What is Collateralization?
Collateralization is a critical concept which it comes to credit risk management. The concept says that when two parties are involved in a trade, one party will have a negative exposure i.e. Party A will have to pay some amount to Party B. The party with the negative exposure will then post collateral in the form of cash or securities to the party with the positive exposure. In essence, collateral is an asset supporting risk in a legally enforceable way.
Example of Collateralization:
One example of collateralization is seen in interbank lending. When Bank A borrows from Bank B, Bank A provides some securities to Bank B which equal or less or more amount than the borrowed amount. If Bank A defaults, Bank B can sell the securities in the market to cover the losses.
Why is Collateralization important?
While there are a lot of benefits of using collateral, some are listed below:
- Reduce credit exposure to enable more trading
- Have the ability to trade with a counterparty
- Reduce capital requirements, and
- Allow for more competitive pricing of counterparty risk.