Collateral, default risk, and relationship lending: An empirical study on financial contracting
Relationship management and credit administration C A credit's risk rating Using two rating systems, one for risk of default and the other for expected loss; assigned collateral and other elements of the loan structure in addition to the. Our results indicate that the use of collateral in loan contracts is mainly driven by aspects of relationship lending and renegotiation risk. Relationship lenders do. This paper provides new insights into the nature of relationship lending by analysing the role of collateral and its real effects with respect to workout activities.
The first step is to identify the risk factors associated with each loan transaction. Knowing your customers and the markets in which they invest are two of the simplest and most basic tools of understanding risk.
Living, working and playing in the same community as your Borrower is a surefire way to know their business environment. This knowledge of the customer is one of the Five Cs of Credit that Lenders use to determine risk levels. These measures incorporate both qualitative and quantitative analytical tools as follows: Generally, the higher the equity contribution, the lower the risk to the Bank; Collateral - An alternative source of repayment if cash flow cannot be relied upon to pay the debt; and Conditions - Also known as loan structure.
This refers to both the return built into the investment the interest rate being charged as well as the conditions placed on the accommodation to ensure the Bank is repaid hopefully in full! This last category, Conditions, is also a means by which Banks can manage the risk to a level commensurate with the return.
Loan structure is considered by many to be the most effective tool Banks have to manage risk. This is because the elements of risk in a transaction can be addressed selectively, with fine tuning used to address those aspects of the transaction that are perceived to be too risky for the return.
Some of the more common structural tools used are: Loan-to-Value Ratio — Determines the level of Borrower equity in the transaction. It is expected that relationship lending measured by the observable factors such as duration of account operation, prompt loan repayment, deposit or investment level of the farmer and the farmers ability to get information from the bank will have negative effects on the collateral pledged by farmers.
However dealing with multiple banks is expected to increase collateral pledged by farmer.
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The remainder of the paper is organized as follows. Conclusion and policy implication of the study appears in Section 5. Literature Review In general before loan are approved and granted to the borrowers, the bank and for that matter the lender normally demand security in the form of collateral or personal guarantees [ 13 ]. The financial institutions take the security for some reasons.
The banks claim that by taking the collateral, borrowers do everything possible to pay back the loan since they are not willing to lose ownership of their assets. This help to address problems of moral hazard and adverse selection, reducing implicitly the probability of default [ 64 ].
Second, the collateral can be disposed of to pay off both the principal and interest in case of default. This reduces the loss of default for the lender [ 16 ] and thereby providing the bank with a hedge in case of default [ 64 ].Collateralized debt obligation overview - Finance & Capital Markets - Khan Academy
It is important to note that loans that attract collaterals are those with a higher probability of default [ 40 ]. According to [ 12 ], whether the bank will take collateral or not depends on the characteristics of the farmer taking the loan, the loan size, availability of information, the length of the relationship, the age of the firm and the features of the governance structures covering the loan contract.
As the firm grows in age, scholars point out that the probability of gaining access to credit increases with a decrease in the request for collateral since newer firms are considered to be the risky to be dealt with [ 3 ].
As the firm grows older, the relationship with the bank increases, and this reduces the collateral requirements [ 2337 ]. Indeed, firms with more experience and with a longer relationship provide banks with a greater amount of private information, giving them the possibility to discriminate between firms with poor track records and those that present moral hazard and adverse selection risks [ 1424 ].
Relationship exhibits a matter of closeness [ 52 ].
The value of private information depends on its concentration, as the greater the concentration, the more complete the information thus the lower the request for collateral. Finally, relationship lending is a matter of quality of information, if the bank gets quality information from clients as a result of closeness it becomes easy for the bank to evaluate the riskiness of the firm and hence the lower the request for collateral [ 35 ].
Research by [ 42 ] found a negative correlation between lending relationship and the collateral request from the bank. That is greater interaction is associated with lower collateral demand.
- Collateral, Default Risk, and Relationship Lending: An Empirical Study on Financial Contracting
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- Collateral, default risk, and relationship lending: An empirical study on financial contracting
Thus, in general lenders ask for less private collateral as the relationship with clients becomes more intense 3. The area occupies a total land area of 63, square kilometers and is centrally located in the middle belt of the country.
The area lies between longitude 0. The population of the study area is about 7, The annual average rainfall ranges between mm and mm. The rainfall pattern is bimodal; the major rainy season starts in March, with a minor peak in August tapering off in November.
Agriculture and related work is the major occupation in all the districts within the study area, though the level and intensity as well as farming systems vary between districts. The proportion of working population engaged in agriculture and agriculture related activities in Brong Ahafo Region ranges from a low of Sampling Techniques The sample was selected in three 3 stages; first was the purposive selection of regions followed by the purposive selection of districts.
Agricultural activities guided the selection of the two regions while the districts were selected based on the level of maize production using official statistics from [ 48 ].
After a consideration of the objectives of the study and time and resources available, eight 8 districts were selected including three from Ashanti Region and five from Brong Ahafo Region.
The third stage of the sampling involved the identification and listing of the communities and the maize farmers in the operational area.