Credit Risk Management Practice Exam

Which of the following describes the primary objective of collateralization?

1. To reduce the principal amount of loans issued

2. To completely eliminate the credit risk of loans

3. To secure loans with other assets as a backup

4. To increase the yield on securitized products

The correct answer is: To secure loans with other assets as a backup

The primary objective of collateralization is to secure loans with other assets as a backup. When a borrower provides collateral, such as property or other valuable assets, it serves as a safety net for the lender. In the event of a default, the lender can claim these assets to recover some or all of the owed amount. This mechanism reduces the lender's risk exposure, as the existence of collateral acts as a guarantee that they will not lose the entire loan amount. Other options do not accurately reflect the core purpose of collateralization. For instance, reducing the principal amount of loans issued does not align with the concept of collateral; instead, it pertains to loan structuring. Completely eliminating credit risk is unrealistic, as all lending inherently carries some level of risk, even with collateral in place. Lastly, increasing the yield on securitized products relates more to investment strategy than to the primary purpose of collateral, which focuses on mitigating risk rather than enhancing returns.