CDS (I) 2021 General Knowledge · Question 5 of 120

Correct — B, Collateral. The stem is a near-quotation of the school definition: collateral is an asset that the borrower owns — land, a building, a vehicle, livestock, a deposit with a bank — and uses as a guarantee to the lender until the loan is repaid. If the borrower fails to repay, the lender may sell that asset to recover the money. Security of this kind is what makes lending possible to a stranger, and it is also why the poorest borrowers are the hardest to lend to: not owning a titled asset, they cannot offer the guarantee that formal lenders ask for, which pushes them towards informal moneylenders on much worse terms. Collateral is one item in a larger package. Interest rate, collateral, documentation requirement and the mode of repayment together make up what is called the terms of credit, and those terms vary sharply between a bank and a village lender.

• (a)Cheque — An instrument for making a payment out of a bank account, not a security pledged against a loan. A cheque instructs a bank to pay; it transfers no ownership of an asset to the lender and guarantees nothing if the account is empty.
• (c)Guarantee card — A card issued alongside a cheque book in some banking systems so that a shop can be sure a cheque up to a stated limit will be honoured. It backs a single payment; it is not an asset the borrower pledges for the term of a loan.
• (d)Bond — A debt instrument — the borrower's own promise to repay with interest — so it sits on the wrong side of the transaction. A bond is what is issued to raise the money; collateral is the property put up to secure it.

A lender parting with money faces the risk that it will not come back. Two devices reduce that risk: information about the borrower, and security in the form of an asset that can be sold if repayment fails. That asset is the collateral. Because it must be owned, transferable and worth something on resale, the requirement excludes many poor households from formal credit — the problem that self-help groups and microfinance were designed around, since they substitute group liability and reputation for a pledged asset.

The word is common enough in newspapers that most candidates recognise it; the item is really testing whether the other three can be told apart from it. Two of them are payment instruments and one is a borrowing instrument, and none is a security. A useful sorting question: does the thing named belong to the borrower and pass to the lender only on default? If it does, it is collateral. Anchoring to the exam year, collateral-free lending had become a live policy instrument in India — the emergency credit line for small businesses announced in 2020 was guaranteed by the government precisely so that banks would lend without security, and the collateral-free limit for agricultural loans has since been raised again.

• Collateral is an asset owned by the borrower and pledged as a guarantee to the lender until the loan is repaid.
• On default, the lender has the right to sell the collateral to obtain payment.
• Interest rate, collateral, documentation requirement and mode of repayment together form the terms of credit.
• Common examples are land titles, buildings, vehicles, livestock and deposits with banks.
• Lack of collateral is a principal reason poor households borrow from informal lenders rather than banks.

• Confusing collateral with the terms of credit, of which it is only one component.
• Treating a bond as security when it is the borrowing instrument itself.
• Assuming collateral must be land; deposits, vehicles and livestock all qualify.

As a one-line definition item, or inside a statements question on why poor households are excluded from formal credit.

• practice — not a real PYQ

  Which one of the following is not part of the terms of credit in a loan agreement?

  • (a)Rate of interest
  • (b)Collateral requirement
  • (c)Mode of repayment
  • (d)The lender's own profit for the year

  Answer(d) the lender's own profit for the year — interest rate, collateral, documentation and mode of repayment together make up the terms of credit; the lender's annual profit is not a term of the contract.

• practice — not a real PYQ

  A borrower who cannot offer any asset as security is most likely to be served by

  • (a)a self-help group or microfinance lender
  • (b)a long-term corporate bond issue
  • (c)a commercial bank's secured housing loan
  • (d)a gold loan against pledged ornaments

  Answer(a) a self-help group or microfinance lender — such lenders substitute group liability and reputation for pledged property, which is why they reach households that banks turn away.