Collateralized Working Capital Loans

INTRODUCTION

The term “asset-based lending” can be defined as any type of lending that can be secured by an asset, and is better known in the industry as collateralized working capital loans. The process simply involves granting working capital loans against a borrowing company’s trading assets.

Such loans can either be paid out on a short-term basis or revolved up and down based on the changing level of the borrower’s collateral. These types of loans seemed to fit neatly into the floating charge / lien concept as defined for example by the Uniform Commercial Code (“UCC”), which gives a financial institution the right of a perfected security interest in constantly changing collateral.

Today however, the term “asset-based lending” has taken on a broader connotation. Lenders are now grouping all company assets – whether tangible or intangible, real or personal property – and other types of credits, such as amortizing term loans, all into the asset-based category. This may not necessarily be correct.

Asset-based lending should only be defined as the extension of credit against a company’s floating assets on a collateral margin basis, with strong emphasis placed on establishing and maintaining collateral controls by the lending institution. Lending against real estate should not be considered as asset-based lending for several reasons. Firstly, real property is subject to individual territorial and country specific legislation. Secondly, real property has many different lending parameters compared to other assets. Also, there is limited need to control and monitor most immovable real property collateral compared to trading assets such as accounts receivable and inventory.

Although asset-based lending involves higher credit risks, there are many reasons why banks should begin to grant loans on the basis of the borrower’s trading assets and gradually enter into this transactional field. One main reason is competition. In general, banks have traditionally been conservative and made the majority of loans based on the strong equity base of borrowing companies. They have shied away from higher-risk loans secured by floating assets. Inevitably, banks have therefore handled a lower volume of loans and maintained a smaller ratio of loans to deposits and capital. The end result was a constricted loan portfolio growth, since funds were loaned only to credit worthy and financially strong borrowers.

Since banks were reluctant to meet the needs of companies which had not yet proved their financial strength, other “alternative” institutions (such as non-banking finance institutions and funds) rushed to fill the void. As a matter of fact, the banking industry has made asset-based loans on a limited basis for years. Since our inception in 1996, we have witnessed many regional and local banks began to make inroads into this market. Since then, certain banks around the world have entered the field of asset-based lending as part of a general trend toward full-service banking. These banks have recognized a very important benefit to be had from asset-based lending: not only did it help them remain competitive and maintain their market share, but asset-based loans generated significantly higher yields and spreads – fulfilling the increasing revenue pressure that today’s bankers are subject to.

Over the years, although the banking industry has become increasingly involved in asset-based lending, banks have all too often neglected to adopt the proper dominion and control procedures required for these loans such as the implementation of a valid bailment in order to render constructive possession over the collateral and the ability to maintain continuous, exclusive and notorious possession over the underlying collateral against which the financing is to be provided.

While it is commonplace for bankers today to make commercial loans against balance sheet assets, many of them do not fully understand how to properly police and control the assets being collateralized. Even when they know what it takes to do the job, they may not want to incur the expenses in getting involved in the handling or monitoring such high-risk credits. Furthermore, many banks may have been lulled into complacency by merely signing a security or pledge agreements and the filing a financing statements such as under the UCC, or other registration documents under applicable statute, ensuring that notice of their interest is provided to the public at large and priority of lien is maintained through such filing and registration.

In reality, that protection may well be illusory as the signing of such documentation does not necessarily mean that the underlying collateral exists at all times throughout the financing and that appropriate controls are in place. Strictly from a credit stand-point there is good reason these days to implement prudent asset-based lending procedures and appropriate controls in order to properly secure the interest of the lending bank. If banks are to operate in the realm of asset-based lending, bankers must know how to control and police their collateral better than before to protect themselves from asset impairments.

The risk becomes greater when making loans secured by asset-based collateral such as accounts receivable and inventory because these often require only collateral margin protection based on a borrowing base formula. Then, in contrast to term loans where banks expect continuous amortization, banks adjust their debt up or down according to the expansion and contraction of such collateral.

As a result, this constantly changing trading asset collateral becomes very important to banks as a secondary source of repayment.

The foregoing discussion and this new emphasis on asset-based lending should not be interpreted to mean that banks should no longer depend on unsecured loans. Banks certainly do make unsecured loans to companies that warrant such credit – and banks would all like to have more unsecured loans in their loan portfolios. We know, however, that this facility is not abundantly available to every bank and to every customer. What needs to be emphasized is that a large majority of companies in the developing countries today are small to medium-sized enterprises. Many are in a state of continuous growth and do not have the financial strength and equity base to qualify for unsecured credit. They represent a vast lending market, and it would be shortsighted for banks to ignore it.

Lending on the basis of trading assets is an investment in the future. The good bankers will not only make loans to asset-based borrowers but will also act in the capacity of financial advisors for the duration of such transactions.

It is advised that bankers should work closely with their asset-based customers to enhance their financial condition so that someday they may qualify for unsecured loans. It is more than likely that this service on the banker’s part will make a loyal and long-term customer out of the borrower – to his benefit and to banks.