Question

3. For commercial and industrial loans, explain how the credit risk profile of the financial institution changes as a result of issuing a secured loan versus an unsecured loan. Explain how syndicating a loan can reduce credit risk for a financial institution.

Answer 1

For secured loan, the credit risk is significantly lower as the debt is secured through a collateral which may be the land, machinery or any such assets against which the loan is given. So in this case, if the borrower is unable to repay the loan, the lending institution has a recourse to these assets which it can liquidate or auction to recover the loan.

The unsecured loan on the other hand does not have any such assets to which a recourse is possible. Hence if the borrower defaults in the payment of the loan, the lender may have to write down the loan or take a hit to the extent of advance made.

Syndicating a loan means that a collection of lenders would come together for providing a loan to the borrower. In this case there is a lead financial institution which acts as a agent and there are several other banks which are involved to collectively make the advance. Since the number of financial institutions are many, the risks of default is spread across these multiple institutions and hence the risk considerably reduces.