This service provided by Banks, namely, financing, or a lot of commonly called lending, is fraught with several inherent risks. Loan defaults might occur for more than one reason, including reasons beyond the management of the borrowers, like for example, in case of floods or a Tsunami which will wipe out the assets of the borrower, except rendering him incapable of restarting his business immediately. The foremost serious risk to Banks in the lending method is the risk of non payment of the loan by the borrower. Imagine a state of affairs where none of the borrowers of Banks repay the loans availed of by them! This could lead to a collapse of the Banking trade!
The present spate of Bank failures in America and elsewhere is, in good half, on account of borrower defaults. Whereas, in an ideal situation, each borrower repays the loan availed by him, from the Bank, in real life, this does not happen. Several a time, borrowers, both individuals and institutions, fail to keep up their repayment commitments, affecting the well being of the lending Bank. Typically, 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 cash 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. Every loan is appraised individually to determine the soundness of the proposal and solely then a decision to grant a loan is taken. Obtaining of security for loans is one of the safeguards that Banks exercise to secure their interests.Among the varied precautions observed by the Banks to safeguard their interests within the lending method, 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 sure qualities, among them, financial price, 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 need to secure the loan. This can be done by approach of making a charge against the asset financed by the Bank. The kind of charge created depends on the character of loan, and therefore the security.
Primarily, there are 2 varieties of securities on the market to Banks to secure a loan. They are Primary security and Collateral security.
Primary Security refers back to the asset directly created out of Bank finance. As an example, where a Bank finances the purchase of a home, the home is the first security. In the identical means, 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 offers the Bank the legal authority to dispose off the asset, and apply the proceeds therefrom, to the loan quantity in default.
Collateral Security refers to certain extra security obtained by the Bank to secure the loan. For example, say, a Bank has financed the acquisition of machinery by a Pharmaceutical manufacturing company. This machinery would be the primary security for this loan. Additionally, the Bank could obtain collateral security in the form of the factory building owned by the corporate, as extra security. This can guard Bank's interests in the event of the first security not having sufficient price to liquidate the loan. Typically, on account of adverse market conditions, the worth of the first security gets eroded, exposing the Bank to a higher risk than it had originally bargained for.
Additionally, loans will also be secured with the assistance of non-public security of the borrower. Obtaining personal security of the borrower permits the Bank to proceed against the borrower and his personal estate, to recover the loan.
Once a Bank secures its loans with proper security, the likelihood of default is reduced, and even in case of default, the quantity of loss it's possible to suffer is lesser than otherwise.
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Joshua Green has been writing articles online for nearly 2 years now. Not only does this author specialize in Security, you can also check out his latest website about:
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