BANK LOANS-SECURITY

Introduction:  Banks lend money to the public, for various purposes, like purchase or construction of a home, for purchase of  consumer goods like a TV, Music System, etc.   Banks also finance businesses, both manufacturing and services.   Apart from all these, they also extend personal loans to members of the public.

This service provided by Banks, namely, financing, or more commonly called lending, is fraught with several inherent risks.   Loan defaults may occur for more than one reason, including reasons beyond the control of the borrowers, like for example, in case of floods or a Tsunami, that may wipe out the assets of the borrower, apart from rendering him incapable of restarting his  business immediately.   The most serious risk to Banks in the lending process is the risk of non payment of the loan by the borower.   Imagine a situation where none of the borrowers of  Banks repay the loans availed of by them!   This could lead to a collapse of the  Banking industry!

The current spate of Bank failures in America and elsewhere, is, in good part, on account of borrower defaults.   Whereas, in an ideal situation, every borrower repays the loan availed by him, from the Bank, in real life, this does not happen.   Many a time, borrowers, both individuals and institutions, fail to keep up their repayment committments, affecting the well being of the lending Bank.   Sometimes, there are even genuine reasons why borrowers become defaulters.

This being the case, Banks invariably, have in place, norms and procedures that they follow before parting with money to a borrower.   Banks examine and evaluate credit proposals, as to their viability and feasibility, both technically and financially, before taking a decision to grant a loan.   Each loan is appraised individually to ascertain the soundness of the proposal and only then a decision to grant a loan is taken.   Among the various precautions observed by the Banks to safeguard their interests in the lending process, is the obtention of security for the loan extended by them.

Definition of Security:  Security, in relation to a loan extended by a Bank to a borrower, means, an asset, of any kind or description, having certain qualities, among them, monetary value, that can be possessed by the Bank, in the event of default, and applied toward repayment of the loan.

Having extended the loan to the borrower, Bank would naturally like to ensure that the loan is repaid with the interest thereon.   That is, Bank would want to secure the loan.   This is done by way of creating a charge against the asset financed by the Bank.   The type of charge created depends on the nature of loan, and the security.

Basically, there are two types of securities availabe to Banks to secure a loan.    They are Primary security and Collateral security.

Primary Security refers to the asset directly created out of Bank finance.   For example, where a Bank finances the purchase of a home, the home is the primary security.   In the same way, a car purchased with the help of a Bank loan, is the primary security for that loan.   Bank creates a charge against this primary security, to secure its loan.   This charge give the Bank the legal authority to dispose off the asset, and apply the proceeds therefrom, to the loan amount in default.

Collateral Security refers to certain additional security obtained by the Bank to secure the loan, in addition to the primary security.   For example, say, a Bank has financed the purchase of machinery by a Pharmaceutical manufacturing company.   This machinery would be the primary security for this loan.   In addition, the Bank may obtrain collateral security in the form of the factory building and land owned by the company, as an additional security.   This will secure the Bank further and safeguard its interests in the event of the primary security not having sufficient value to liquidate the loan.   Many a time, it so happens, that on account of adverse market conditions, the value of the primary security gets eroded, exposing the Bank to a higher level of risk han it had originally bargained for.

In addition to the above discussed securities, there is also the scope of securing the loan with the help of personal security of the borrower.   Obtaining personal security of the borrower enables the  Bank to proceed against the borrower and his personal estate, in order to recover the loan.

Qualities of a Security:  In order that a security may provide a real means of liquidation of a loan in part or in full, the concerned asset must have the following important qualities, among others:

1.  Valuable Security:  A security obtained as a cover against default, of the borrower,  in repayment of the loan, must have some monetary value that can be realised and adjusted toward the loan.   Intrinsic value alone would not be helpful to the Bank in mitigating the problem arising out of a default.

2.  Marketable Security:  Even though a security may have a monetary value, it may not be  possible to encash the value as and when needed by the Bank, because it may not be easily marketable.   That is, it may not be easy or even impossible to dispose off the security and realise its proceeds, for various reasons.  

For instance, the asset obtained as a security for a loan, may not be in demand, at the time it is required to be encashed or realized and credited to the loan amount in default.

3.  Stable Security:  Stability of security here means the stability of the value of security.   Certain securities have widely fluctuating values, depending on market and other conditions.   As a rule, Banks prefer securities that are not prone to market gyrations, and offer a reasonable chance to the Bank to have it adjusted to repay a good part of the loan in default,  if not the  entire loan.

4.  Transferable Security:  The security offered by the borrower to secure the loan, must have the quality of transferability.   That is , the ownership, or the interest in the security, must be capable of being transferred to the lender, without too much effort and expemses.

As can be seen from the above, securing the loan extended by the Bank is of vital importance and also necessity to the Bank, as otherwise, it may jeopardise the interests, or even the survival of the Bank.   That apart, securing a loan with an asset of the borrower increases the stake of the borrower, who would have more reasons to make his venture a success by doing his best.

This home truth has been forcefully brought forth in the current economic crisis, in which many Banks have realized their folly in not properly securing their loans.