Overcollateralization

Overcollateralization is a risk management feature in secured lending in which the value of the collateral posted by the borrower exceeds the principal amount of the loan. The excess collateral acts as a cushion to absorb losses if the borrower defaults or if collateral prices fall.

The key metric is the collateralization ratio, calculated as collateral value divided by the loan amount. A ratio above 100% indicates overcollateralization; lenders may specify a minimum ratio, frequently expressed as a multiple or percentage. If the ratio falls toward the minimum, borrowers may face margin calls or automatic liquidations.

In traditional finance, overcollateralization appears in asset-backed securities, where the collateral pool provides protection against losses, and in many secured loans with collateral values exceeding the loan balance, creating credit enhancement. In decentralized finance and crypto lending, platforms routinely require high collateral ratios (for example around 150% or higher) to account for volatile prices and smart contract risk.

The primary benefit is reduced credit risk for lenders and broader access to credit for borrowers who may not qualify for unsecured loans. The main drawback is higher capital cost for borrowers and the risk of rapid liquidations if market prices move against the collateral.

Overcollateralization interacts with liquidity and valuation dynamics. It does not remove risk entirely; extreme price shocks, liquidity squeezes, or model errors can erode the collateral cushion and lead to losses or systemic stress in some structures such as securitization deals.