Vinu: Manu, I’ve heard about floating charges and fixed charges in banking. But what exactly is a floating charge?

Manu: Good question, Vinu! A floating charge is a security interest taken by a bank or lender over a pool of changing assets. These assets can include stock-in-trade, debtors, raw materials, and work-in-progress. The key aspect is that the borrower can continue using, selling, and replacing these assets in the ordinary course of business.

Vinu: So the borrower is free to manage those assets without the lender’s direct control?

Manu: Exactly! Unlike a fixed charge, which is tied to specific assets, a floating charge is flexible. However, this flexibility exists only until a certain event triggers what we call crystallisation.

Vinu: Crystallisation? That sounds serious. What does it mean?

Manu: Crystallisation is when a floating charge converts into a fixed charge. Once this happens, the borrower loses the freedom to deal with the charged assets, and they become locked under the lender’s control.

Vinu: That sounds like a major shift. What situations lead to crystallisation?

Manu: There are several events that can trigger crystallisation:

Vinu: I see. So, if any of these events occur, the lender’s interest is locked into specific assets?

Manu: Exactly! Once the floating charge crystallises, it functions like a fixed charge, meaning the borrower cannot deal with the assets without the lender’s consent.

Vinu: Can you give me an example to make this clearer?

Manu: Sure! Imagine ABC Ltd. takes a loan from XYZ Bank, and in return, XYZ Bank secures a floating charge over ABC Ltd.’s stock-in-trade and book debts.

Initially, ABC Ltd. operates as usual – buying and selling stock and collecting receivables. But let’s say ABC Ltd. defaults on repayment. As per the loan agreement, this default triggers crystallisation.

Vinu: That makes sense. So, the lender takes control at the moment of crystallisation to safeguard their interests?

Manu: Precisely! The process ensures that lenders can recover their dues, especially in cases of financial distress or insolvency.

Vinu: What are the key advantages of crystallisation for banks?

Manu: There are a few major benefits:

Vinu: That’s a crucial safeguard for lenders! Does this also impact other creditors?

Manu: Yes, it does. Once a floating charge crystallises, unsecured creditors and even other secured creditors with lower priority may get a smaller share of assets in liquidation. This is why some lenders insist on fixed charges instead of floating ones.

Vinu: I can see why banks use floating charges but also want the ability to crystallise them when needed. Thanks for the detailed explanation, Manu!

Manu: Anytime, Vinu! Understanding these concepts is key for effective credit risk management in banking.