1 SECURITY DISCOUNT FACTORS

We will now look at why, when a bank is valuing an item of security, it will normally take only a
percentage of the underlying value of the asset into its calculations. There are a number of reasons why
a bank will choose to discount the value of a security:

• The value of the security may fall from time to time therefore the bank may wish to build in a
contingency against the value of the security being lower at the time of realisation than the value at the
time the advance was agreed.

• If the bank has to realise the security, there could be expenses associated with this therefore the bank
would want to have these costs covered from the proceeds of the realisation of the security.

• If the security has to be realised, the customer may well have been having financial difficulties and so
has not been able to meet the ongoing interest charges on the borrowing which may be added to the
outstanding obligation. As a result, the final debt that the customer owes the bank may be greater than
the amount of the outstanding borrowing. Again, the bank would want to guard against possible loss
here by having a margin on the underlying value of the security.

Security discount factors will be reviewed from time to time (and can vary from bank to bank) to take
account of the changing economic conditions. Therefore, you should not look upon the discount factor
as something that is set in stone but rather as something that will change with the different
circumstances prevailing in the economy, For example, security discount factors will normally be
reviewed as a result of falling property prices and stability of the stock market. Having looked at why the
bank would want to discount the value of the security, we will now consider the different types of
security that the customer could offer, before later looking at the various discount percentages (or
security margins) used.

2 TYPES OF SECURITY AND THEIR DISCOUNTED VALUE

Some of the many types of security that personal customers may offer are:

• Cash deposit

• Guarantee

• Residential property

• Letter of undertaking/irrevocable mandate

• Life assurance policy

• Gilts

• Stocks and shares.

We examine securities from companies in a separate section. Different securities are given different
discount factors by a bank. We will look at some indicative discount percentages for each type of
security.

2.1 CASH DEPOSIT

Normally the bank would take 100% of the value of the cash deposit that has been pledged as security
because the value of this security will not decrease as the funds will be placed in a separate account. It is
also normal to expect the value to increase over time as interest is earned on the deposit and added to
it.

2.2 GUARANTEE
A guarantee may be valued at 100% but this will be determined by whether or not the guarantee is
supported or unsupported. A supported guarantee is one where the guarantor has provided additional
security which can be looked to only in the event that the guarantor is not able to fulfil their guarantee
obligation if called upon. We cannot realise more from the collateral security than the amount of the
guarantee.

2.3 RESIDENTIAL PROPERTY

Normally residential property is taken at around 80% of the market value which will allow for a potential
drop in the value of the housing market. You will recall that recently property value fell substantially.
Hence it is important to maintain a margin. There are additional items to think about if the bank only
holds a second charge over a property. This could be where the customer has granted a first security
over their property to their mortgage provider and then gives the bank a subsequent security over their
property. Example The customer has a residential property valued at £150,000 and has granted this
property in security to the Rutland Building Society for their mortgage – let’s say the outstanding
mortgage is £50,000. We could calculate the value of the second security as follows: Value of property
£150,000 Less discount – 80% 120,000 Outstanding mortgage 50,000 Security value £70,000 Therefore,
for security purposes, this property is valued by the second security holder (the bank) at £70,000.

2.4 LETTER OF UNDERTAKING/IRREVOCABLE MANDATE

You will recall from the chapter on lending products that this is a security normally encountered when
dealing with bridging finance which can either be open ended or closed ended. This distinction affects
the security discount factor. Normally for closed bridging the full value of the security is taken, but for
open bridging a reduced figure in the region of only 80% of the value of the security is usually taken The
reason for the difference is that open bridging is a riskier proposition as there is not a firm settlement
date for the sale of the customer’s existing property, hence the more conservative view.

2.5 LIFE ASSURANCE POLICY

Around 75% of the value of the policy is taken for security purposes. This will cover any potential
shortfall in the value of the policy.
2.6 GILTS
Gilts, or government securities, are a less risky form of investment than shares as they are issued by the
government to support their medium to longer term borrowing requirements; they therefore carry little
risk. Additionally, as the price of gilts tends to be much more stable than shares, banks will place a less
conservative discount value against them; hence a discount factor of around 75% is normally applied
here.

2.7 SHARES
A number of different types of share can be offered as security:

• Shares quoted on the Alternative Investment Market (AIM)

• Shares quoted on the main market, often included in the FTSE indices

• Unquoted shares.

These are given varying discount values primarily due to the marketability of the investment type and
the volatility of the market in which the investments are traded. The figures we should be considering
here are:

• AIM shares – generally around 25% of the value

• FTSE shares – generally around 50% of the value

• Unquoted shares – generally no value is placed on these shares due to their very limited marketability.

A bank may still want to take unquoted shares as security because they see the pledging of these shares
as a mark of the customer’s commitment to the lending proposal. Although these shares are valued at
zero for security purposes, they still have a monetary value that the bank could utilise in the event of
default by the customer. All the above securities can be granted by individuals, including sole traders,
and partners in a partnership.

2.8 SECURITIES FROM LIMITED COMPANIES

Basically, there are two types of security which a company may grant:

• Fixed securities

• Floating charges.

A fixed security is over the company’s property which comprises land, buildings, and anything attached
to the land or buildings that cannot be removed, such as heavy plant or machinery concreted to a
factory floor Once registered, a fixed security, known as a legal mortgage fixes or attaches to the land
buildings and other heritable assets belonging to the company and mentioned in the document creating
the charge. A fixed charge ranks prior to a floating charge. Fixed charges rank in priority according to
their date of registration.
3 CATEGORIES OF SECURITIES

3.1 PRIME SECURITIES

Primary Security is one which is deposited by the borrower himself and thus provides the main cover for
the advance made. Primary security may be either personal Security or Impersonal security or both.

3.1.1 Personal Security:

When personal advance is made the borrower is personally liable to repay the advance for which he
executes promissory note, accepts or endorses a bill of exchange and makes personal covenants in
mortgage deed or loan agreements.

Banker has the right of action to proceed against the borrower personally in the event of default or non-
fulfillment of conditions as per agreements.

3.1.2 Impersonal Security:

Impersonal security is given when a charge is created by way of hypothecation/pledge/mortgage over
the borrower’s tangible assets-such as, goods and commodities, fixed assets, book debts and bills
receivables etc.

In case of default, the bank is empowered to proceed directly or through the intervention of the court to
dispose of the impersonal security and realize the dues. Impersonal security may take the form of either
specific security or continuing security and realize the dues.

Impersonal security may take the form of either specific security or continuing security. She specific
security covers the specific loan alone and does not cover any other indebtedness of the borrower to
the bank.

In case of continuing security for an advance in cash credit or overdraft account, the memorandum
creating a charge on the assets is so worded as to make it a continuing one to cover all sums due now or
in the future form the borrower until the ultimate balance is determined and regardless of whether the
account may at times go into credit.

3.2 COLLATERAL SECURITIES

A collateral security is a security belonging to and deposited by borrower himself or by a third party to
secure loans and advances. Collateral security is in addition to primary security.

Collateral security in a wider sense is used to denote any type of security that runs parallel to or side by
side with the personal right of action against a debtor in respect of an advance.

Collateral security may be direct or indirect.

Collateral security obtained from the borrower himself to secure his own account is known as direct
collateral security. Advance against hypothecation of stock-in-trade which is considered a weak security
is strengthened by equitable mortgage of title deeds of house property of the borrower.
Indirect collateral security means any form of security given by a third person to secure a customer’s
account. A guarantee is an indirect collateral security because it is given by one person to secure
another person’s indebtedness.

These collateral securities are advantageous form the banker’s stand-point because, in the case of
insolvency of the customer, the can prove for his whole amount of debt against the assets of the debtor
and receive form the customer’s estate all he can in the course of distributing by the official assigned,
and thereafter fall back upon the collateral security for the deficiency.

The usual practice should be to obtain a memorandum of deposit of security in a proper form. This is
most essential because even though in law such memorandum is not necessary, the banker, by using it,
protects himself by inserting in ti the clauses necessary for such protection.

3.3 MOVABLE SECURITIES

Moveable security is based upon the assets that can be move from one place to other i.e. car, machine
etc.

3.4 IMMOVABLE SECURITIES

Immovable security is based on an immovable object/asset, an item of property that cannot be moved
without destroying or altering it or property that is fixed to the earth, such as land or a house.

3.5 TANGIBLE SECURITIES

“Tangible” is based on an asset that you can feel or see; for example, buildings and land are tangible,
intellectual property rights are intangible.

3.6 INTANGIBLE SECURITIES

“Intangible” is based on an asset that you cannot feel or see; for example intellectual property rights are
intangible.

4 LEGAL FORMS OF SECURITIES

In the lending process, there is a concept of right type of security structure for a particular type of loan /
facility. This in other words means that right security structure for one type of finance facility might not
be right for some other type of financing facility for example for working capital loans the primary
security is the hypothecation of stocks and receivables while mortgage of collateral is the secondary
security for such loans. But if we use this type of security structure for Cash finance facility, this will not
work and it will require yet another different type of security which will deem fit for this type of finance
facility. In the previous sections we have read shortly about particular types of securities for particular
types of loans which is comprised of primary securities, secondary securities guarantees etc.

Common types of collaterals / securities used in different combinations for securing different types of
loans / facilities are discussed as under:
4.1 HYPOTHECATION
An arrangement in which neither the possession nor the title but only the right to sell an asset or
property passes on to the creditor or lender. In other words when a moveable property / goods are
charged with the amount of debt but neither the ownership nor the possession is passed to the lender,
it is said to be hypothecated.