How a Collateral Management System Can Reduce Risk

Collateral is as much a part of the loan process as money is. It has been used for hundreds if not thousands of years as a way of placing a guarantee of payment against a loan. But it wasn’t until the 1980’s when the collateral management system came into being. At the time there were no legal standards for it and most transactions were calculated by hand. It wasn’t really until the full integration of the computer came into business transaction that collateral management became wide spread and in 1994 the first standardization processes began.

What is Collateral Management?

Collateral management is the term given to the process of managing all facets of the securities issued on any loan. This type of management is most commonly used in over the counter (OTC) trades. In the beginning this was in the form of bilateral insurance in all over the counter financial transactions, but current collateral management now includes repossessions, collateral arbitrage, cross border collateralization, credit risk collateral outsourcing, tri party/multilateral collateral, counterparty credit limits and more.

It is the method used to grant, verify and give advice on all types of collateral loans with the purpose of reducing credit risk for the bank or financial institution.

It is an area in the loan industry that has experienced rapid growth in the last decade or two, and has been influenced by new technologies, competition and heightened risk taking. It deals with the management of asset pools, leverage, and other facets of the financial world making it very complex with many different interrelated functions, involving corporations, financiers, banks and legal teams.

The Collateral Swap

Collateral swap is an important part of the overall management process. In this type of transaction a bank and large corporation make an agreement where one party makes a profit while the other makes a corresponding loss. The party experiencing the gain can request collateral, whereas the party with the loss has to post collateral.

The Purpose

Collateral management has many functions. One is to offer credit enhancement where a borrower can get better loan rates. But it also affects other facets of finance. For instance, capital adequacy, risk management, operational risk and asset liability are also affected by these procedures.

Parties Involved

There are many different parties involved in a collateral management system. Usually, credit analysis, management, and the legal departments of one or more financial and corporate departments are involved in the process. At times even third-party service providers are involved in the process.