives. These too are secured through margins, which is a collateral that a bank takes in the form of cash, securities or other liquid assets to support the trade for its customers.
Banks want to reduce their credit risk and, at the same time, offer additional loans to their customers. The banking industry is also changing rapidly with more stringent regulations, consolidation in the industry, increased competition from new entrants, more demanding customers and pressure on margins. As the global economies boom and trade flows grow, banks are looking at new ways of increasing their revenues without increasing their risks. Some key drivers for collateralization are explained below:
Besides the primary purpose of mitigating credit risk, Basel II has provided a new impetus for collateralization, as it can significantly reduce the capital charge that a bank needs to allocate for its exposures. Under Basel II, collaterals that comply with the loss given default (LGD) eligibility criteria will reduce the solvency requirements of a facility. The LGD classification reflects the structure of the credit facility and gives an assessment of the percentage of the exposure the bank could expect to lose if the counterparty defaults. Collateral is one of the key criteria for the determination of this LGD classification of a facility.
The financial markets have witnessed rapid growth in derivatives and securities trading. According to Bank for International Settlements (BIS) and International Swaps and Derivatives Association (ISDA) reports, over-the-counter (OTC) and exchange traded derivatives have been growing by over 20 per cent over the past few years. These are highly volatile asset classes and banks need complex collateral management systems to cover their counterparty risks.
As many departments work in silos, there is duplication of effort in managing collateral. Same collateral may get used by different groups with overlapping claims giving inaccurate cover to the bank. To successfully compete in the new financial markets a bank must have a robust collateral management process in place.
To further grow their business, banks need to lend more in new growth economies. These countries in Asia, Africa and South America have poor quality of credit information but relatively better legal systems. As collaterals replace credit risk by legal and documentation risk, it would be prudent for banks to use collaterals to secure their exposure in these countries.
The World Bank survey below highlighting the Legal rights and Credit Information Index validates the approach of using more collateral backed lending. (Countries, such as China and India, have relatively better legal rights than credit information availability.)
| Region or Economy |
Legal Rights Index
(0-10) |
Credit Information Index
(0-6) |
|---|---|---|
| East Asia & Pacific | 5.3 | 1.8 |
| Europe & Central Asia | 5.6 | 2.5 |
| Latin Amer & Caribbean | 3.8 | 4.5 |
| Middle East & North Africa | 4.1 | 2.0 |
| OECD: High income | 6.3 | 5.0 |
| South Asia | 3.8 | 1.8 |
| Sub-Saharan Africa | 4.4 | 1.5 |
With the collateral management function gaining importance, it becomes vital for the credit risk management team to identify the key challenges faced by the function today – particularly, in an environment where the ability to work across functions, across business lines and across locations becomes the key to success.
Different lines of business (LOB) within the bank are currently managing collaterals for their services independently. There is duplication of systems and processes as similar functions are performed by different businesses. Collateral information also remains dispersed within the organization, which makes it difficult for the risk management team to get collateral data for capital calculation. An enterprise wide collateral management system and a shared service centre can bring significant reduction in costs and improve management control.
Relevant documents for collateral valuation (and loan documentation) for each counterparty should be obtained before lending activities commence. Third party valuation checks, market feeds, external ratings and verification may be required to assess the true value of an asset. The facility structure may also require covenants to safeguard the exposure in case the collateral value changes suddenly.
Legal documents need to be vetted by lawyers for accuracy. This is to ensure that the collateral is legally enforceable/valid if the counterparty defaults at a later date.
Period valuation of collateral is advised to ensure that all exposures are adequately collateralized, the collateral should be marked to market with external prices feeds or third party authorized appraisers. The real challenge is the need for timely data feeds, reliable and accurate data, faster turnaround times in other parts of the process, such as settlements, and the need to send correct margin calls to the customers. Also, authorized personnel should be involved in the acceptance or release of the collateral. Collateral insurance documentation should be periodically reviewed. In addition, with regard to reporting requirements, any shortfall in collateral should also be reported to the management on priority. Escalation in case of collateral not sold in a defined period of time when necessary should also be reported.
The increasing range, complexity and volume of collateral agreements coupled with the urgency to comply with Basel II requirements is forcing financial institutions to review their IT strategy for designing specialized and efficient collateral management systems. The collateral management system is expected to provide the functionality to automate many of the routine tasks and facilitate enterprise wide risk management. In view of this, there are essentially two general solutions identified for creating a collateral management function:
The pros and cons of these two approaches are identified in the box below.
| Tactical | Strategic | |
|---|---|---|
| Pros | Easier to customize/modify existing systems if requirements are simple.Investment in existing system not wasted. | Centralized enterprise-wide control on collateral management policies/procedures/data recording and reporting.Availability of features, such as maintenance of multiple collateral types and complex collateral-asset relationships, valuation and monitoring, etc. |
| Cons | Not feasible if significant changes required.Poor flexibility of offering varied front-office and back-office processes.Inadequate ability to map complex relationships between collateral and exposures. | Significant impact on existing business processes with changes made to suit the new product systems.In-house build – gathering requirements for a comprehensive collateral management system and the actual build/test is a mammoth task. A phased out approach is advised. Product solution may require customization to suit specific requirements and lead to a dependence on the vendor for support. |
Whichever strategy is selected by a bank, a service oriented architecture (SOA) approach is ideally suited to provide a scalable and flexible framework. SOA allows collaborating systems to produce and consume services that are loosely coupled entities representing business functions. Key features that SOA offers are ease of integration, process flexibility and re-usability of IT assets (hardware and software).
This framework increases operational efficiency, not just by reducing IT costs, but by also providing an enterprise wide function that can meet different business demands and offer custom services to LOBs as well as a consolidated and accurate view of all collateral and accurate measurement of capital requirements.