News Column

Risky business: Name lending vs lending against intangible assets

August 6, 2014

As defined by the International Accounting Standards (IAS), "An intangible asset is an identifiable non-monetary asset without physical substance. An asset is a resource that is controlled by the entity as a result of past events (for example, purchase or self-creation) and from which future economic benefits (inflows of cash or other assets) are expected (IAS. 38.8), Thus, the three critical attributes of an intangible asset are: 1. Identifiability, 2. Control (power to obtain benefits from the asset) and 3. Future economic benefits (such as revenues or reduced future costs)."

The following are a few examples of intangible assets that are considered as passive income generators - computer software, patents, copyrights, licenses, franchises, trade-marks and goodwill.

Even though intangible assets are not widely accepted as collateral, there does remain a trend in the US market to lend against these types of assets. On the other hand, name lending is classified as non-covered facilities in the sense that loans are provided based on trust and the reputation of the customer. This type of lending is popular in the Middle East taking into consideration the cultural factor. Also, its inherent risk is relatively high in the sense that one defaulting customer might nullify the profit generated from twenty customers (assuming that the interest rate is five per cent and the same amount of facilities are provided to the twenty one customers over a one-year period).

Moreover, the default of one large customer might create a domino effect and negatively affect the whole economy of the country.

One of the main problems associated with pledged assets is the risk of impairment loss that carries related risks.

As per the International Accounting Standards (IAS) 36:

?"Impairment loss: the amount by which the carrying amount of an asset or cash-generating unit exceeds its recoverable amount.

?Carrying amount: the amount at which an asset is recognised in the balance sheet after deducting accumulated depreciation and accumulated impairment losses.

?Recoverable amount: the higher of an asset's fair value less costs of disposal (sometimes called net selling price) and its value in use." Moreover as per the same standard the entity should on a yearly basis test its assets (including intangible assets) for impairment.

Evaluating intangible assets is not an easy exercise, compared to tangible assets (e.g. investments, properties etc.) whose valuation is straightforward due to the existence of an active market for them. Also, a large haircut should be applied to these types of collateral in order to ensure proper coverage in case of defaults.

It is worth noting that even though pledging intangible assets as collateral is relatively safer than name lending, it is still risky and I personally do not recommend these types of lending.

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Source: Banker Middle East

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