Bank securitisation provides for the transformation of illiquid assets into a liquid tradable instrument. The liquid tradable instruments possess a recognized flow of revenue payments. The transformation of illiquid assets is driven through a special purpose vehicle (SPV). SPVs are unique to the entity with ownership rights. Therefore, bank securitisation permits banks to convert heterogeneous assets into liquid and homogenous securities fit for sale to third parties. Various assets that can be securitised include mortgage loans, bonds, auto loans, and credit card receivables. 1
Bank securitisation evolved in the 1970s at a time when the existing thrift system was deemed incapable of financing the increasing demand for housing. The thrift system limited banks’ abilities to attract sufficient deposits at a reasonable cost for financing homeownership. Government-sponsored enterprises (GSEs) were responsible for the development of bank loan securitisation. The United States (US) congress introduced GSEs as a means to provide stability to the market for residential mortgages and to encourage access to mortgage credit and homeownership. At the time, relevant GSEs included the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. These GSEs contributed to the growth of securitisation by purchasing the largest percentage of mortgages in the US. 2 Bank securitisation is beneficial to both lenders and borrowers. Regulatory reforms can be used to preserve the beneficial features of bank securitisation while mitigating potential risks to financial stability.
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Benefits of Securitisation
One of the main advantages associated with bank securitization is that it affords banks with a source of financing their investment opportunities. Banks are capable of funding new loans by securitising them. Therefore, banks shift from viewing deposit institutions as the sole source of liquidity. Deposit institutions act as intermediaries between borrowers and the capital market. 3 Including various sources of liquidity ensures diversity and mitigates risks since banks can finance new loans in diverse areas. Therefore, if an economic downturn was to occur in one of the sectors, the bank has other funding sources to lean on. The reduced dependency on deposits could lead to a reduction in the cost of financing. A reduction in the cost of financing is indicated by a reduction in interest rates, which is likely to attract more borrowers. An increase in borrowers allows small enterprises to purchase loans, thus supporting economic growth. Additionally, it also leads to an increase in banks’ financial performance.
Apart from providing a source of financing for investment opportunities, bank securitization also allows banks to hold more diverse loan portfolios. Having a diverse loan portfolio distributes financial risks, thus making banks immune to local economic shocks. Banks enjoy the freedom of providing loans in areas where they possess superior knowledge of market conditions. Bank securitisation allows banks to bundle these loans with other loans purchased in the country. Bundling these loans allows banks to supplement regions with unsatisfied loan demands with excess deposits from regions of superior market condition knowledge. 4 Having a diverse loan portfolio increases competitive advantage. 5 Increasing competitive advantage is likely to increase loan performance, thus allowing bank growth.
Risks and Challenges of Bank Securitisation
Before the implementation of bank securitisation, banks played a traditional lender role. The financial product transformed banks into loan originators and distributors, thus affecting bank behavior. Bank securitisation creates a distance between loan originators and the bearer of the loan’s default risk. Therefore, securitisation could lead to a reduction in bank screening and monitoring incentives. Consequently, banks favor holding riskier loans and selling better quality loans, which creates vulnerabilities in their loan portfolio. Banks are mandated to signal the quality of securitized assets to the market by retaining riskier loans. 6
Securitisation is also likely to increase the risk appetite of banks since they can transfer the risk by selling the loans to others. The higher appetite for risks also encourages banks to lessen their lending standards, thus threatening financial stability. The financial system also becomes more fragile due to the build-up of imbalances in the credit market. 7 When banks enjoy the luxury of selling risky loans at will, it reduces their commitment to their customers. Therefore, customer satisfaction levels are likely to decline, leading to a loss of faith in financial institutions.
Owing to the high appetite for risks, securitization encourages lenders to approve loan requests from high-risk people. The ease of giving loans leads to unwise lending by banks, which could lead to an increase in the number of loan defaulters. An increase in default rates could lead to the loss of value of mortgage securities.
Bank Securitisation Regulatory Reforms
Risk Retention Rules
One of the benefits associated with bank securitisation is that banks can hold more diverse loan portfolios. This means that banks can procure loans from various sectors and bundle these loans together to reduce risks. Bank securitisation leads to an increase in banks’ appetite for risks. They have the freedom to withhold high performing loans and sell those that have a higher risk, thus the need for regulatory reforms regarding risk retention. Risk-retention rules ensure that the loan issuer retains at least a 5% ownership interest in securitised assets. Apart from the 5% risk retention rule, Article 122a also requires originators and critical investors to undertake due diligence, risk management, and disclosure practices on an on-going basis. Failure to do so will attract hefty penalties. 8 Ensuring that all banks perform due diligence before granting loans will ensure that they are aware of the risks they are undertaking and that they consider their capabilities to handle the risks. It will reduce banks’ appetite for risk, thus reducing vulnerabilities in financial stability. Ensuring that banks retain 5% of the risk ensures
that they consider loan performance while considering the loan. It will prevent blind acceptance of loans without adequate screening and monitoring.
Basel III Liquidity Requirements
The Basel II liquidity requirements limit the future demand for securitized products by the banking sector. Asset-backed securities (ABS) are excluded from eligible securities meeting the required liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). 9 ABS includes mortgages. The ABS were eliminated since they have higher risks, which create vulnerabilities in financial stability. Other securities, such as covered bonds and corporate bonds are favored since they attract a more favourable risk weighting.
Credit Rating Agencies
The use of faulty ratings and flawed assumptions by credit rating agencies (CRA) contributed to the growth of the 2007/2008 financial crisis. Therefore, regulatory reforms targeting CRAs are likely to reserve the securitisation benefits while mitigating some of the risks to financial stability. The reforms should target increasing oversight and eliminating conflicts of interest. The regulations also target increasing transparency and disclosure requirements for these agencies. 10
Conclusion
Bank securitisation allows the transformation of illiquid assets into a liquid tradable instrument. The transformation is driven through the use of SPVs. Securitised assets include mortgage loans, auto loans, and credit card receivables. Bank securitisation is associated with several benefits such as providing banks with an additional source of financing their investment opportunities, thus encouraging increased financial performance. Another advantage is that it allows banks to diversify their loan portfolios. However, bank securitisation is also associated with some risks and challenges such as a reduction in bank screening and monitoring incentives. It also leads to an increase in the risk appetite, thus threatening financial stability. The benefits associated with bank securitisation can be reserved while mitigating associated risks using regulatory reforms such as risk retention rules and Basel III liquidity requirements.
Bibliography
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