Why The Need For Collateral Security In Loans

In real life, it often happens that the recovery value of the collateral is less than its deterrent value. The difference, i.e. deterrent value - recovery value, is the “margin buffer” or the extra comfort a lender gets. The higher the difference, the higher the buffer, as the loan amount is mostly lower than the recovery value of the collateral.

- V.P. Nandakumar is MD & CEO of Manappuram Finance Ltd.

A question that banks and NBFCs (or others in the business of lending money) often get asked is, why do they require collateral? In the context of finance, collateral is a property or any other asset that a borrower offers to the lender to secure the loan. If the borrower defaults on the loan repayments, the lender can take possession of, and sell off, the collateral to make good the losses.

Collateral serves two primary purposes. The first is to act as a deterrent to the borrower against defaulting on his promised repayments (i.e. deterrent value). The second is to help the lender with the recovery of the dues (i.e. recovery value).

In real life, it often happens that the recovery value of the collateral is less than its deterrent value. The difference, i.e. deterrent value – recovery value, is the “margin buffer” or the extra comfort a lender gets. The higher the difference, the higher the buffer, as the loan amount is mostly lower than the recovery value of the collateral. Of course, in some cases, the actual recovery amount could turn out to be less than the collateral’s assessed recovery value. Such variances can arise either due to faulty assessment or changes in market conditions.