Question

Briefly describe three characteristics of good collateral by completing the table below. (6 marks) Quality Description

Answer 1

Characteristics of a good collateral

The suitability of collateral would depend on following factors - Standardization, , identification,durability, marketability and stability of value.

• Standardization:

Some items especially commodities can be graded, classified or grouped e.g. cocoa beans, to reflect their qualities or standards and therefore facilitate the use in trade transactions as collateral. It is always preferable to use an asset which is graded or of specific quality as a collateral. This removes ambiguity and improves the resale ability of the collateral. It also clears all the doubts of the party asking for collateral.

• Durability

Durability means how much can a collateral overcome the wear and tear of the daily and and stay in working condition/ good quality. Durable goods are better collateral than non-durables. The economic life of a collateral should always be more than the time period for which it is held as collateral. This ensures resale value if at all the collateral is to sold to recover the principal in case of no repayment.

• Marketability:

This refers to how easily can the asset used as collateral be sold in the secondary market. this can also be termed as liquidity in terms of easy conversion to cash which ensures easy money recovery in cas the debtor is unable to repay the loan. Assets with big secondary markets are better collaterals than those with little or no secondary market.

• Identification:

A collateral should have unique characteristics such as serial number, model or marks that cannot be erased are preferable to assets that have no distinguishing features. The lender should be easily able to identify the relevant asset that has been pledged to it as collateral.

• Stability of Value:

Lenders prefer collateral which has market values and are not likely to depreciate significantly during the life of the loan. For example cocoa beans would not be desirable a collateral as a building even for a short-term loan. Banks prefer assets with easy secondary market as collateral. Assets with highly rapid obsolescence are less preferred as a collateral.