An unencumbered asset is an asset that is wholly-owned, free of any associated debt, liens, or claims. Conversely, an encumbered asset is an asset that does have associated liabilities or claims.
Unencumbered Assets Deeper Dive
Knowing that an unencumbered asset is the opposite of an encumbered asset, what causes a particular asset to become encumbered?
- Legal or Contractual Claims — Specific legal agreements or contractual requirements can cause an asset to be considered encumbered. For example, a term loan covenant may prevent a borrower from selling its headquarters’ real estate. The real estate would become unencumbered when the term loan is paid back and the covenant no longer applies.
- Collateralized Assets and Associated Liabilities — An asset can also be considered encumbered if it is pledged as collateral for a loan, or has liabilities associated with it that render it not wholly-owned. For example, a house with a mortgage is typically considered an encumbered asset. The same applies to securities bought on margin.
Unencumbered Assets in Banking
The term unencumbered asset is particularly important in an institutional banking context. Financial regulations require banks to meet certain liquidity thresholds (such as minimum liquidity coverage ratios), with assets generally being considered liquid only if they are unencumbered.
This means that banks and regulatory authorities closely track measures of unencumbered assets. Should they fall too low, a bank could be in breach of applicable laws or regulations. Dangerously low levels of unencumbered assets could also portend a liquidity crunch and bring the bank’s solvency into question.
Banking-Specific Definition
The standard definition above applies in banking context, but there are also more specific guidelines in this context.
Generally, a bank’s asset is considered unencumbered if it has no restrictions on the bank’s ability to liquidate, sell, or transfer said asset. This means that, to remain unencumbered, assets must not be used to cover trading positions, secure or collateralize a transaction, nor be designated to cover operational expenses (staff salaries, etc.).
Bank deposits at the relevant central bank are also typically considered unencumbered, but only if they are in excess of required reserves. Assets that are used to meet the required reserves are considered encumbered, because there is clearly a restriction on their withdrawal or use.
For those curious, here’s a 2013 paper on asset encumbrance and financial collateralization published by the Committee on the Global Financial System.