Hypothecation occurs when assets are used as collateral against a loan. The asset is the insurance the lender has if the debtor defaults on repayment, in such an event the asset can be seized by the lender to cover the cost of the lost investment.
The asset used as collateral by the initial borrower is seen as an asset of the lender and can be used as collateral for a second time by the lender. When this happens it is known as rehypothecation and allows banks to liquidate assets and make further investments.
Rehypothecation can be beneficial to the banking system because it speeds up the lending process and provides asset backing to loans. However there are some draw backs. The main one being debtors, who undertake the initial loan and whose assets are used in rehypothecation, are not always aware the asset they have used as collateral has been rehypothecated.
Another problem arises from the value of the asset, which can fall as well as rise. If the value of the asset falls below the loan repayment requirement, it would not be sufficient to cover the invested sum causing bad debt. This is true for hypothecation too however the bad debt is now spread across two debt obligations.
The final problem and perhaps the worst, there is no limit on how much an asset can be rehypothecated in the UK. There is a limit in America of 140% of the asset value and in Canada, it is banned entirely. Perhaps it is time the UK followed suit and at the very least put a cap on the level of rehypothecation.
As the UK is currently in a downturn and asset values are currently falling, it might be prudent to introduce a limit of 60% - 80% of the current value of the asset if rehypothecated. This should reduce the risk of bad debt if the asset used as collateral loses value, assuming the debtor defaults.
Such a limit could be a suggestion for the new banking regulations put forward by the coalition government. By putting a cap on the level of rehypothecation allowed it could stop contagion of bad debt in the worsening financial crisis.