Bankers must be assured, first and foremost, that the business is well run, has good prospects, and generates sufficient cash flow to service its debts. But the security provides a vital back-up to the loan request, and the provision of collateral clearly enhances access to credit for small businesses. These guarantees provide a bank with an additional source of comfort that its loan will be repaid. In addition to meeting a bank security requirements, the use of personal assets and guarantees as collateral demonstrates to the bank the business owners commitment to the enterprise. Frequently, personal guarantees are released by banks over time as the performance of the firm and its management is proven.
Banks tend to value collateral differently from business owners for a reason.
Bankers look at the assets liquidation value, that is, what the assets would be worth if the business fails and assets are liquidated through a forced sale. That can differ sharply from the book value or the customer's estimate of the value of their business. Further, banks face significant legal and wind-up costs when realizing on security. Those costs, combined with the low liquidation rate for assets, mean that collateral taken for small business loans is generally insufficient to guarantee that the bank will fully recover its funds. A Last Resort for Banks Beyond the cost of liquidating and low recovery rates, banks don't want to sell or realize on pledged collateral for a very important reason.