SME finding lending process - report 5


73. The asset-based loan agreement often allows for a revolving arrangement, whereby, if the
borrower needs other advances, these can be secured by more assets, such as more receivables, as others
are collected and paid off. Hence, as the borrower generates receivables from new sales or builds more
inventories, these assets are generally eligible for inclusion in the ‘borrowing base’. This arrangement
requires constant monitoring of collateral by the lender to control and manage the credit risk. Typically the
lender audits the borrower’s assets daily, to monitor and secure the performance of the loan (GE Capital,
1999; Caouette et al., 2008).
74. As unsecured loans, asset-based loans expose the lender to the generic credit risk, that is, to the
risk related to ‘integrity, moral character, debt-paying habits and ability of the proposed borrower’ (Clarke,
1996, p. 15).

 In addition the asset-based lender is exposed to risks that are specifically related to the
securing mechanisms underlying ABL, such as (Caouette et al., 2008):
• Collateral risk, i.e. the risk that the collateral securing the loan will decline in value after loan
inception and be insufficient to liquidate the loan. In the case of account receivables, for instance,
the asset can be diluted by credit notes (for returns, errors or damages), write-offs (i.e., for bad
debt), payment discounts, as well as customer rebates and allowances (Benchaya and Anderson,
• Collateral illiquidity, i.e. the risk that the process to liquidate the collateral will be time-consuming
and costly, detracting from the ultimate returns. Accounts receivable are considered to be highly
liquid assets, whereas inventory may be more difficult to value, monitor and liquidate;
• Legal risk; i.e. the risk of incurring costly legal mistakes, due to inadequate legal documentation or
mismanagement of the loan facility.
75. In light of the above risks, particularly of the expected asset value dilution and losses, asset-based
lenders typically lend at a discount to the actual value of the secured assets. For accounts receivables, a
loan-to-value ratio (LVR) of 80-85% is considered normal (Caouette et al., 2008). On the other hand, in the case of less liquid assets, the LVR can be significantly lower. For instance, if inventory is the secured asset
the lender might extend a credit of up to 40% of the estimated value. Lenders often seek advice regarding
the appropriate LVR from specialised appraisal firms,

 which evaluate the collateral value of inventory
goods (GE Capital, 1999). The interest rate applied on the loan also reflects quality and liquidity of the
assets, and is often higher than the rate on conventional bank loans. Furthermore, a service charge to cover
the costs of administration of the account adds to the costs for the borrower.
76. Although the costs of funds may be higher than in traditional lending, a decline in the costs of
asset-based lending has been observed over the last decades, as this type of financing, which was earlier
considered to be a last resort option for firms in financial difficulties, has become widely accepted by
financiers and increasingly popular in the business community (Caouette et al., 2008). 

Over time, the
increased competition within the industry has also contributed to bringing down the costs of asset-based
lending, as a variety of players entered the market, including traditional commercial finance companies,
hedge funds and cash-rich companies seeking to diversify their business.
77. Against this medium- to long-term trend, however, the 2008-09 global financial crisis has
brought about increased costs for asset-based lending, as with other more traditional forms of lending. This
is in part because the value of collateral decreased, while the probability of default increased. Basel III has
also been producing effects in the industry, raising the prices of lending products, although, as Nuccio and
Loewy (2013) note, the new regulatory framework does not especially disfavour loans secured by
inventory and receivables. Rather, some indirect effects are to be expected, in the sense that the new
regulatory standards may increase the costs of funding from bank regulated entities, and may reduce the
level of assets deployed by banks to this sector. This may create opportunities for non-bank lenders, which
are not subject to the same costly capital requirements.

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