A secured advance is not really secured unless the security deposited satisfies certain requirements. There must be a critical appraisal of security. Let’s discuss the attributes of good security.
There are two angles to the appraisal of security. One is the legal angle regarding the validity and enforcement ability of the security. The second angle is the economic one, involving the consideration of marketability, valuation, and other economic considerations.
Attributes of good Security
1. Legal Aspects
Ascertainment of title: It should be possible for the banker to know that the borrower’s title to the security is clear and undisputed. It has, therefore, to be verified if there are any other interests in the security such as poor charges or encumbrances thereon. The solicitors have to verify the title of the borrower to the property. Even after that is done, litigation may arise because a certain point was inadvertently omitted or an inquiry was not made relating to the claims of one or more persons to the property.
The validity of title: The banker cannot enforce the security unless he obtains a valid title from the borrower. If there is any defect in the title of the borrower, the banker can obtain only a defective title. The rule is that no one can convey a better title than what he has. So, the banker will not be in a position to sell the security if he himself about the title of the borrower. The legal interest must be properly conveyed to the banker by executing the appropriate instrument.
2. Economic aspects
Marketability: The security taken must be readily saleable with the minimum of expenses and without this essential attribute of ready reliability, the security is worthless. The banker should prefer essential goods, industrial raw materials, and other manufactured goods having ready marketability for the purpose of collateral.
Easy ascertainment of value: The security must be capable of being valued with ease. There are certain securities for which the market is continuous and active and, therefore, the banker does not find it difficult to value the security. A reference to the commercial columns of any standard newspaper would enable the banker to obtain the day-to-day quotations prevailing in the markets for different types of securities or commodities. There may be some articles or highly specialized machines or buildings located in out-of-the-way places, which are not easy to make an assessment of their value except by making reference to an expert.
Stability of price: The value of security must be fairly stable. Bankers must also make sure that the value of the security does not fluctuate violently over short periods. Where such heavy variation in prices of security is apprehended, the banker may accept such security only with a higher margin.
Easy storability: Where goods are pledged, the banker must keep them under his custody when it is possible for him to supervise. Some goods are easily storable and do not require special storage facilities and they satisfy the condition of easy storability. Certain types of securities such as iron ores near the mines and timber floating on rivers pose peculiar problems for storage and supervision and also require huge space necessitating higher storage costs. The same considerations apply to goods that cannot be stored except in air-conditioned godsons. Some goods are risky to store, such as inflammable articles.
Durability: Security should be reasonably durable. Perishable commodities like vegetables, fruits, fish as securities. Some of the commodities like chilies, woolen garments, etc. require special care in storage; otherwise, they depreciate in quality and value. There are a few types of grains and oilseeds that can be stored for 3 to 4 months only. There are other commodities such as metal and iron and steel goods which do not deteriorate much in quality for many years. Bankers should prefer such securities which are reasonably durable.
Transport ability: A security should be of such a nature that it can be moved from one place to another without much difficulty. For instance, if cloth bales of certain varieties are not easily marketable in one place. And it is possible to find a ready market for them in another place, they can be sent to the other place where they can be easily disposed of. Therefore, securities which are easily transportable at less cost are preferable to bulky materials like heavy machinery which are difficult and expensive to transport.
Cost consideration: Certain securities are very costly to keep. For example, if an advance is given by obtaining a pledge of the goods, the banker has to maintain godowns, appoint storekeepers, insure the goods, etc. Instead of advancing against goods, it may be preferable to advance against reliable warehouse-keeper transferable receipts as security.
Absence of contingent liability: Security which carries with it an onerous liability as in the case of partly paid it an onerous liability as in the case of partly paid shares where unpaid amount on the share money has to be paid to the company when calls are made, cannot be considered suitable security. Therefore, a banker should prefer fully-paid shares to partly-paid shares as security because it is free from such disabilities.
Yield: A security which provides a steady income is most welcome to the banker since such income enhances the value of the security and also facilitates the repayment of capital and interest; for example securities like gilt-edged securities and highly marketable shares on which substantial dividend is regularly received. In the case of these securities, the banker can obtain a mandate from the borrower to collect interest or dividends, which can be appropriated in the reduction of the loan account.
In practice, hardly any security possesses all the desirable attributes mentioned above and such defects as exist in the security are sometimes covered by taking a higher margin.
As a rule, the banker should not lend the full value of the security. The borrower must have a substantial stake and only then he will take a proper interest in the business to make it more successful than maybe in the case when he is dealing entirely with borrowed funds.
In banking terminology, margin means the difference between the market value of security and the amount of advance granted against it.
The banker must keep a cushion against possible fluctuation in prices, shortage, and depreciation in storing, for an increase due to the application of interest.
There has always to be some margin to cover the cost of realizing the dues by sale of the assets in the value of the securities and the amount up to which the borrower can draw is known as margin.
The percentage of margin to be kept differs from one security to another because of several factors such as price fluctuation, marketability, deterioration in storage, possible loss from such hazards as fire, burglary, etc.
Finally, it is the business integrity of the borrower. i.e., his overall character which ranks above everything else for a banker to determine the margin to be kept.
In granting secured advances, a task of practical importance is the execution of legal documents. Although there are no hard and fast rules about the documents to be taken and each bank has its own set of forms, there is agreement on fundamentals.
Apart from the promissory note given under the signature/seal of the borrower, the usual document associated with secured advances is:
- Letter of pledge/hypothecation duly signed by the borrower;
- Letter of continuity;
- Letter of declaration, bearing appropriate stamps, by the borrower that the goods are according to specifications, and he has got the right and title to pledge them; and
- Letter of a lodgement-take delivery order. These documents should preferably be in writing so that in case of any disagreement, the terms and conditions therein could be referred to.
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