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Framework and factors influencing lending
Creditworthiness as a key security factor
Security through collateral is always a top priority in financial transactions. This principle also applies to the handling of loan transactions between banks and borrowers. Especially when the borrower’s financial circumstances are not clearly positive, additional mechanisms are generally used to ensure proper repayment of the loan. Collateral provides the necessary security in these cases.
Framework and factors influencing lending
From the lender’s perspective, the decisive criterion for granting or denying a loan is the answer to whether the loan will likely be repaid without problems. To protect the lender from losses in the event of the debtor’s payment difficulties, lenders typically require the borrower to provide collateral.
Although there is no statutory obligation to provide loan collateral, the Kreditwesengesetz lists the legal transactions that are generally suitable for securing a loan. Essentially these are pledge (Pfandrecht), guarantee (Bürgschaft), mortgage (Hypothek), assignment of claims (Forderungszession) and retention of title (Eigentumsvorbehalt).
The effect of these security instruments for the lender is that they grant additional rights over the debtor’s economic sphere or over the debtor’s movable or immovable assets. The creditor may also be granted a right of recourse to agreed third parties for the satisfaction of their claim.
The effectiveness of individual securities varies, so each must be assessed separately with regard to its potential value as collateral. In particular, it is examined whether the bank-standard criteria applicable to loan collateral, which are laid down in the so‑called Solvabilitätsverordnung (SolvV), apply to the security.
According to these provisions, securities must exhibit a high degree of value stability and fungibility (easy conversion of the asset into liquid funds). The security must also not be positively correlated with the borrower’s economic situation. Furthermore, the asset must be separable from the insolvency estate in the event of the debtor’s insolvency.
If the debtor’s financial situation deteriorates or the value of the security decreases, institutional capital providers (e.g., banks) often reserve the right in the loan agreement to require the borrower to provide additional collateral. In any case, the general situation on the capital market as well as the individual situation of the lender — especially with regard to its liquidity and capital adequacy — are decisive factors in granting a loan.
Creditworthiness as a key security factor
Providing valuable collateral together with a guarantee by a creditworthy guarantor and the borrower’s impeccable credit standing form a set of instruments to maximize the likelihood of proper loan repayment. A creditworthy guarantor who can take over the loan payments in an emergency is always a compelling argument in favor of granting a loan.
To protect customers from over-indebtedness and thus ensure the recoverability of the claim arising from the loan relationship, institutional lenders and borrowers always prepare an individual financial plan. This includes the debtor’s monthly living expenses including all burdens such as maintenance obligations or outstanding installment purchases. A financial reserve for unforeseen events is also always planned. The remaining balance can be used to service the loan installments.
Consequently, in assessing creditworthiness, the borrower’s income, living expenses and other financial burdens as well as existing collateral are considered in relation to one another and each significantly influence creditworthiness. The borrower’s economic situation is usually directly related to the collateral they can offer, since a borrower with excellent credit will typically also possess correspondingly valuable collateral.
As a result, in modern finance existing collateral is no longer viewed purely as a means to compensate possible credit risk, but as an integrated part of the borrower’s economic situation. The strong correlation of indicators affecting creditworthiness, however, also allows participants in the financial markets with less favorable economic conditions to raise external capital by accepting a higher interest rate that reflects the increased risk.
Types of collateral for loans
The types of security most commonly used in practice to secure a loan, and which are also considered suitable by lawmakers, are the following:
- Pledge (Pfandrecht)
- Guarantee / Suretyship (Bürgschaft)
- Mortgage (Hypothek)
- Assignment of claims (Forderungsabtretung)
- Transfer of title as security (Sicherungsübereignung)
In German law, Pfandrecht in the narrow sense refers only to a pledge on movable items and rights. Land charge (Grundschuld), mortgage (Hypothek) and annuity charge (Rentenschuld) are grouped together as land charges and are therefore considered a form of pledge in a broader sense.
A guarantee (Bürgschaft) is a unilateral binding declaration by the guarantor to ensure repayment of the loan in the event of the borrower’s insolvency. In an assignment of claims (also called cession), the borrower’s claims against third parties are transferred to the lender for the purpose of securing the loan.
Assigned claims may be based on deliveries, services or insurance contracts; assignment of wage or salary claims is also possible. Claims arising from insurance benefits are often assigned for security purposes. From the borrower’s perspective, assigning a life insurance policy as collateral has the advantage that capital continues to accumulate, which can be used to repay the outstanding loan if payment becomes impossible.
Commercial borrowers also have the option of assigning several claims from deliveries or services to the creditor at once by way of a so‑called global assignment (Globalzession).
Requirements for collateral
A basic prerequisite for a claim to be usable as loan collateral is, in addition to its legality, a sufficiently high probability of enforceability. In a pledge under Pfandrecht, a security changes hands but remains legally the property of the debtor. Pledging is mainly used in financial practice for securities portfolios.
Applications of collateral
A special form of pledge is the mortgage, where the borrower assigns rights in a property to the lender as security for the loan. Because of the complex procedure and relatively high costs, this security measure is usually used for financing larger investments with a longer time horizon.
A transfer of title as security (Sicherungsübereignung) is common in vehicle financing. The asset is transferred to the creditor in terms of ownership as security, but the item remains physically in the borrower’s possession. The risk for the lender of depreciation or loss of the security means this option is usually considered when the asset used as security is essential to the debtor’s economic existence — for example when machines or inventories are transferred as security.
A common banking method to secure claims from a loan agreement is also taking out a credit balance insurance (Kreditrestschuldversicherung). In the event of the borrower’s death or incapacity to pay, the credit balance insurance pays the outstanding loan balance; all claims against the insurer arising from this are transferred to the lender.