Media reports say that Bangladesh Bank (BB) is in the process of developing a database for collateral securities retained by banks against granting loans and advances. The purpose of developing such collateral database is to prevent fraudulent practices of submitting fake documents regarding collateral security for securing loans. The government will also enact laws in this regard, according to the reports.
Accepting genuine and unencumbered collateral security is the core responsibility of the concerned lending entities and Bangladesh Bank has no role to play in this connection. By way of getting involved with commercial banks' affairs, the central bank is swamped with so much on-sight and off-sight supervision that its prime responsibility of formulating policy and enforcement thereof is affected. And for no reasons it has to take the blame for any failure in the country's banking industry. This situation will continue unless the financial institutions are compelled to play their self-regulatory role in their day-to-day affairs.
However, Bangladesh Bank's proposed collateral database may not serve the purpose and objective as expected. Collateral locking, instead, may be envisaged as a suitable alternative. Centralized control, along with locking system, is the only measure which, if introduced, may avoid duplication as well as fraudulent acts related to collateral security.
The centralized control and locking system of collateral security have never been inroduced in our country. In fact, the most unorganized and chaotic situation is prevailing in the operation of collateral security in the country's banking industry. Most of the loans and advances have been sanctioned keeping some form of tangible assets as collateral security, yet the loans cannot be realized through collateral security. The mismatch between the value of collateral securities and outstanding loans has assumed critical proportions. This is the result of overvaluation of land and building, submission of fraudulent documents, lack of proper collateral locking process, duplication of collateral security, submission of third-party property, sharing of charges, wrong physical property and many others. Thus, the initiative of streamlining collateral security is definitely a praiseworthy measure. This, however, needs to be done in line with modern practices of collateral management system of financial market.
PRIMARY SECURITY: Loans and advances granted by banks and financial institutions are mostly secured under two broad categories of security arrangements - primary security and collateral security. Primary security refers to the business products based on which lending decision is made. It mostly comprises hypothecation and pledge of goods produced or traded by the borrowing company. Both hypothecation and pledge are the process of retaining the title to goods to the bank. However, these two means of securing loans are different in terms of control over the goods.
Under hypothecation, the control of goods is retained with the borrower and bank has no physical control over the hypothecated goods. The borrower periodically submits the stock report on hypothecated goods based on which basis of borrowing is determined. Bankers are supposed to randomly visit the store or warehouse and verify the stock report. This is merely a kind of paper work. On the other hand, bank has full physical control over goods pledged to the bank. Goods are stocked in the warehouse and kept under lock and key by the banker. Borrower will pay off the loan and then the quantity of goods worth the proportionate amount of loans is adjusted. Pledge was once very popular and the common form of primary security arrangement against loans and advances. But financial scandals, particularly regarding delivery of goods without adjustment of loan and stocking fake or inferior goods instead of original goods under pledge, marred the reputation of this security arrangement and it has now almost disappeared from our country. Only hypothecation of goods and service remains effective.
However, in the developed world, the concept of pledge has been modernized into legal/documentary pledge and all forms of security arrangement against loans and advances are pledged.
COLLATERAL SECURITY AND ASSIGNMENT OF BILLS: In addition to borrower's regular business product, bank's loans and advances are secured by taking additional form of security which is known as collateral security. This collateral security usually consists of mortgage of land and building and assignment of bills receivables.
In many cases, both assignment of bills and mortgage of land and building are taken together as collateral security, especially when loans and advances are disbursed against work-order. In fact work-order finance and construction loans require this type of security arrangement. This form of security arrangement is executed through legal documentation. Assignment arrangement is made with the work-order issuing authority which provides a sort of assurance that bills against the given work-order is to be issued to the order of lending bank and in this connection the borrower executes a power of attorney authorizing the lending bank to receive the bill on behalf of the borrower. Upon receipt of each bill against assigned work-order, certain amount as per agreed terms is retained by the bankers towards adjustment of outstanding loans. Even, the loan limit and APG (Advance Payment Guarantee) value, if issued, is also reduced accordingly.
This assignment of bills poses serious challenge and weaknesses from operational perspective. In many cases, the work-order issuing authority does not want to be the party of the assignment and as such does not want to stand as assignor through execution of assignment document. In this situation, lender has to exclusively rely on borrower without any legal binding of receiving bills or cheques issued in favour of the borrower. Even there are instances that in spite of having assignment arrangement in place, the work-order issuing office do not make the bills/cheques to the order of the lending entity. Under this situation, cheques/bills are issued which allow the borrowers to deposit to any of their account exposing the risk of outstanding loans remaining unadjusted. Finally, even the bills/cheques issued to the order of lending bank may be deposited to the borrower's accounts with the understanding of those banks and so there are possibilities of fund diversion which is likely to result in defaulting loans. Defective assignment arrangement or limitation of assignment is considered as one of the main reasons of high rate of NPL (Non-Performing Loans) in the work-order finance in our country. At the same time, the work-order finance is the most popular form of bank loans and its volume will persistently rise as more development works are likely to take place in the days ahead. Time has come to streamline this collateral security arrangement so that risks associated with assignment of receivables are mitigated.
COLLATERAL SECURITY AND MORTGAGE OF LAND AND BUILDING: The most important and popular form of collateral security is mortgage of land and building. Almost all commercial loans and advances are backed by mortgage of land and building. Practice of mortgaging land and building to bank is so widespread that sometimes it seems that no single piece of land can be found unencumbered in the country.
Though bankers prefer land and building as collateral security against each and every loan, the fallacy of mortgage of land and building is that it does not guarantee the recovery of loans at all. Collateral is rather viewed as a great impediment to business growth. Enterprising and thrifty businessmen and entrepreneurs never spend their surplus money to purchase land and building. They, instead, grab more and more investment opportunities with the surplus money and thus ensure growth of their business. On the other hand, risk averters always prefer to spend their money to purchase land and building. They are not apparently good at business. So preference of land and building as collateral security has the risk of selecting wrong borrowers.
History also shows that mortgage of land and building does not guarantee the recovery of loans. Though land and building are mortgaged with bank against loans and advances, the debt servicing performance is not satisfactory at all in our country and the percentage of NPL is persistently rising. Banks have miserably failed to recover outstanding loan by disposing mortgaged land and building. The banking industry in the developed world had this bitter experience and the practice of mortgaging land and building against commercial loan has long been discarded. Except residential and commercial real-estate financing, mortgage of land and building is no more an acceptable form of collateral security in the developed countries. Instead, the borrowers are now tied with legal binding to repay the loan.
Our banking industry should actively consider to bringing about reforms in the lending system. The collateral-based system should be replaced with one of strong legal binding. This will require restructuring of the industry through strengthening laws regarding bankruptcy, merger, acquisition, takeover, etc.
Nironjan Roy, CPA, CMA is a banker in Toronto, Canada.
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