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FOS Blog

06 Oct

The new “KYC”…Know Your Collateral

The new “KYC”…Know Your Collateral!

When we think of the commercial lending world, we think of creative underwriting and complex transactions; however, in its simplest form, it can be divided into two different approaches: the cash flow-based credit market or the asset-based credit market, also known as asset based lending.

In the past, the cash flow approach was generally used in which the borrower’s credit capacity was determined by its enterprise value.  In contrast, with asset based lending, the borrower’s credit capacity is dependent on the value of its business assets.  Over time, lenders have found that the valuation of a borrower’s assets has proved to remain stable over a variety of business and economic cycles; thus, making the asset based lending approach a reliable method of calculating the borrower’s credit capacity.  For these reasons, asset based loans, or ABLs, are often viewed, for certain types of borrowers, as a more reliable form of lending than the cash flow approach.

ABLs are most frequently used to finance working capital for reasons such as seasonal changes, dividends, distributions, repurchase programs or acquisitions; they also play a key role in the financing of companies facing financial hard times.

Prior to committing to asset-based lending, Banks should consider both the pros and cons.  For lenders, ABLs can be profitable, well-secured as well as a low risk line of business provided strong controls are in place.  On the other hand, the administration and monitoring can be time consuming and costly in addition to being susceptible to borrower fraud.

Regardless of the reason for the ABL, Banks must “KYC“or Know Your Collateral.  This all depends on the financial institution’s ability to monitor, track and know everything there is to know about the assets that were pledged.  In order to get acquainted with these assets, due diligence should be performed up front and the following practices should be considered:

  • Establish inventory caps to ensure the credit does not make up more than 50% of the line. Repayments should come from receivables for liquidity purposes.
  • Obtain a daily (or at least monthly) account of the receivables. Some banks manage the assets through a lock box.  In this way, they can track deposits towards the receivable, know what’s being paid and adjust the availability as necessary.
  • Know the ease or difficulty in liquidating the assets if the situation should arise. The Bank should be aware of the quality, location and the options to sell in the shortest period of time.  Borrowing base certificates can aid in this process of determining quality and location but periodic, independent inventories are recommended.

The bottom line is if you don’t know your inventory, meet it, touch it, visit it!  In the asset based lending world, knowing your collateral is just as important as knowing your customer!