MADISON, Wis. (6/17/13)--A new white paper from the CUNA Lending Council examines how collateral risk management can be used in an environment in which few financial institutions have been immune to recent dramatic economic effects on loan portfolios and the collateral tied to them.
If a loan is secured by collateral--a home, a car or other personal assets--collateral risk is the chance of loss arising from errors in the nature, quantity, pricing or characteristics of that collateral.
This paper, "Collateral Risk: Insights on Loan Portfolio Monitoring and Management," focuses on the causes of collateral risk exposure, how macro- and microeconomic factors affect collateral risk, risks specific to certain loan types, proactively managing collateral risk, implementing systems, policies, and procedures, National Credit Union Administration requirements, data gathering, and bringing the conversation full circle with a discussion about member outreach.
Contributing factors to collateral risk are more numerous than the types of collateral, the economic times, and the societal factors that change over time, the paper said. While collateral-risk exposure is most commonly associated with real estate, it noted, for any type of secured loan, managing collateral risk must occur at both the loan and portfolio levels.
The four main risk-collateral "channels" the report describes are:
- Lender selection--Lenders more often require observably riskier borrowers to pledge collateral to reduce after-the-fact frictions.
- Borrower selection--"Unobservably safer" borrowers tend to pledge collateral more often to signal their underlying quality.
- Risk shifting--Borrowers are encouraged to shift into safer investment projects when pledging collateral.
- Loss mitigation--Collateral reduces losses in the event of borrower default, as the lender is able to recover value from the pledged assets.
For all four, the report noted, the channel should be stronger when the observable economic characteristics of collateral are more desirable. For example, "borrower selection" should be stronger when the collateral is more desirable, because the "unobservably safest borrowers" are expected to choose the lowest loan rates and to pledge the most desired types of collateral.