Rehypothecation refers to a practice where financial institutions like brokers and banks reuse the assets that have been posted as collateral by their clients for purposes of securing their own borrowings and therefore they provide a rebate or lesser cost of borrowing to the client who permits rehypothecation of their collateral.
When an individual decides to give away his asset as collateral to get a sanction of loan from a bank or financial institution, it is known as hypothecation. However, when the bank now decides to use the collateral posted by the client for purposes or transactions of its own with that of another financial institution by providing the same asset of the client as collateral, the first bank is said to have engaged in rehypothecation. The client will now be rewarded with a lower cost of borrowing on his funds or maybe even a certain rebate amount.
Examples of Rehypothecation
Let us consider an example of Scott who requires capital for his business. He owns a house and thus decides to hypothecate the same to the bank in order to gain the sanction of the amount for his business. Thus Scott has made hypothecation to bank A.
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Now the bank wishes to indulge in another financial transaction by borrowing money from bank B using the asset posted by Scott as collateral. Scott is now rewarded with a lower financing cost and some rebate.
Another example would be of Mr. Tony who owns shares of company Good Co to the extent worth $100. He wants to purchase shares of Better Co but lacks the financial resource to do so. He can now make use of his margin account by hypothecating $100 to the borrower and borrowing against shares of Good Co.
The balance sheet would now tend to look like this.
How Can I Plan for Rehypothecation?
- If an individual is planning for rehypothecation he needs to be ready to let go of his asset that gets pledged as collateral and enter into an agreement with the financial institutions like banks and brokerages, stating that he/she is ready to allow the financial institution to use his asset as a collateral against which the bank can now rely on to engage in transactions for purposes of its own.
- The individual needs to make an assessment of the requirement and extent of loan required and only then proceed with the exercise of hypothecation. Normally only 70-80% of the collateral value is sanctioned as loan and the individual needs to gauge his/her requirement and then make the assessment in this regard.
- The banker or lender will now have access to the collateral of the individual which can then make use and pledge with other banks and financial institutions to gain further funding or borrowing for purposes of its own. The lender has the right to seize the collateral if payments are not being made and the individual who pledges his asset needs to be careful in this regard.
Advantages of Rehypothecation
- Lower Cost of Borrowing: When a borrower undertakes to let go of his asset as collateral to be used for rehypothecation he tends to be awarded a certain amount of rebate or lower cost of borrowing for the loan that he has requested. Thus the individual or entity tends to save a lot of amounts owing to lower interests and costs of borrowing.
- Helps Financial Institutions to Access Capital: There will be times when banks, brokers, and financial institutions are in a crunch too and would need help in accessing capital. It is at times like this that methods like rehypothecation emerge as saviors for the occasion. By pledging the original collateral of the customer or entity the bank is now free to engage in additional transactions for purposes of its own with other banks and financial institutions, thereby providing the necessary finance and capital to carry out its operations without hindering them or coming to a significant halt.
- Promotes Leverage: By engaging in trading without the use of own money by pledging and rehypothecating securities, leverage is being generated in accessing capital markets. Thus necessary trading encourages price discovery and helps to bring about efficiency in the capital markets.
- Consumers in Dark: There may be times when an individual is unaware that he/she has signed on the rehypothecation clause and the asset being used for further rehypothecation by the entity for its own speculative purposes. The customer would not want that and the bank would tend to act against the interest of the consumer by at times misusing the asset for its speculative purposes. Securities are often misused in this fashion.
- Risk of Default: Owing to leverage and borrowing if the underlying entity defaults, it causes enormous stress on the whole financial system as this happens to have a cumulative effect causing repercussions on the whole economy. One default would magnify the effect owing to the significant leverage that is involved and rehypothecation tends to cause massive losses in this regard.
- Misuse: There may be times when banks may often misuse the underlying pledged collateral to their advantage and even for speculative activities.
Rehypothecation being a method commonly adopted by banks and financial institutions to undertake further transactions for purposes of its own allows banks to gain access to further such capital by using the borrower’s assets as collateral. In doing so the borrower is also gaining owing to the lower cost of funds and rebate income. However, it becomes of utmost importance for companies to be prudent in having to carefully use such collateral and not misuse the borrower’s assets for speculative purposes and for their own advantage.
This has been a guide to what is rehypothecation and its definition. Here we discuss how does Rehypothecation work along with examples, advantages and disadvantages. You can learn more about financing from the following articles –