How can you measure collateral risk to reduce default?

1 Collateral valuation

The first step in measuring collateral risk is to determine the current market value of the collateral assets, which may vary depending on the type, quality, location, and condition of the assets. There are different methods of collateral valuation, such as market comparison, income approach, cost approach, and discounted cash flow analysis. Each method has its advantages and disadvantages, and the choice depends on the availability and reliability of data, the nature and purpose of the loan, and the regulatory requirements.

2 Collateral volatility

The second step in measuring collateral risk is to estimate the potential changes in the value of the collateral assets over time, which may be affected by various factors, such as supply and demand, economic conditions, interest rates, inflation, and market sentiment. There are different methods of measuring collateral volatility, such as standard deviation, coefficient of variation, value at risk, and stress testing. Each method has its own assumptions and limitations, and the choice depends on the level of risk tolerance, the time horizon, and the complexity of the loan portfolio.

4 Collateral coverage ratio

The fourth step in measuring collateral risk is to compare the value of the collateral assets after applying the haircut to the amount of the loan outstanding, which indicates the degree of protection that the lender has in case of default. This comparison is known as the collateral coverage ratio (CCR), and it can be calculated by dividing the net collateral value by the loan balance. The higher the CCR, the lower the collateral risk, and vice versa. The CCR can be used to monitor the performance of the loan, adjust the loan terms, or trigger corrective actions.

5 Collateral diversification

The fifth step in measuring collateral risk is to evaluate the degree of diversification of the collateral assets, which affects the correlation and concentration of the collateral risk. The more diversified the collateral assets, the lower the chances that they will all lose value at the same time or in the same proportion, and vice versa. There are different methods of measuring collateral diversification, such as portfolio variance, Herfindahl-Hirschman index, and entropy. Each method has its own merits and drawbacks, and the choice depends on the size, composition, and structure of the collateral portfolio.

6 Collateral management

The final step in measuring collateral risk is to implement a collateral management system, which involves the policies, procedures, and tools that enable the lender to identify, measure, monitor, and control the collateral risk. A collateral management system should include the following elements: a clear collateral policy, a robust collateral valuation process, a regular collateral monitoring and reporting mechanism, a flexible collateral adjustment and substitution mechanism, and a sound collateral recovery and disposal mechanism.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?