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The importance of security in lending

Hausarbeit 2015 8 Seiten

BWL - Investition und Finanzierung

Leseprobe

Table of Contents:

Introduction

Information asymmetry and credit risk

Security and The Floating Charge

Crystallization / De-crystallization

Evaluating Floating Charge As Security

References

Introduction

For a company to start and run its business, the availability of capital for instance through bank loans would require some agreement or promise to repay the loan. Living in an uncertain economy with financial instability, makes it harder to bring about secure financial transactions. Indeed, the availability of information regarding the borrower to the lender has been seen as asymmetrical and led to some problems associated with credit risk. Hence the need for security for the lender. In this case, floating charge in particular is an English innovation in security that very well serves both borrower’s and lender’s objectives. This paper shall critically discuss it.

Information asymmetry and credit risk

It was in the context of the 1970s' 'economics of imperfect information' proned by G. Akerlof, M. Spence, and J. E. Stiglitz (who received the 2001 Economics Nobel Prize for their contribution on the analysis of markets with asymmetric information), that « the current theories of the economic role of financial intermediaries (...) began to emerge ». According to Claus I. and Grimes A, (2003) banks, also known as financial intermediaries, « exist because they can reduce information and transaction costs that arise from an information asymmetry between borrowers and lenders ». Financial intermediaries' economic roles are provided through the provision of liquidity (i.e. the transformation of illiquid assets into liquid liabilities ») and the « ability to transform the risk characteristics of assets ».[1] Indeed, the main purpose that would affect at the macroeconomic level, is the reduction of « the cost of channelling funds between borrowers and lenders, leading to a more efficient allocation of resources ». In other words, Claus I. and Grimes A (reffering to the study of Diamond and Dybvig,1983), assert that :

Banks can improve on a competitive market by providing better risk sharing among agents who need to consume at different (random) times. An intermediary promising investors a higher payoff for early consumption and a lower payoff for late consumption relative to the non-intermediated case enhances risk sharing and welfare.[2]

Information asymmetry in credit markets usually takes place because one party (the borrower) has access to more information about its own investment plan, than the other party (the bank lender). Indeed, during an 'ex ante' (before providing for loans) situation, the lender meet an 'adverse selection' issue between borrowers with different credit risks. It would take an increase in the interest rates to select those high-risk borrowers « because those who are willing to pay high interest rates will, on average, be worse risks ».

In the case of 'ex post' situation, the infomation asymmetry problem arises when borrowers « can observe actual returns after project completion”, that could lead to a 'moral hazard' issue, when legal or illegal activities will take place in order to « reduce the likelihood of a loan being repaid ».[3]

Financial intermediaries' role in dealing with information asymmetry would lead them to « develop special skills in collecting information, evaluating prospective borrowers and investment projects, (...) monitoring loan contracts, [i.e. ] monitoring borrowers’ performance and risk sharing ». However, since « the existence of imperfect, asymmetrically-held information causes frictions in the credit market », the important role of banks and other intermediaries lies in the fact that « they provide credit to borrowers on terms which those borrowers would not otherwise be able to obtain ».[4]

Nonetheless, the need for security remains an important condition for loan approval to the borrower and as a provision for repayment to the lender, in response to information asymmetry and credit risk issues.

Security and The Floating Charge

According to Ellinger (2011, p.808), bank customers making loans usually need « to provide 'security' for the loan to improve the bank's chances of repayment ».[5] In this context of debtor and creditor relations, security is to « provide the creditor with a means – through the exercise of proprietary or possessory rights – of obtaining payment, in addition to mere reliance on the debtor's personal liability ». In other words, security's main purpose is to « protect the creditor should the debtor be unable or unwilling to repay ».[6]

The different types of securities are classified under the notion of propriety. A division first takes place between 'proprietary' and possessory securities, which relates to « the legal nature of the arrangement involved »[7]. In the case of proprietary securities, while during the arrangement the debtor's property is still in his possession, the creditor now has proprietary rights over the debtor's property and can therefore seize it in the event of the debtor's default or insolvency.

Another classification is between open-ended and closed-ended securities. As a proprietary security, a floating charge falls into the category of the open-ended securities, which involves economic factors. According to Ellinger, (2011, p.812) « the freedom that the debtor has to dispose of the collateral (...) is the hallmark of a floating charge ». The floating charge « 'hovers over' the corporate debtor's property without precluding the disposal of that property » until the crystallization phase, when the charge becomes fixed, with the debtor's default taking place and the fixed charge « covering the debtor's property »[8]

Ellinger (2011, p.814) argues that « both proprietary securities and possessory securities generally give adequate protection to the creditor against the debtor's insolvency ».[9] As a proprietary security, floating charge is usually used by financial institutions, for instance, with the banks in the case of financial operation of finance companies.[10] Indeed, the mostly used security « to secure advances made to a company is the charge ». In a legal perspective, « a charge is regarded as a mere agreement to confer some security interest ». In the 1862 Holroyd v.Marshall case, it was decided « as a general rule, a charge is effective if the agreement under which it is created would be specifically enforced in equity ».[11]

The beginning and the functionning of a company requires capital financing, in the form of equity or debt. According to Odo et al., (p.1) « although equity securities represent an ownership interest in the company (...), most companies finance most of their continued operations through debt securities ».

In order to obtain a large funding amount, the borrower needs providing security to the lender, i.e. to repay its debts. In other words, « a holder of the security interest is entitle to seize and usually sell the property to discharge the debt that the security interest secures »[12].

The floating charge can be defined according to Smith I. O., 1992 (in Odo et al., p.2) as. « an equitable charge on all or any of the company's property or assets, the constituent items of which are constantly changing»[13], until the charge become fixed.

It was during the 2005 case of the National Westminster bank plc v Spectrum Plus Ltd, that the House of Lords elected stated that « the essential test of whether a charge was a fixed charge related to the chargor's power to continue to deal with the asset.» In other words, in the case of floating charge, « the chargor is able to deal with the asset, such as by drawing from the account in which charged funds are kept, or into which the proceeds of trade receivables are deposited, then the holder of the charge does not have effective control »[14]. In the same line, Ellinger (2011, p.844) also argues that, « it is the degree of control (...), the freedom the chargor retains to deal with the property and remove it from the charge, that is the main determinant whether the charge is fixed or floating ». The floating charge's advantages thus remain in this « freedom for the chargor to carry on business by dealing with the charged property ».[15] Or in Goode, R. & McKendrick E., 2010 p.733) words, « a floating charge leaves the company free to deal with its assets in the ordinary course of business »[16]

The floating charge has also been « a security favoured by bank », because it has been argued that a floating charge is in harmony with a bank's way of transacting business ».[17] However, some disadvantages related to this freedom, are the chargor's possibility to « create subsequent charges with priority over the floating charge », and « for the charged assets to be depleted in the course of trading » unless the company is profitable again.[18]

[...]


[1] http://www.treasury.govt.nz/publications/research-policy/wp/2003/03-19/04.htm

[2] Ibid.

[3] http://www.treasury.govt.nz/publications/research-policy/wp/2003/03-19/04.htm

[4] Ibid

[5] Ellinger, E, Lomnicka E & Hare C (2011), 'Ellinger's Modern Banking Law', Oxford University Press

[6] Ibid. p.811

[7] Ellinger, E, Lomnicka E & Hare C (2011), 'Ellinger's Modern Banking Law', Oxford University Press, p.823

[8] Ellinger, E, Lomnicka E & Hare C (2011), 'Ellinger's Modern Banking Law', Oxford University Press

[9] Ibid.

[10] Ibid. pp.821, 838

[11] Ibid. p.842

[12] Odo I., Arinoa A., Awaji C., Falade O., 'Floating Charge As A Means Of Security In Corporte Finance', University of Lagos, LLM Program Course : Secured Credit Transaction [accessed May 2015]

[13] Ibid.

[14] Odo I., Arinoa A., Awaji C., Falade O., 'Floating Charge As A Means Of Security In Corporte Finance', University of Lagos, LLM Program Course : Secured Credit Transaction [accessed May 2015]

[15] Ellinger, E, Lomnicka E & Hare C (2011), 'Ellinger's Modern Banking Law', Oxford University Press p.845

[16] Goode, R. & McKendrick E., 2010. Goode on Commercial Law, LexisNexis UK and Penguin Books, 4 ed.

[17] Ibid. pp.854-5

[18] Ibid. p.850

Details

Seiten
8
Jahr
2015
ISBN (eBook)
9783668749955
ISBN (Buch)
9783668749962
Dateigröße
484 KB
Sprache
Englisch
Katalognummer
v432709
Institution / Hochschule
School of Oriental and African Studies, University of London – CEFIMS
Note
60.00

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Titel: The importance of security in lending