Collateral or security represents the asset pledged by a borrower against the performance of a credit facility to the effect that the bank (lender) could sell it (collateral) off in the event of default. It would thus appear that collateral reduces the bank's risk when it grants a loan even as it increases the costs to the bank(lender) because of increased documentation as well as the costs of monitoring the collateral. Banks most often than not pass on the documentation costs for security perfection to the borrower.

On the other hand,collaterals should reduce the cost of borrowing to the borrower since it reduces the bank's risk, which in turn should reduce the bank's costs and lending rates. The place of collateral or security in credit structuring and analysis remains debatable. This is because of the fact that the best collateral for any loan is the borrower's ability and willingness to repay the same according to one school of thought. Another school of thought however insists that sound banking practices require that certain type of loans should be backed by some collateral at least. This school argues that the collateral aside from providing some psychological comfort would serve as a fall back in the event that the borrower fails in meeting up with its projected cash flow for whatever reason. Experience has however shown that some less credit worthy borrowers especially within the middle market tier may not be able to raise loans without one form of collateral or the other unlike the large blue-chip companies. Thus it would appear that collateral benefits both borrowers and lenders in certain types of loans. In situations where it is expedient to insist on a collateral it would be advisable for the value of the collateral to be higher than the loan amount. This is because of the fact that by the time the loan goes bad such that the lender wants to rely on the collateral, it would then be a case of 'forced' or auction sale. Under such forced sales one can only realize a percentage of the initial value of the collateral even before deducting costs associated with the auctioning exercise.

Some types of loans collateral may be unnecessary particularly for very short-term loans that are made to large credit-worthy public companies or corporations. For example, a highly credit-worthy multi-national borrowing Ten million dollars as a bridging loan for thirty davs or less tenor to enable it pay duty and clear goods at the port may not be required to offer collateral since the facility will be fully repaid even before the arduous process of collateral documentation and perfection are completed. In practice however, some banks tend to lend unsecured loans to the multi-national blue-chip companies as long as they (multi- nationals) execute a negative pledge over their assets. Banks and other lenders are driven to lend unsecured largely by competition and secondly by their belief that such blue-chips will always meet their obligations either from own cash flow or by refinancing.

The negative pledge would ensure that all the lenders to the company are on equal footing such that in the unlikely event that the company defaults on its loan, all the lenders would share the assets of die company on a pari passu basis. It is pertinent to note that negative pledge is not a security per se. While it is advisable to insist on a befitting collateral for loans it is extremely impor­tant for the credit analyst to look on to the borrowers cash flow and the collat­eral for the loan repayment. The collateral should serve as a fall back comfort in the event that the primary and secondary sources of repayment fail.

Characteristics of a good collateral

The suitability or appropriateness of any item or asset for use as collateral would depend in varying degrees on the following factors relating to the asset: Standardization, durability, marketability, identification, and stability of value.

1. Standardization:

Some items especially commodities have been graded, classified or grouped e.g. cocoa beans, ginger, rice, etc to reflect their qualities or standards and hence facilitate their use in trade transactions and/or as collateral. [t would be preferable to use an item that has a standard or grade as a collateral. Aside from eliminating any ambiguity between the parties the lender appreciates the worth and re-sale ability of such asset in the event of default. It also leaves neither party in doubt as to the value of such collateral and hence the amount of loan it can collateralize

2. Durability

Durability relates to the ability of the asset to withstand wear and tear for the most part of its useful or economic life. Durable goods are better assets for use as collateral than non-durables. The useful or economic life of an asset should be longer than the tenor of the facility for which it is used as collateral. This is to ensure that the collateral will still be in useful condition and hence saleable from after the maturity of loan. Hence it can still be sold in the event that the borrower could not pay,at maturity of the loan. the craft of credit creation

3. Marketability:

This refers to the depth of the market including secondary market for the collateral and determines the ease or chances that the lender will be able to dispose of the asset in the event of default. Thus, assets that lend themselves to wide applications are better collaterals, than specialized equipment with limited use. Similarly assets that have wide secondary or tertiary markets also represent better collaterals than those with little or no secondary market at all.

4. Identification:

A collateral that can be identified by unique features or characteristics such as serial number, make, model or marks that cannot be erased are preferable to assets that have no distinguishing features. Also assets that cannot be easily moved such as real estate and machinery and equipment represent better collateral. The essence is for the lender to be able to easily identify the relevant asset that has been pledged to it as collateral even amidst several other assets. An identifiable collateral could frustrate a would-be dubious borrower from swapping another asset for the one originally pledged as a collateral for a credit facility.

5. Stability of Value:

Lenders would cherish collateral which market values are not likely to depreciate or drop significandy during the life of the loan. For example cocoa beans would not be as desirable a collateral as a building even for a short-term loan. Also banks prefer assets with ready secondary (resale) market as collateral. Assets that are highly susceptible to rapid obsolescence render older models less valuable.

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