Collateral and Guarantees

7292019 Collateral and Guarantees

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Supervisory Policy Manual

CR-G-7 Collateral and Guarantees V1 ndash 290601

1

This module should be read in conjunction with the Introduction and with theGlossary which contains an explanation of abbreviations and other termsused in this Manual If reading on-line click on blue underlined headings toactivate hyperlinks to the relevant module

mdashmdashmdashmdashmdashmdashmdashmdashmdash

PurposeTo provide guidelines to AIs on the management of collateral andguarantees for credit risk mitigation

Classification

A statutory guideline issued by the MA under the Banking Ordinancesect7(3)

Previous guidelines superseded

Guideline 55 ldquoSection 80 of the Banking Ordinance Advance againstSecurity of Own Shares etcrdquo dated 101090

Application

To all AIs

Structure

1 Introduction

2 Policies and procedures

3 Acceptance criteria

31 Collateral

32 Guarantees

33 Concentration limits

4 Validity of collateral and guarantees

41 Enforceability

42 Title and ownership

5 Loan-to-value ratio





2

6 Valuation

61 Basis of valuation

62 Valuersrsquo competence

63 Frequency of revaluation

64 Independence of valuation

65 Stress-testing

7 Safe custody and access controls

8 Top-up of collateral

9 Insurance

10 Disposals

11 Management information


1 Introduction

11 AIsrsquo primary consideration when approving credits should alwaysbe the borrowerrsquos financial strength and debt-servicing capacityIt is important that they do not rely solely on collateral or guarantees as the primary source of repayment or as asubstitute for evaluating the borrowerrsquos creditworthiness

12 Nevertheless collateral1

and guarantees if properly taken andmanaged do serve a number of important functions in credit riskmanagement These include

bull to mitigate credit risk by providing AIs with a secondarysource of repayment in the event that the borrower defaults on a credit facility

bull to gain control of the collateral which is the primarysource of repayment of a facility in default For examplea loan to a property developer secured on the propertybeing developed would be repaid by the sale proceeds of that developed property

1 ldquoCollateralrdquo has the same meaning as but is used in preference to ldquosecurityrdquo to avoidconfusion with stocks shares etc





3

bull to provide early warning of a borrowers deterioratingrepayment ability (particularly for credit facilities such asmargin financing where top-up of collateral may berequired from time to time) and

bull to enable locally incorporated AIs to apply a lower capitalrisk weight to credits which are secured by collateral or guarantees as specified in the Third Schedule to theBanking Ordinance2

13 AIs that rely on collateral to provide secondary protection in theevent of a borrowerrsquos default in repayment however face twomajor risks

bull they may be unable to establish a title to the collateral for disposal and

bull the cash proceeds eventually realised by the disposal of the collateral may be less than its estimated value

14 It is therefore essential for AIs to set up appropriate systems andcontrols for the management of collateral and guarantees

15 For the purpose of this module guarantees refer to thoseaccepted by an AI to support the granting of credit facilities andreduce the underlying credit risk It does not cover thoseguarantees accepted simply as additional comfort for thefacilities granted


21 AIs should have in place written policies approved by their Board of Directors the Credit Committee or senior management

2

Such collateral or guarantees mainly include

bull cash deposits

bull residential mortgages within the meaning of the Third Schedule to the BankingOrdinance

bull securities or guarantees issued by the Exchange Fund the central government thecentral bank or public sector entities of a Tier 1 country or multilateral developmentbanks and

bull guarantees from AIs or banks incorporated in a Tier 1 countryPlease see the Third Schedule to the Banking Ordinance for details





4

with delegated authority for the management of collateral andguarantees They should cover inter alia

bull criteria for the acceptance of collateral and guarantees

bull validity of collateral and guarantees

bull loan-to-value ratios

bull valuation

bull safe custody and access controls

bull top-up of collateral

bull insurance

bull disposals and

bull management information on collateral held

22 AIs should have detailed procedures for enforcing the abovepolicies

23 Internal Audit should carry out periodic checks to ensure that theabove policies and procedures are adhered to


31 Collateral

311 AIs should ensure that assets accepted as collateralsatisfy the following criteria

bull the market value of the asset is readilydeterminable or can be reasonably establishedand verified

bull the asset is marketable and there exists a readilyavailable secondary market for disposing of theasset

bull the AIrsquos right to repossess the asset is legallyenforceable and without impediment

bull the AI is able to secure control over the asset if necessary In the case of a movable asset the AIshould either have physical custody of the asset(eg gold precious metal or taxi medallion) or have the means of locating its whereabouts (eg

vehicle machinery or equipment) and





5

bull the AI has the expertise and systems to managethe asset concerned

312 Collateral which does not satisfy the above criteria maystill be accepted as additional comfort but the facilitiesconcerned should be regarded as unsecured

313 AIs should align the term of validity of the collateral withthat of the obligation it secures For example if aproperty development loan is collateralised on the

property being constructed the collateral right over theproperty should not be released before the loan is fullyrepaid

314 Collateral whose value has a material positive correlationwith the credit quality of the borrower (eg securitiesissued by the borrower or any related group entity) islikely to provide little credit protection to AIs They shouldnot therefore rely too much on such collateral for reducingcredit risk

315 For internal control purposes AIs should draw up the

types of asset acceptable as collateral and the maximumloan-to-value ratio for each of these assets (see section 5below) They should take into account the criteria set outabove and the following statutory restrictions under sect80of the Banking Ordinance

bull sect80(1) prohibits AIs from granting any creditfacilities against the security of their own shares

3

and

bull under sect80(2) prior written approval should beobtained from the MA if an AI wishes to grant any

credit facilities against the security of the shares of its holding company or a subsidiary of itself or itsholding company

32 Guarantees

3

A loan by an AI secured by an instrument creating a charge or other security over that AIrsquosown shares is illegal void and consequently unenforceable This could happennotwithstanding that the charge or security was over a portfolio of shares and the AIrsquosshares constituted only a portion of the shares In such circumstances it is unlikely that theillegal portion of the contract could be severed from the remainder The whole securitywould be void





6

321 For the purpose of credit risk mitigation AIs shouldensure that guarantees accepted fulfil the followingcriteria

bull the guarantee should represent a direct claim onthe guarantor

bull the guarantee should be unconditional andirrevocable4

bull the guarantee should be properly documented andlegally enforceable

bull the guarantee should remain continuously effectiveuntil the facility covered by the guarantee is fullyrepaid or settled and

bull the financial strength of the guarantor should bethoroughly assessed and considered as adequatefor discharging the obligation under the guarantee

322 The creditworthiness of a guarantor should ideally not belinked to or affected by the financial position of the

borrower

323 Where an AI has accepted a guarantee the financialstrength of the guarantor should be reviewed whereappropriate (eg during the annual credit review) toensure that the guarantee remains valid for credit riskmitigation

324 Guarantees should not be regarded as collateral and thefacilities covered by them should be regarded asunsecured unless the guarantees are issued by thecentral government or the central bank of a country

without repayment difficulties an AI or an overseasincorporated bank which is under adequate supervision


331 Taking the same type of asset as collateral or acceptingcollateral or guarantees from the same issuer or provider

4

In the case of a continuing guarantee (ie one securing both a specific sum and any further advances that may be made to the borrower in future) a guarantor may by giving notice tothe AI revoke his guarantee in respect of any new advances to be made to that borrowerNormally AIs will allow the guarantor to revoke his guarantee after a period of notice Suchrevocation will therefore only discharge the guarantorrsquos obligation in respect of newadvances made after the expiry of that period but not those outstanding prior to that





7

creates a concentration risk AIs should consider formulating a policy with respect to the amount of concentration risk they are prepared to run

332 For example the limits on concentration risk could be inthe form of a cap on the amount of

bull lending secured by the same type of collateral

bull financial collateral taken from a particular issuer or market and

bull credit protection obtained from a particular guarantor


41 Enforceability

411 AIs should ensure that credit documentation includingguarantees and pledge agreements is legallyenforceable in all relevant jurisdictions Whereappropriate AIs should obtain positive legal opinions tothis effect

412 The credit documentation should empower the AI to applythe collateral freely to discharge the borrowersobligations in so far as they are not discharged by theborrower in accordance with the loan agreement (egdue to breach of repayment terms liquidation or bankruptcy of the borrower)

413 Where the cost of liquidating collateral is to be borne bythe borrower this should be clearly stated in the relevantloan agreement to give the borrower notice and to avoidsuch a clause being unenforceable against a persondealing as a customer by virtue of the UnconscionableContracts Ordinance

414 AIs should comply with section 20 of the ldquoCode of Banking Practicerdquo in respect of guarantees and third partysecurity provided by individuals


421 AIs should verify the existence and ownership of theassets being pledged before acceptance





8

422 AIs should ensure that there is no prior claim or claim of equal ranking by another party on the collateral

423 AIs should secure their control of the collateral prior to thedrawdown of credit facilities For example they shouldobtain customersrsquo authorization to transfer the legal titleto the pledged shares to them or receive their lawyersrsquoconfirmation of having taken possession of the originaltitle deeds for mortgaged properties

424 Where there is a need for the collateral to be held by athird party the AI should obtain that partyrsquos writtenconfirmation that it has no claim over the collateral

425 Charges on collateral should be registered promptly withthe relevant authorities (eg the Companies Registry)where appropriate


51 AIs should specify the maximum loan-to-value ratio for major types of asset to be accepted as collateral Such ratios should

be commensurate with the relative risk of the assets and be ableto provide an adequate buffer against potential losses inrealising the collateral arising from the following

bull potential fluctuations in the market value of the collateral(or the exchange value for foreign currency assets)

bull the carrying costs of maintaining the repossessedcollateral before it is disposed of and

bull the costs incurred for disposing of the collateral (egauction fees of properties)

52 The HKMA has from time to time issued guidance on themaximum loan-to-value ratios that should be observed by AIs inrespect of some common types of secured financing (egresidential mortgages share margin financing taxi loans etc) AIs are expected to adhere closely to such guidance and will berequired to justify any departure from the maximum loan-to-value ratios prescribed





9

6 Valuation


611 Valuation should be based on the current market value of the collateral and should not be biased in order to enablethe AI to grant a higher credit limit to the borrower or improve its internal credit rating make a smaller amountof provision or continue interest accrual for a problemcredit

612 AIs should ensure that the valuation method usedwhether internal or external is based on assumptions thatare both reasonable and prudent and all assumptionsshould be clearly documented

613 Collateral should be valued wherever possible at netrealisable value being the current market value less anypotential realisation costs (eg carrying costs of therepossessed collateral legal fees or other chargesassociated with disposing of the collateral)

614 Market value should be the price at which an asset mightbe sold at the valuation date assuming

bull a willing buyer and seller

bull the transaction is at arms length

bull a reasonable period has been allowed for the saleand

bull the asset is freely exposed to the market

615 To cater for collateral whose market value is highly

volatile AIs should apply a conservative haircut whenvaluing it for the purpose of determining the extent towhich an exposure is secured The quantum of thathaircut will depend on the price volatility of the collateralthe term of the exposure and whether the collateral isdenominated in a different currency to the underlying debt

616 A more conservative approach should be adopted for valuing the collateral of problem credits This is becausein practice the forced-sale value rather than the openmarket value is likely to be closer to what eventually may

be realised from an asset sale when the marketconditions are unfavourable Therefore a discount to the





10

estimated market value should be applied whereappropriate

617 In assessing the value of an asset temporary aberrationsshould be disregarded (eg a sudden rebound in themarket price)

62 Valuers competence

621 AIs should establish criteria for determining when to use

external valuers For assets without a readily availablemarket value (such as unlisted investments or a largecommercial complex) and assets which an AI does nothave the expertise to assess (such as fine arts andantiques) external valuation is called for

622 AIs should maintain a list of approved external valuersand surveyors They should be professionally qualifiedreputable experienced and competent Their performance should be regularly monitored and evaluated

623 AIs which have their own internal valuation unit shouldensure that the responsible staff possess sufficientknowledge and expertise to perform their duties

624 Procedures should be established to ensure that internalvaluations are not out of line with prevailing market valuesFor example internal valuations can be cross-checkedfrom time to time with professional valuations on asampling basis

625 Accuracy and effectiveness of methodology for conducting internal valuations should also be back-tested

by comparing the valuation with actual sale proceedsreceived on subsequent disposal of the assets

626 In cases where there is any doubt about the valuationmade by internal or external valuers the HKMA reservesthe right for the purpose of assessing the adequacy of provisions to request an AI to obtain an independentsecond valuation from another valuer


631 Collateral should be revalued on a regular basis though

the frequency may vary with the type of collateralinvolved and the nature and the internal credit rating of





11

the underlying credit For example AIs should mark tomarket their portfolio of shares pledged by marginfinancing customers at least on a daily basis At timeswhen the stock market is highly volatile this should beperformed intra-day at short notice (and margin paymentshould be demanded if appropriate) For large or problem exposures which are secured by propertiesthere should preferably be quarterly revaluations Thefrequency may need to be increased further to monthly if

the property market is declining rapidly


641 The back office5 is normally assigned with theresponsibility to perform periodic valuations of collateralStaff conducting internal valuations carrying out site visitsto collateralised properties or deciding on the use of external valuers should be independent of the marketingor credit initiation function

65 Stress-testing

651 AIs should monitor general trends in markets (egproperty price and stock indices) for the major types of collateral taken

652 AIs are recommended to conduct stress-tests andscenario analysis on their portfolio of collateral in order toassess the impact under unusual market conditions (ega significant decline in property or stock prices)


71 Authority and responsibility should be clearly delegated torelevant individuals and departments for approving theacceptance monitoring or safe custody of collateral

6and

guarantees

72 Collateral and guarantees received by AIs should be kept in afire-proof safe or vault

5

Please see Diagram 1 of CR-G-1 ldquoGeneral Principles of Credit Risk Managementrdquo for anillustration of functions typically performed by the back office

6 In this context the term ldquocollateralrdquo refers to both physical collateral (eg marketable shares)and any forms of document representing the legal title to the collateral (eg title deeds)





12

73 The location of collateral and guarantees placed in the custodyof AIs should be properly recorded and controlled to facilitateeasy retrieval in future

74 There should be dual control over the access to collateral andguarantees in particular where the collateral is in bearer formor can easily be sold in the market

75 Movements of collateral and guarantees should be dulyauthorized acknowledged by the persons taking possession of

them and properly recorded76 Collateral and guarantees withdrawn for processing should be

promptly returned to the officer in charge of their safe custodyThe officer should chase up collateral and guarantees withdrawnfor an unusually long period

77 Prior to the release of collateral or guarantees the officer incharge of their safe custody should ensure that

bull all conditions for release stipulated in the relevant loanagreements have been fully complied with and

bull the release has been properly authorized78 Once the conditions for release are satisfied collateral and

guarantees should be returned to the borrower promptly exceptin cases where it is stipulated in the relevant documentation thatthe guarantee remains the property of the AI after the principalindebtedness has been repaid

79 Confirmation of receipt should be obtained from the borrower upon the release of collateral and guarantees

710 In relation to the handling of collateral AIs should ensurecompliance with relevant laws and regulations eg AIs whichare exempt dealers should observe sect81A of the SecuritiesOrdinance for securities accepted as collateral


81 Where it is anticipated that a borrower may need to provideadditional collateral the conditions warranting this action shouldbe clearly documented in the relevant agreement with theborrower

82 Cases where additional collateral may be required include

bull the value of the original collateral has fallen significantlydue to fluctuations in market price (eg of commodities)





13

bull a decline in the value of collateral has caused themaximum loan-to-value ratio for that type of collateral tobe exceeded (eg share margin financing)

bull the original collateral has become obsolete due to theintroduction of new substitutes or more superior models(eg hi-tech equipment) and

bull deterioration in the debt-servicing ability of the borrower

83 Procedures for requesting additional collateral should be clearlydocumented

9 Insurance

91 AIs should wherever possible take out insurance for collateralnaming the AI as the beneficiary

92 The cost of insurance unless borne by the borrower should befactored into the pricing of the credit

93 The insurer should be under adequate supervision7 financiallysound and independent of the borrower concerned If theinsurer is a related company of the AI it should also beoperationally independent of the AI (ie with a separatemanagement team) In addition the AI should consider takingappropriate measures (eg reinsurance) to ensure that thegroup as a whole is not exposed to undue risks

10 Disposals

101 All properties share capital and debt securities acquired by alocally incorporated AI in the course of the satisfaction of debts

due to it should be disposed of at the earliest suitableopportunity and not later than 18 months after its acquisition or within such further period as may be approved by the MAOtherwise the AI will be required to include the assets acquiredand held for more than 18 months or such further periodapproved by the MA in the computation of its exposure relatingto the following statutory limits

Type of collateral Statutory limit

Share capital and sect81(1) ndash Financial exposure to a person should not

7 This condition is satisfied in relation to insurance companies in Hong Kong by virtue of their supervision by the Insurance Authority





14


debt securities of an issuer

exceed 25 of an AIrsquos capital base

Share capital sect87(1) ndash Aggregate value of an AIrsquos shareholding inother companies should not exceed 25 of the AIrsquoscapital base

Properties sect88(1) ndash Aggregate value of an AIrsquos interest in landshould not exceed 25 of the AIrsquos capital base

102 Disposal of collateral should be at armrsquos length and through atransparent process (such as a public auction or independentestate agents for foreclosed properties) to avoid complaints bythe original owner

103 AIs should ensure that the disposal of collateral is in compliancewith relevant laws and regulations For example AIs which areexempt dealers should observe sect81A of the SecuritiesOrdinance when disposing of securities pledged as collateral bytheir customers Where appropriate legal advice should besought


111 Management information on collateral should be producedperiodically to facilitate management of credit risk Informationrequired will depend on the nature and value of collateral takenby an AI AIs may wish to include where appropriate thefollowing information

Managementinformation

Proposedfrequency Purpose

Breakdown of credit exposureby type of collateral

Monthly For the identification of concentration risks in the poolof collateral accepted andstress-testing

Borrowingsexceedingmaximum loan-to-value ratio

Marginfinancingdaily

Othersmonthly

To highlight facilities requiringtop-up of collateral





15



Total currentmarket value of assets foreclosedin the course of satisfaction of debts

Monthly To facilitate formulation or modification of strategies for disposal of assets foreclosed(eg residential properties ndashwait for market to improve or sell immediately)

Comparison of latest assessedmarket valuewith actualproceeds of collateral sold

Monthly To facilitate evaluation of theaccuracy and validity of methodology for conductingcollateral valuations

Current marketvalue of collateralrelated to eachclassified credit

Quarterly For determining the amount of provision required for classifiedcredits


Contents Glossary Home Introduction





2

6 Valuation


62 Valuersrsquo competence



65 Stress-testing



9 Insurance

10 Disposals



1 Introduction

11 AIsrsquo primary consideration when approving credits should alwaysbe the borrowerrsquos financial strength and debt-servicing capacityIt is important that they do not rely solely on collateral or guarantees as the primary source of repayment or as asubstitute for evaluating the borrowerrsquos creditworthiness

12 Nevertheless collateral1

and guarantees if properly taken andmanaged do serve a number of important functions in credit riskmanagement These include

bull to mitigate credit risk by providing AIs with a secondarysource of repayment in the event that the borrower defaults on a credit facility

bull to gain control of the collateral which is the primarysource of repayment of a facility in default For examplea loan to a property developer secured on the propertybeing developed would be repaid by the sale proceeds of that developed property

1 ldquoCollateralrdquo has the same meaning as but is used in preference to ldquosecurityrdquo to avoidconfusion with stocks shares etc





3










2


bull cash deposits








4





bull valuation



bull insurance

bull disposals and





31 Collateral











5









3

and



32 Guarantees

3






6








borrower






4






7







41 Enforceability











8
















9

6 Valuation


















10



















11





65 Stress-testing





6and

guarantees


5







12




















13





9 Insurance




10 Disposals










14
















Othersmonthly






15















3










2


bull cash deposits








4





bull valuation



bull insurance

bull disposals and





31 Collateral











5









3

and



32 Guarantees

3






6








borrower






4






7







41 Enforceability











8
















9

6 Valuation


















10



















11





65 Stress-testing





6and

guarantees


5







12




















13





9 Insurance




10 Disposals










14
















Othersmonthly






15















4





bull valuation



bull insurance

bull disposals and





31 Collateral











5









3

and



32 Guarantees

3






6








borrower






4






7







41 Enforceability











8
















9

6 Valuation


















10



















11





65 Stress-testing





6and

guarantees


5







12




















13





9 Insurance




10 Disposals










14
















Othersmonthly






15















5









3

and



32 Guarantees

3






6








borrower






4






7







41 Enforceability











8
















9

6 Valuation


















10



















11





65 Stress-testing





6and

guarantees


5







12




















13





9 Insurance




10 Disposals










14
















Othersmonthly






15















6








borrower






4






7







41 Enforceability











8
















9

6 Valuation


















10



















11





65 Stress-testing





6and

guarantees


5







12




















13





9 Insurance




10 Disposals










14
















Othersmonthly






15















7







41 Enforceability











8
















9

6 Valuation


















10



















11





65 Stress-testing





6and

guarantees


5







12




















13





9 Insurance




10 Disposals










14
















Othersmonthly






15















8
















9

6 Valuation


















10



















11





65 Stress-testing





6and

guarantees


5







12




















13





9 Insurance




10 Disposals










14
















Othersmonthly






15















9

6 Valuation


















10



















11





65 Stress-testing





6and

guarantees


5







12




















13





9 Insurance




10 Disposals










14
















Othersmonthly






15















10



















11





65 Stress-testing





6and

guarantees


5







12




















13





9 Insurance




10 Disposals










14
















Othersmonthly






15















11





65 Stress-testing





6and

guarantees


5







12




















13





9 Insurance




10 Disposals










14
















Othersmonthly






15















12




















13





9 Insurance




10 Disposals










14
















Othersmonthly






15















13





9 Insurance




10 Disposals










14
















Othersmonthly






15















14
















Othersmonthly






15















15











Documents

Collateral and Guarantees