Indirect security refers to a type of security that a borrower provides against a loan, and is not directly related to the assets pledged as collateral. Usually, when a lender extends credit facilities to a borrower, they require the borrower to pledge certain assets as security for the loan. The type of collateral pledged depends on the purpose of the loan.
The collateral can take the form of real estate, a motor vehicle, machinery, etc. The collateral provided acts as a form of protection for the lender such that, if the borrower defaults on the loan, the lender can seize the collateral and sell it to recoup some or part of the losses.
However, lenders may sometimes accept indirect security as collateral for the loan. Indirect security is usually a weaker form of reassurance compared to direct security, which the lender can seize and sell to recover any losses incurred. The main forms of indirect security are guarantors and letters of comfort.
Indirect security is a form of collateral that is not directly linked to the asset provided as collateral for a loan.
The main forms of indirect security are guarantors and letters of comfort.
Lenders prefer direct security over indirect security because the former allows them to seize the pledged assets to recover any losses incurred when the borrower defaults on their financial obligations.
Types of Indirect Security
The following are the main types of indirect security:
A guarantee refers to a promise by one party (the guarantor) to take responsibility for the financial obligations of another party (the creditor) for its debt payments to the debt holder. If the borrower fails to repay the lender for the outstanding financial obligations, the guarantor agrees to cover part or all of the liabilities owed to the lender.
A borrower with a poor credit profile may not qualify to get credit from a lender due to the high risk of default. Therefore, a guaranteed loan is a viable option for borrowers with poor credit history, since the presence of a guarantor reduces the risk of the borrower defaulting on repayments.
A guarantee may take different forms. In the case of companies, guarantees are issued by parent companies for loans taken by a subsidiary or by insurance companies for the benefit of another company. For example, assume that XYZ Limited is a subsidiary of ABC Limited. Company XYZ is in the process of building a new plant that will cost $10 million, and it intends to borrow the said amount from the bank.
However, since XYZ Limited does not own sufficient assets to offer as collateral, the bank requires the parent company, ABC Limited, to guarantee the loan. By agreeing to act as a guarantor, ABC Limited agrees to take responsibility for the financial obligations of XYZ Limited using its cash flows in the event that XYZ Limited is unable to generate adequate cash flows to meet its financial obligations.
2. Letter of Comfort
A letter of comfort is issued by a third party, assuring the other party in a transaction of its willingness to provide financial support to its client. It may be provided by a parent company when its subsidiary requires to borrow a loan from a financial institution.
A letter of comfort is often seen as a weaker form of assurance since it provides a mere affirmation and not confirmation of financial support. Issuers of the comfort letter are careful in their wording to avoid being entangled in a legally enforceable obligation.
A bank comfort letter (BCL) is one of the most popular types of letters of comfort, and it is issued by a bank to a supplier. A BCL assures the supplier that the client is financially capable of conducting the trade and that their cash flows are sufficient to purchase the merchandise on a loan.
However, a letter of comfort is a mere affirmation and does not mean that the bank assumes the responsibility of the client’s liabilities. If the client is unable to get a bank comfort letter from its lender, it can be interpreted to mean that the client lacks sufficient cash flows to meet the financial requirements of the trade. In such a scenario, the supplier may be hesitant to enter into a trade agreement with the client on the basis that they present a high risk of default.
Indirect Security in the Stock Market
When buying stocks, investors are given the option of owning stocks directly or indirectly. The determining factor on whether stock ownership is direct or indirect is whether or not the stockholders receive voting rights.
When an investor picks and buys a company’s shares through their brokerage account, they get direct stock ownership and can vote as a shareholder and get a say in how the business is run. Similarly, stocks held in trust or through a partnership that an investor is part of are classified as direct stocks.
On the other hand, indirect stock ownership occurs when investors purchase stocks through mutual funds or exchange-traded funds. In such an arrangement, the fund is the direct owner of the stocks it holds on behalf of investors, and the investors do not get voting rights for the stocks held by the fund. Therefore, the shareholders entrust the fund to vote on shareholder issues on their behalf.
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