Role of Banks in Securitization - Essay Example

Role of Banks in Securitization Introduction Global Economic Recession is a common household in the wake of 21st century. In the last decade, the effects of the economic recession have been enormous and turbulent to businesses globally, only second to the great depression of 1930. Giant financial institutions have fallen prey of the recession and collapsed.  Governments have been forced to bailout a number of financial institutions to save them from collapse, but despite these short-term measures to save them from the harsh effects of global financial crisis, many organizations and banks have gone under. According to the 2008-2012, Global Economic Crisis report, interplay of a number of factors may have triggered this crisis. Some of those factors include high-risk mortgage lending rate, inaction by the financial systems’ regulators to enforce available financial prudence acts and laws which created a loophole that allowed some financial players to act and lend imprudently, untrue credit ratings given to investors by some financial system players to woe and attract investors, and valuation and liquidity problems in the banking systems of global economies. Its turbulences and ripple effects have been heavily felt by virtually all economies, both great and mighty, and fairly considered small ones.1 A number of research have been done in the line of global economic crisis delving into what may have been underlying factors that led to great global economic recession. Commissions of inquiries into causes of the global financial crisis have been constituted and reports have been raised on the possible factors that may have triggered the crisis. Levin-Coburn Report in particular investigates on causes of financial crisis and concludes that, the crisis that plunged many economies into collapse was avoidable if due diligence was followed by major players in the banking systems, especially the ones in the mortgage lending section. Prudence in mortgage lending and adept adherence to the financial regulations and acts could have certainly saved many financial economies from collapsing under the harsh effects of the global recession. To avoid failures by banks insinuated as possible reasons for the global economic crisis, financial regulators have tightened the existing regulations on lending, liquidity and reserve requirements among others, and banks are now keener in how they handle credit risks. The concept of Asset securitization as a prudent risk management tool is finding global acceptance and many financial institutions concede that it could have relieved the harsh effects of recession, if it was correctly applied. This is because it allows for transfer of risks to institutions such as mutual and pension funds, which are willing and able to bear them. This paper seeks to study the role that banks have on securitization, and if truly prudent securitization could have been a solution in the wake of the global financial crisis. To comprehensively evaluate and divulge into the role of banking in securitization, my work has been broken down into five main parts systematically to enable me reach an accurate determination. The first part gives a preview of traditional banking and its evolution in the dawn of global crisis. The second part analyses benefits that banks and other saving institutions derive from asset securitization in light of global economic crisis. The third section delves into the roles of a bank in securitization process. The fourth section analyses the effectiveness of securitization as a risk management tool. If Banks could have played their roles better, could the world economies be in the economic mess/crisis they are today? The final section is made up of summary and conclusion. Traditional Banking and its Evolution Banking has its history dating 2000 B.C and since its inception there have been tremendous degree of evolution on how banking is done system-wise. The overall regulations and management is in tandem with evolution in banking systems challenges.2 Tremendous strides on the banking system evolution have been recorded time and again in response to evolving challenges, from free banking era with virtually little supervision banking activities to the modern era robust banking operation systems and regulations. The Challenges the banking systems faced then are way different and advanced from the ones financial and banking systems in the 21st century face, “failures then were from systematic problems rather than fraud or mismanagement”3 For the period prior up to 1970, banks merely performed their conventional functions of deposit taking and portfolio lending. They held and funded loans through deposits and sometimes debts till the time loans matured and got paid up (buy and hold model). This basically translated to the portfolio lending. Banks fully shouldering the credit risk, just in case a situation of default in loan payment occurred. An exciting trend developed early 1970s, with an increase in human population; demand for housing credits shot up, banks and saving institutions could not service the increased demand of housing credits. As a result, a new innovation of asset/ mortgage securitization came to birth.4 This innovation allowed banks and other saving organizations to originate mortgages and then sell them to investments banks. This package was then used as collateral for bonds that could be sold to pension funds or to bankruptcy-remote special purpose vehicles.5 This marked a shift from conventional “Buy and Hold” to “Originate and Distribute Model”. This model provided banks and saving institutions with an investment structure that isolated defined mortgage pools, segmented the credit risk, and structured the revenues from the underlying loans. According to Ehrhardt, Securitization occurs in two stages; first, a debt instrument that could not be traded becomes actively traded (802). Secondary, a security is created by pledging a specific asset resulting in the creation of Asset-Based Securities. Benefits of securitization Thomas defines securitization as “the transformation of illiquid financial assets into highly marketable capital market instruments” (211). To a financial lending institution, securitization results into increased supplies of lendable funds and transfer of risks from the lending institution to investment institutions willing to invest and bear the risks. Bodie and Marcus define securitization as “pooling loans into standardized securities backed by other loans, which can then be traded like any other security” (15). This structure allows banks to finance their credit growth and to a greater extent minimize their credit risks and arbitrage their Capital requirements. 6It provides banks and other financial institutions with a well laid out structure/ procedure of packaging interests in loans and other receivables to Asset-Backed Securities (ABS). Asset securitization can rightfully be recognized as one of the necessity innovations in the banking and financial sectors in the wake of global economic recession.7 A number of benefits accrue from securitization. For example, Securitization means that conventional mortgages, which could not be traded just like any other security, could now be traded. It equally means that financial institutions can readily raise funds to seize a given opportunity in the market, unlike in the ‘buy and hold model’ since the “originate and distribute model” arising from securitization no longer depends on the local credit conditions. It depends on where demand is greatest - it boosts investors’ confidence. Asset securitization expands the spectrum of selection by investors as they can now buy mortgage-backed securities or invest in the mutual funds.8 Securitization allows banks and other financial institutions to transform their otherwise illiquid assets into liquid assets as a result improving returns on capital, since the lending institution still stands to benefit from the income streams arising from the securitized asset. This happens even after transferring the risks to investment institutions willing to invest in the securitized assets. If the transformation of illiquid assets into liquid assets is structured as a sale, it helps the originator to reduce its assets and debts on the balance sheet, hence increasing the scope of borrowing and as a result attain greater leverage. Securitization of assets makes it possible for originators to sell a section of those loans, especially the ones of better quality. They can then use the proceeds of the part-sell to extend the loans to borrowers, whom they discreetly deem as less likely to default. This increases the expected returns to the portfolio with no variation in capital requirements. Securitization of assets also allows the seller to continue as a servicer, thus retaining the servicing fees and surplus collateral once the Asset-Based Securities are redeemed. Finally, as Kidwel and Peterson states, the securitization process not only generates quick cash flow for the owner of the assets, but also provides potentially useful vehicles for institutional investors to enhance portfolio risk-return trade-offs by allowing diversifications beyond traditional mix of stock and bonds (45). Banks’ role in securitization Securitization is a banking innovation concept that has tremendously transformed the rules of the game of conventional traditional banking. It is a banking innovative concept that has enabled banks to discreetly manage risks better, readily raise funds in a more cost-effective way and efficiently allocate capital through security markets to service portions of loan units/portfolio. To a greater extent, securitization of assets is a preserve of banks and financial institutions, though in the recent past as a result of diversity of needs, we have seen the entry of other participants such as state-owned enterprises and infrastructure projects into the market.9 Banks play a key role in securitization, both as a securitizer and advisor.10 Banks play an advisory role to other financial institutions regarding securitization of loans and leases, and at the same time often provide turnkey services by purchasing institutions loans and leases. They also transform them into highly marketable capital instruments and selling the newly created securities to investment institutions willing to bear risks and invest, such as Pension funds and mutual funds. In conclusion, one may not be entirely wrong to say that banks as originators of loans and distributors of risks have played a critical role in asset securitization. Possibly, without banks participation, the securitization of assets concepts will be unheard of. Banks play a critical role in securitization of assets by being able to isolate the better performing assets from the poorer ones, hence making them more identifiable, secure and liquid. As originators, banks transfer risks of the identified assets and in turn create tradable securities that are attractive to investors. Agreeably, no better institution can perform all these better and above banks, making them key players in asset securitization.11 Asset securitization and financial economic crisis Securitization seems to be embraced by almost all economies in the world, including Lebanon lately. It is seen to be a prudent way of managing investment risks as it allows the investment banks transfer their risks to those willing to bear and invest institutions such as mutual and pension funds. But is asset securitization enough to shield financial systems from the shock effects of global recessions? Levin-Coburn report investigated the causes of financial crisis in U.S. The detailed report of the parliamentary committee identified high-risk mortgage lending that many banks were unable to sell during the build-up to global economic crisis. According to a conclusion supported by Ehrhardt, lack of action by the financial regulators and untrue credit ratings made the investors the greatest responsibility bearers for the global economic crisis that flattened operations of giant financial institutions (804). If well practiced, securitization is meant to lead to a win-win situation, but despite its application in the last decade, it has resulted in a loss-loss situation.12 Summary and conclusion Asset Securitization is a procedure through which banks and savings institutions can sell or rather transform their illiquid assets into liquid assets to obtain some degree of liquidity and to a greater extent mitigate themselves against credit and even event risks and arbitrage capital requirements. The significance of securitizing assets has come into sharp focus especially at the dawn of global recession. The extent to which asset securitization can effectively mitigate risks depends greatly on the prudence by the lending institutions in its application. As it can be deduced for the three key ingredients for securitization, the ability of the lending institutions to separate or rather isolate the good/better performing assets from the poorly performing assets makes them more identifiable, secure, and liquid. This is very critical in ensuring the success of asset securitization as a risk management and mitigation tool. Failure of the lending institutions to prudently isolate the better performing assets from the poorer ones will certainty result into failure of securitization as a risk management tool.13 The financial lending institution (Originator) should be able to create tradable securities, making economic efficiency by providing cost savings to borrowers, developing capital markets, and creating attractive investment opportunities for investors. Inability of the originator to create tradable securities, which attract investors, becomes a great hindrance to the full realization of securitization benefits. Thus, prudence should be observed in the creation of tradable securities to result in economic efficiency by providing borrowers with cost savings, developing capital markets, and creating attractive investment opportunities for the willing investors. Finally, the inability of financial institutions to transfer risks of the identified and isolated assets will result in the ineffectiveness of asset securitization as a risk management tool. Ehrhardt attributes the global financial crisis to the inability of the financial mortgage lenders to sell their stock of high-risk mortgages in the build-up to the economic crisis. In essence, this translates to the inability of the financial institutions to transfer risks of the identified and isolated assets (804). Securitization for banks and saving institutions (Loan Originators) is a prudent means of converting their on balance-sheet lending business into an off-balance-sheet, while still maintaining most of the economic benefits arising from servicing the loan and freeing up capital for servicing other loans or supporting further loan writing. For banks and saving institutions that are risk management tools deficient, securitization of assets provides an alternate avenue for funding that boosts their ability to match the maturities of their assets and liabilities. It is clearly evident that one cannot discuss of Securitization of Assets in isolation without banks. Banks comprise of a huge percentage of originators and issuers of loans and credits. They are the first to be hit severely by the effects of economic turmoil. They, therefore, stand to benefit immensely from Asset Securitization if, and when effectively and prudently practiced. Well managed securitization enables a bank to obtain liquidity by issuing covered bonds or Asset-Based Securities. This transforms illiquid and long-term maturity assets into liquid instruments, arbitrage capital requirements and changes the risk profile of its portfolio to mitigate credit risks, liquidity risks, interest rate risk and maintaining customer relationships as well as diversifying their funding sources.14 Asset securitization leads to improved return-on-asset and returns on equity ratios and reduced exposure to concentration risks. As inferred, this depends on the prudence put into practice in the isolation of the better performing assets from the poorly performing ones, transferring risks of the isolated assets and lastly creation of tradable securities able to attract willing investors. Certainly, securitization of assets is undergoing evolution and further researches should focus on assets that qualify for securitization, recent development of securitizing sports sponsorship leaves a lot to be desired in the study of asset securitization Works Cited Block, Geoffrey and Bartley Danielsen. Foundation of Financial Management. New York. McGraw-Hill, 2009. Print. Bodie, Alex and Allan Marcus, Essentials of Investment. New York. Irwin/McGraw-Hill, 2010. Print. Ehrhardt, Eugene. Financial Management: “Theory and Practice”. New York: United States of America. South Western-Cengage Learning, 2011. Print. Howells, Keith. Financial Markets and Institutions. Great Britain. Prentice Hall, 2007 Print Jeff, Madura. International Financial Management. New Delhi. Cengage Learning EMEA, 2007 Print. Kidwel, David and Richard Peterson. Financial Institutions, Markets and Money. Jefferson City. John Wiley &Sons, Inc. 2008. Print. Lloyd, Thomas. Money Banking and Financial Markets. New York. Thomson/South-Western. 2006. Print. Cecchetti, Stephen. Money, Banking and Financial Markets. New York. McGraw-Hill 2008 Print. Zock, Geoffrey. Foundation of Financial Management. New York. McGraw-Hill, 2009. Print. Read More