TYPES OF COLLATERALS AND THEIR CHARACTERISTICS | SFB IMPORTANT NOTES
Previously we studied the types of charges, here we’re going to carry the topic further and learn about the types of collaterals and their characteristics.
Why is collateral needed?
Banks serve as financial middlemen through which government funds are raised and lent to different economic sectors. The money is repaid to the lender with interest and according to the agreed-upon schedule by the bankers. Bankers typically take assets as collateral to protect the loaned funds if the borrower defaults.
Security can be categorised as primary, collateral, primary and tangible, as well as personal and tangible. Personal security entails personal responsibility, while tangible security is something that can be realised by a sale or transfer. The banker has a right of action against the borrower, c. the guarantee. Security is divided into two categories: primary security and collateral security. Main security is the primary insurance for an advance, while collateral security is not the principal security by the borrower or a third party.
Following are some common types of collaterals defined along with their characteristics
Land and buildings
The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI Act, 2002) allows banks to sell immovable property taken by way of the mortgage without the intervention of the court. This has gained importance now and is viewed with favour by banks due to the right of sale without court intervention. The nature of the charge created on this type of security is the mortgage.
Immovable property mortgages can be used as primary or collateral security. If an advance is approved against the primary security of real estate, its intended use must be specified. A subsequent review and renewal proposal should be made if approved for use as working capital. In other instances, a workable repayment plan should be established if an overdraft against title documents is sanctioned.
- Assessing the Property’s Title
Before accepting any movable item as security, the bank’s attorney should review the borrower’s title to the relevant property.
- Documentation that must be requested from the mortgagor
All tangible title documents, such as a sale deed, gift deed, will, or division deed, pass the title in his favour.
- Property valuation
Before granting the advance, it is important to have the immovable property used as security for the advance appraised by a bank-approved engineer. The valuation must be cautious, realistic, and based on a forced sale. The factors to take into account while determining the valuation include:
- Construction nature
- The building’s age and current condition
- Paid taxes
- The site’s value
- The property’s location
- The kind of title—freehold or leasehold
- The rent yields
- The area of the property and the building.
- Construction expenses
Banks often offer loans in exchange for collateralized items such as agricultural products, raw materials, semi-finished goods, and finished goods. Key cash credit or open cash credit can be used to extend an advance against goods by maintaining the commodities as a pledge or hypothecation.
The charge created in an open cash credit is hypothecation, as ownership of the items is not transferred to the banker. In a key cash credit, the charge is a pledge, while in an open cash credit, the charge is hypothecation.
The bank does not acquire ownership of the goods in either pledge or hypothecation scenario. Trade finance is the term used to describe a loan secured by products. These short-term loans are provided to help the borrower with working capital needs.
Security Measures for Goods Advance
The most important details are that the goods must command good demand in the market, the borrower should have been dealing in them for a sufficient amount of time, no advances should be made for speculation or hoarding purposes, the goods charged to the bank should be fully paid, the age of the stock should be taken into account, the ownership of the goods should be confirmed, and the stipulated margin should always be maintained. Additionally, the items should have sufficient insurance to protect them from dangers like fire, strikes, riots, and other calamities.
Storing of Goods
Goods should be stored in godowns of good construction to protect them from weather and monsoon.
Stock audits are an effective credit monitoring tool, providing a qualitative assessment of the advance and improving the borrower’s management of inventories and receivables.
Stocks are valued using the lower cost price or the market price for each share.
In case default occurs
The Indian Contract Act, of 1872 grants a right to the pledgee (bank) to sell pledged goods after providing reasonable notice to the pledger. The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 grants a right to the hypothecate bank to take possession of the goods hypothecated and to sell them without the Court’s intervention after observing certain formalities.
A document used in the regular course of business to prove possession or control of goods that authorises or purports to authorise, either by endorsement or delivery, the possessor of the documents to transfer or receive the goods thereby represented is referred to as a document of title to goods under Section 2(4) of the Sale of Goods Act, 1930”.
- Advancement of loans against the Insurance policies
Life insurance policies are allowed as primary and collateral security for an advance.
The policy must be in effect and the premiums current, the policy paper supplied as collateral must be original, suitably stamped, and signed by the issuing body, and the bank must record the most recent premium receipt.
Restrictive or burdensome provisions should not be present in the contract, and the insurance provider should have acknowledged the assured’s age.
The following securities are not accepted as security in general
- a) Children’s endowment policy.
- b) Policies are taken out specifically for purposes like estate duty.
- c) Children deferred policy.
- d) Policies with nominations under Section 6 of the Married Women’s Property Act, 1874.
The transfer of a policy must be witnessed by a person, and when the advance is repaid, the policy must be reassigned in favour of the policyholder. In the event of the assured’s death, the assignee is entitled to collect the policy amount.
- Loan advancement against shares
Advances made against shares should be used for worthwhile endeavours and not for speculation. Banks require the shares to be dematerialised, and only fully paid shares are used as collateral. The shares should be listed on and traded on an established stock exchange, and a private limited corporation cannot have a debt secured by its shares.
Loan advancement against shares to individuals
Loans from the banking system to individuals secured by shares, convertible bonds, convertible debentures, and units of equity-oriented mutual funds should not exceed the limits of & 10 lacks per individual and & 20 lacks per individual, respectively, if the securities are held in physical form.
- Lending against book debts
Claims from credit sales are referred to as book debts. Both drawing bills and debiting the buyer’s account are methods that can be used to effect credit purchases.
Bills Receivable is the term used to describe the total amount of unpaid bills, and Account Receivable is the term used to describe the total debit balance in the buyer’s account.
Book debts are the aforementioned receivables. The sum due from other parties as a result of business transactions is represented by this.
- Lending against the term deposits
The term deposits that banks frequently lend against include fixed deposits, cumulative deposits, recurring deposits, etc.
Term deposits are used as security for facilities that can be either loans or overdrafts; the nature of the charge formed throughout the loan-granting process is a pledge.
- Interest rate and margin
Banks often lend up to 90% of the deposit amount or accrued value of the account, with the loan’s interest rate being 1% to 2% higher than the deposit’s interest rate.
Any date prior to the loan’s maturity may be used by the borrower to repay it using his own resources.
- Deposits in a Minor’s Name
If a loan is requested by the guardian for the needs of the minor depositor, the bank may consider it after receiving a letter of commitment from the guardian stating that the loan proceeds will only be used for those needs. Normally, no loan can be granted against the security of a deposit receipt standing in the name of a minor.
- Lending against the gold ornaments
Banks give loans against gold ornaments for agricultural and non-agricultural purposes.
The nature of the charge created is a pledge, and some banks allow overdrafts against the security of gold ornaments. The record of security, period, margin, default, and reminder should be recorded in the gold ornaments register.
The gold ornaments registry should contain the borrower’s full name, residential address, date of advance, amount, and description of the ornaments. The period of advance should be limited to 6 months or 1 year, but in the case of a demand loan/term loan, it can be up to 60 months.
The margin should be maintained on the market value. If the borrower fails to repay the loan, a notice should be given and if no response is received, a reminder should be sent by registered post informing the borrower that the ornaments would be auctioned and the balance, if any, would be paid to the borrower.
Solve the exercise based on what you learned so far in ‘Types in charges’ and Types of collaterals’
|I. Which of the following statement in the context of Mortgage is correct?
A. A mortgage is a transfer of an interest in a property to secure payment of money advanced.
B. A mortgagee advances money to the mortgagee.
C. The mortgagor provides some property as security to the mortgagor.
|II. Which of the following statement is true in the context of Hypothecation
A. This is a charge on immovable assets.
B. A fixed charge is created on specific and identifiable assets like machinery, vehicle etc.
C. Possession and ownership of goods remain with the lender.
|III. Which of the following statement is true in the context of the Pledge?
A. The pledge is the bailment of goods to secure repayment of debt or the performance of a promise.
B. Possession & control of goods remain with the bank and ownership remains with the borrower.
C. Bank can sell the goods in case of non-payment by giving notice of sale which is mandatory. Bank has to take due care of the goods and insure them.
|IV. A bank finances a person to buy a car, the loan is secured by
|V. MNC Ltd is given an overdraft by ABC Bank on the number of book debts. The basis for this is:
|VI. The riskiest charge from a banker’s point of view is
| VII. In a usufructuary mortgage, the mortgagor transfers to the mortgagee possession of the property and the right to receive revenue from it.
|VIII. ‘The owner has to transfer his title deed to the lender, thereby creating a charge on the property’. Which of the following kind of mortgage is defined in this statement?
|IX. Right to combine two accounts by banks is called
|X. Which of the following acts defines the ‘Mortgage’?
|XI. All of the following are advantages of securitization EXCEPT:
|XII. The mortgage transfers the mortgaged property to the mortgagee on the condition that it will be retransferred upon payment of mortgaged money. This is