Why does a bank value your collateral below the market price, and how is the amount you can borrow calculated?
The market price of a warehouse, a truck and goods totals 1 150 million soum, but the bank counts them as 720 million and asks for 625 million of collateral for a 500 million loan. This is not unfair, it is protection against losses on a quick sale of the collateral. A full calculation with hypothetical coefficients, the difference between types of collateral and where collateral appears in the accounts.
Zarina, director of "Chorvoq agro" LLC, applied for a loan of 500 million soum to export dried fruit. She offered three things as collateral: the warehouse building, a truck and the goods in the warehouse. Adding up the market prices given by the valuers, she got 1 150 million. "We are giving twice as much collateral as the loan, no problem," Zarina thought. The bank, however, named a different figure.
All the coefficients, requirements and amounts below are hypothetical, compiled by the author. Each bank sets them by its own internal rules, so find out the exact terms only from your own bank. Amounts are in million soum.
Why do the market price and the bank's valuation differ?
Think about how the bank uses collateral. Collateral is needed only in a bad situation: the debt has not been repaid, the company is struggling. Then the bank tries to sell the property and get its money back. And this sale is worse than a "normal" sale in three respects: - a forced sale: there is no time to wait months for a buyer, so the price is cut; - selling costs: valuation, advertising, paperwork, sometimes court proceedings; - time: until the property is sold, interest on the debt keeps accruing, while the property wears out or loses value.
Taking the warehouse as an example: the market price is 600. If the price is cut by 15% for a quick sale, 510 remains. If 5% of that goes on selling costs, 484.5 ends up in hand. That is roughly 81 percent of the market price, and losses from time and interest have not yet been taken into account. That is why the bank multiplies the market price by a discount coefficient.
How is the collateral value calculated?
| Collateral | Market price | Bank coefficient (hypothetical) | Value accepted by the bank | Discount |
|---|---|---|---|---|
| Warehouse building | 600 | 0.70 | 420 | 180 |
| Truck | 250 | 0.60 | 150 | 100 |
| Goods in the warehouse | 300 | 0.50 | 150 | 150 |
| Total | 1 150 | 720 | 430 |
Why are the coefficients different? The logic is the same: the faster the property loses value and the harder it is to sell, the lower the coefficient. - A building does not move, does not disappear, and its price changes relatively slowly. But finding a buyer takes a long time. - A truck wears out every year and can be damaged in an accident, but it is easier to sell. - Goods in the warehouse are the most "mobile" collateral: they are sold every day and new ones arrive, some spoil, and their price changes with the season. They are the hardest for the bank to monitor.
How much can be borrowed?
The bank wants to cover not only the debt itself but also the interest and costs that will accrue. That is why it may require the collateral value to exceed the loan amount by a certain proportion. In our example the bank's condition is: the collateral value must be at least 125 percent of the loan amount (hypothetical).
So a loan of 500 million requires a collateral value of 500 × 1.25 = 625.
| Property pledged | Collateral value | Maximum loan (collateral value : 1.25) | Enough for 500? |
|---|---|---|---|
| Warehouse only | 420 | 336 | No |
| Warehouse and truck | 570 | 456 | No |
| All three | 720 | 576 | Yes |
Zarina's idea of "twice as much collateral" was correct at market prices: the loan is about 43 percent of the market price (500 : 1 150). But at the bank's valuation the cushion is much smaller: 720 exceeds the required 625 by only 95.
What happens if the collateral value changes during the loan?
The goods in the warehouse fluctuate the most. If Zarina sells off the goods at the end of the season:
| Goods in the warehouse (market price) | Collateral value of the goods (× 0.50) | Total collateral value | Requirement: 625 |
|---|---|---|---|
| 300 | 150 | 720 | Met |
| 180 | 90 | 660 | Met |
| 100 | 50 | 620 | Short by 5 |
If the goods fall to 100, the collateral is 5 short of the requirement. In such a case, depending on what the bank agreement says, additional collateral or early repayment of part of the debt may be required. That is why, with collateral in goods, the agreement usually sets a minimum balance and a reporting procedure: read these clauses carefully before signing.
Where does collateral appear in the accounts?
Pledged property remains the company's property. The warehouse building stays in account 0120 "Buildings, structures and transmission equipment" and the truck in account 0160 "Vehicles", and depreciation is calculated as before. The NAS No. 21 table contains no sample on-balance-sheet journal entry for pledging.
Off-balance sheet account 009 "Security for obligations and payments – issued" is designated in NAS No. 21, paragraph 446, for guarantees given to secure obligations; it also says there that the amount of security is written off as the debt is repaid. State clearly in your accounting policy whether collateral is tracked in this account and at what amount (the value in the agreement or the carrying amount).
Practical tips
- Before applying for a loan, do the calculation yourself the bank's way: add up not the market prices but the discounted values. Then there will be no unexpected "not enough" answer when you go to the bank.
- If there are several items of collateral, make the most stable one (for example, the building) the main one: goods and vehicles may lose value during the loan.
- Selling, leasing out or re-pledging pledged property usually requires the bank's consent: do not make such a decision without reading the agreement.
- Collateral value does not replace the ability to repay the debt. The bank looks first at whether the company's cash flow can cover the debt; collateral is the second line of defence.
Test yourself
5 questions on this topic: pick an option or reveal the answer.
In the simplified textbook deposit multiplier model, banks hold no money beyond required reserves, and all loans granted return to banks as deposits. If the notional reserve ratio is 20%, by at most how much can total deposits increase as a result of a new deposit of 10 000 000 soum entering the system (multiplier = 1 / reserve ratio)?
A bank took the borrower's property as collateral under a loan agreement. What is the main meaning of collateral for the bank?
An entrepreneur took a bank loan of 10 000 000 soum: 1 year, 20% simple annual interest, interest and principal paid at the end of the year. When issuing the loan the bank immediately withheld a one-off fee of 2% of the amount (hypothetical terms). What is the approximate effective annual cost of the loan relative to the money actually received?
A hypothetical commercial bank's assets: government securities 300 bln soum (risk weight 0%), loans to companies 500 bln soum (100%), funds in other banks 200 bln soum (50%). The bank's capital is 90 bln soum. What is the ratio of capital to risk-weighted assets (hypothetical weights)?
According to the bank statement, account 5110 "Settlement account" had an opening balance of 15 000 000 soums at the start of the month, debit turnover during the month of 40 000 000 soums and credit turnover of 32 000 000 soums. What is the closing balance at month-end?
Answered: 0 / 50 of 5 correct
All tests →See also
Sources
- NAS No. 21 "Chart of Accounts for Accounting of Business Entities and Instructions for Its Application", paragraph 446 · purpose of account 009: tracking the amount of guarantees the company has given to others (security for obligations and payments) and how it has changed; as the debt is repaid, the amount of security is written off
- NAS No. 21 "Chart of Accounts for Accounting of Business Entities and Instructions for Its Application", list of accounts · 0120 "Buildings, structures and transmission equipment", 0160 "Vehicles", name and type of account 009 (off-balance sheet)
- Fundamentals of banking (general concepts) · collateral, the market value of collateral and the value accepted by the bank, the ratio of the loan amount to the collateral value (loan-to-value); general knowledge
- Example, company name, coefficients, amounts and calculations · compiled by the author, hypothetical; each bank sets its collateral coefficients and requirements in its own internal rules