Loan security
When processing financial transactions (loans) at credit institutions such as banks, the need for security is always very pronounced. If a lender therefore wants to secure its claim against the risk of the borrowed amount not being properly repaid, appropriate measures to ensure the highest possible collectability of the claim are necessary.
In principle, a borrower’s good creditworthiness, guarantors with joint liability who are creditworthy (guarantee/surety), and loan collateral that the lender can access in the event of the borrower’s insolvency all increase the likelihood of an orderly repayment of the loan.
Legal framework for loan security
If the creditor does not want to leave its claim unsecured, the legislator has declared the conclusion of certain legal transactions as suitable for loan security. These essentially include retention of title, guarantee/surety, mortgage and pledge (lien).
However, there is no statutory obligation for the lender to obtain collateral for loan security. Thus, lenders may decide autonomously whether and when they require collateral or other forms of loan security for a loan.
Because the conclusion of loan security arrangements is carried out in the course of granting a loan, the existence of a legitimate claim against the debtor is always a prerequisite for the legal effectiveness of the loan security. The lender always bears the liability for the legal existence of the loan claim.
The securitisation effect of such legal transactions for loan security always consists in granting the lender additional rights. These rights may relate to the debtor himself or to his movable, immovable, tangible or intangible assets. The lender may also be granted the right to involve third parties in enforcing its claims.
Reasons for loan security
The conclusion of a legal transaction for loan security may be required when the underlying transaction has the character of a banking business, regardless of whether this banking business is conducted by a credit institution, a credit broker or another financial service provider.
Whether and under which conditions a legal transaction such as loan security has the character of a banking business is clearly defined in the Banking Act. Due to the close interconnection among credit institutions over time, general security criteria have crystallised in monetary transactions, which were ultimately elevated to a binding standard in lending by being included in the Solvency Regulation (SolvV).
These provisions essentially state that loan collateral must be subject to only minor value fluctuations and must be convertible into liquid funds at short notice if required. The asset’s value stability and fungibility must therefore be ensured. In addition, the collateral must not have a positive correlation with the borrower’s economic situation.
For this reason, securities are only permitted as instruments of collateral under certain conditions. Ultimately, a possible insolvency of the borrower must not affect the posted collateral; it must therefore be separable from the insolvency estate.
Common bank collateral types for loan security
Personal collateral that meet the requirements of common banking security criteria include the following types:
- Guarantee / surety
- Warranty
- Assumption of debt
- Letter of comfort
A guarantee / surety represents a unilateral contractual obligation of the guarantor to secure the loan by standing in for repayment of the outstanding loan amount in the event of the borrower’s inability to pay. The guarantee belongs to personal securities. With personal securities, a third party undertakes to pay the debtor’s obligations should the debtor default. An assumption of debt refers to another debtor stepping into the debt or credit relationship with the creditor’s consent, while a letter of comfort is a contractual statement by a company or a public authority to take care that a subsidiary fulfils its credit obligations.
Real (asset) collateral for loan security
Suitable asset-based securities (also real collateral) include the assignment of claims, transfer of ownership as security, pledges (lien), mortgages and land charges. In the assignment of claims (cession), the borrower assigns his receivables from deliveries, services or insurance contracts to the lender. The borrower is liable for the legality of the assigned claim (risk of inaccuracy); moreover, there must be a sufficiently high probability of collection of the claim in order for it to be usable as collateral.
With a transfer of ownership as security (security transfer), legal title to the collateral is transferred to the creditor, while the borrower remains physically in possession of the object serving as collateral. Because the lender is thereby exposed to a greater risk of loss or depreciation of the collateral, such security transfers are usually carried out when the collateral is indispensable for the continuation of the debtor’s business operations, for example inventories or machinery. Security transfers are also common in the financing of motor vehicles.
Other types of loan security
The counterpart to a transfer of ownership as security is the pledge within the framework of a lien. Here the debtor remains the legal owner of the collateral, but the collateral itself passes into the possession of the lender, who thus gains physical control over the item securing the loan. Pledges are especially common for securities portfolios; such a loan secured in this way is referred to in finance as a Lombard loan.
The mortgage also represents a form of lien, the so-called land charge. In this case, the borrower assigns property rights in real estate to the lender for the purpose of securing a loan. The possible amount of the mortgage depends on the market value of the property and must always exceed the loan amount, because the mortgage also secures ancillary claims such as various fees and charges in the event of the borrower’s insolvency. The risk of achieving a lower sale price in the event of a disposal must also be taken into account.
The term land charge (Grundschuld) is used particularly in construction financing. A land charge is the right to demand payment of money from the title to property, land, or a right equivalent to those values (e.g. hereditary building rights). A land charge is not tied to a single loan and can also be used for future loans.
Criteria for assessing collateral for loan security
Since not all forms of loan collateral have the same securitisation effect, they must be evaluated regarding their usefulness. In particular, the fulfilment of the criteria according to the Solvency Regulation (standard banking criteria) is used to assess suitability for loan security. The results of the evaluation are reflected in the lending value and in different lending limits.
If the posted collateral loses value or the borrower’s economic circumstances deteriorate significantly, banks typically include in the loan agreement the obligation of the debtor to provide additional collateral. The quality and extent of the collateral offered provide insights into the general financial situation of the borrower and are directly related to the applicable interest rate.
High-value collateral for loan security leads to a reduction of risk for the bank and consequently to a reduction in the interest rate, whereas poor collateral increases the risk and thus the interest rate. However, this strategy by institutional lenders also opens the possibility of a positive credit decision to less well-off borrowers who have no collateral or only a low income, provided a higher risk-related loan interest rate is accepted by the lender. From the borrower’s perspective, collateral that is as valuable as possible and thus reduces the interest rate should always be sought in accordance with their financial circumstances.