Professional collateral management entities can minimise bank frauds

The recently-surfaced bank frauds at the Punjab National Bank, Oriental Bank of Commerce and other public sector banks expose the lack of operational controls and point to the failure of banks’ risk management functions.

A common feature of these frauds has been that borrowers, with malafide intent, in collusion with bank managers at the lower levels, are able to exploit the deficiencies in the system which has limited independent oversight and scrutiny in the implementation of operational protocols.

This is where collateral management companies come into the picture. Such systemic risks can, to a large extent, be mitigated by mandating that scrutiny and management of securities and collaterals while sanctioning credit by lenders is entrusted to credible professional collateral management companies.

Warehouse receipts

In the agri-credit space, the commodity collateral belonging to borrowers against which the credit is disbursed is increasingly being entrusted to professional collateral management companies. This collateral based credit (through the instrument of warehouse receipt finance) has increased to over ₹60,000 crore annually with minimal NPAs of the banking system.

More and more farmers in India, and agri-space participants, including the large population of tenant farmers who cannot mortgage land or equipment, are using warehousing receipts as a tool to meet their working capital and consumption needs in the post-harvest season.

Since such agri-commodities have an established value and market, quick liquidation mechanisms provide sufficient funds to cover a loan extended against them in case of a default.

Third party services

A neutral third party for collateral management of commodities (both agri as well as non-agri) has become beneficial and highly relevant in this context since the banks have neither the bandwidth nor the expertise to monitor and manage the commodities stored as collateral.

Banks also lack the expertise to value commodities, the technology to track and act on commodity prices, and the relationship with the producer-warehouse ecosystem.

The third party takes custody of the storage structure and the collateral on behalf of lending banks/financial institution and issues secured warehouse receipts after checking of the quality and quantity of the commodities received at the controlled storage structure.

The third party stands liable for loss, damages, cost or expenses caused to the bank as a result of breach of its obligations under the agreement signed between the party and the bank. Thus, the operational or performance risk is offloaded to the collateral management agency. The party also obtains the insurance cover.

Benefits of third party service

There are multiple benefits of a third party managing the collateral. It enables the bank managers to focus on financials rather than logistics and operational risk associated with the collateral. It converts credit risk on the borrower to performance risk. The security of the collateral is ensured by the third party, who can deploy adequate manpower and security at processing plants and factory premises to monitor and provide regular reports to lending banks and financial institutions on movement of raw materials, semi-processed and finished goods.

This enables partner banks in keeping watch on movement of the collateral under hypothecation.

Further, the third party expands the credit portfolio based on warehoused commodities/materials as a result of enhanced credit portfolio ratings. The third parties throw up early warning signals on the branch manager’s screen and even advise lenders on a regular basis on market prices and adequacy for enabling them to undertake adequate risk management practices to protect the underlying collateral during tenure of the loan.

The legal or litigation risk is reduced as the collateral manager ensures proper documentation and adequate insurance cover.

More critically, as these third party entities are neutral and independent, this collateral management arrangement ensures that are no “conflict of interest” situations and bank managers would not get compromised. This instrument can increasingly be deployed to cover all commodities, materials, equipment as well as securities to create a safe and relatively risk-free lending environment for banks, especially where governance practices are not robust enough.

The writer is CEO and Managing Director of the National Collateral Management Services Ltd. Views are personal.