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Why do bank securitize their assets

Securitization is structured finance process wherein it allows the transformation of illiquid asset into a tradable instrument which is liquid and which has a future income flows. Not only this, but it also manages to convert risk by separating of decent financial assets from a financial institution or a company with a slight loss of revenue. This conversion is likely to be made by Special Purpose Vehicle (SPV). This is also known as special purpose entity. The only purpose of this entity is to acquire certain assets or derivative exposure and issuing liabilities thus linked to solely those assets or exposures. ‘An SPV is designed to be a bankruptcy remote’ (creditors cannot claim against originators assets). SPV are used for all kinds of Asset Backed Securities (ABS) along with Collateralized Debt Obligation (CDO) as well as credit linked notes.

Securitization was first created in 1920s, when mortgage insurance companies sold guaranteed mortgage participation certificates for pools of mortgage loans. Investors aggressively traded these certificates in anticipation of real estate market crash during great depression. In the late 1970s and early 1980s securitization was like miraculous comeback.

The twin energy crisis brought about cause on the economy in 1970s and banks experienced strict withdrawal from intermediaries (Prof. George Jackson, 2001). Till September 2007 securitization market maintained its stability.

And in recent years, it has become centre of attention due to access of securitization which consists of doubtful instruments, impatient investors and ignorant regulators. These complications were created by the subprime crisis and swelled by the failure of Lehman brothers over and above us federal agencies nationalisation- Fannie Mae and Freddie Mac. Additionally, many banks balance sheet were deteriorated by holding tranches of ABS and Mortgage Backed Securities (MBS).

In modern financial environment, securitization has become an essential component of financial innovation. Even though in current financial crisis, securitization has played an vital role in dispersing credit risk, thus improving the resilience of the financial system (Anil Kashyap and Hyun Song Shin (2008), Shin, Hyun Song (2009)). But in actual, securitization functioned to focus risks in banking sector and it is viewed as balance sheet management by banks. Securitization has grown from non-existence industry in 1970 to $6.6 trillion as of second quarter of 2003.

Current study focuses not only on one country but both the developing and developed countries banks. This way it is distinct from the previous studies. Analysis of ABS and MBS market will be done from 2000 to 2009 on countries from three continents like US, Europe and Asia. Since ABS brought into being a rising sector of the Asian and global capital markets, the study will see the specific characteristics of domestic financial system effect bank securitization.

2. History of securitization

Looking back at the scenario in 2001 securitization had both elements of confidence and depression. However it activity picked up fast in Korea and Singapore. Commercial banks owns a higher share of Asset Backed Securities and even insurance companies and pension funds are more and more interested in these type of mechanisms.

The volume of structure finance issuance in emerging market was US $34.5bn in 2005 and it grew to about 20 % in 2006 amounting US$41.5bn. Relatively the cross border volume of future flow transaction have decreased in these recent years, with existing asset deals now reporting for about 80% of total issuance, a large amount of these in local currency and domestic markets. Securitization activity in Latin America is reporting for about 37% of total issuance in emerging market took place mostly in the local currency with consumer credit subject to ABS asset class. Europe, Middle East and Africa regions have been reported for about 38% issuance of total emerging market. Future flow transaction in securitization activity prevailing in the cross-border market indicates 40% growth. Asian markets reported about 25% issuance of entire emerging market was evenly split among domestic and cross-border subject to real estate related asset class.

Securitization made its re-entrance in 1970 when the market of MBS was created by US government national mortgage association, Ginnie Mae. Till 1995 the issuance volume of structured finance which consist of ABS, Residential Mortgage Backed Securities (RMBS), Commercial Mortgage Securities (CMBS), Collateralised Debt Obligation(CDO) was comparatively low, and only started picking up a pace after it attained roughly US $ 500 billion in 2000. The figure exceeds US$ 2 trillion for the first time in 2006, as all measured by denominated currency that is dollar. The technology for securitization remained in US for a very less period. Then it reached to Europe in 1988 and extended to Asia pacific and the emerging markets in the early 1990.. The first securitization took place in United Kingdom were the issuance of mortgage-backed bonds in 1980s. New issuance rose from $30 bn $599bn with an overall increase of securitization activity in Latin America. Not just securitisation market in Latin America increased fourfold in size from 2000 to 2006, while domestic securitisation characterized only 25% of the US$4bn issued in 2000, it represented almost 90% of the US$15.3bn issued in 2006. The two largest economies in the region, Brazil and Mexico, accounted for 73% of the domestic issuance. Even though auto loans, mortgage backed securities, consumer loans correspond to the largest percentage of asset classes securitised, the composition of assets were diversified. Russia issuance was blown up from US$ 198mn the year preceding 1995, to US$ 3.5bn concerning half of the volume was correspond to ABS, including securitisations of consumer loans, auto loans and receivables.

Argentina rebounded in 2005 with just under US$2bn in issuance, followed by a strong2006 with US$2.5bn. While Titularizadora Colombiana, Chile, Peru, and Costa Rica together represented less than 3.5% of total domestic issuance in the region. The emerging markets of Europe, Middle East, and Africa achieved issuance of US$15.7bn in 2006. However, issuance was heavily dominated by Turkey, South Africa, and Russia, together accounting for 85% of the region’s total. South Africa which is the second largest market in the region, recorded a growth in 2006 with issuance volume of US$4.5bn primarily from ABS and RMBS transactions. Further, as the region continues to introduce new securitisation legislation in countries such as Hungary, Kazakhstan, Romania, Russia, Turkey, and Ukraine, the prospects for continued growth in the region looks bright. Egypt saw the issuance of one deal in 2006 for US$28m, a repeat transaction from the prior year. As the region continues to introduce new securitisation legislation in countries such as Hungary, Kazakhstan, Romania, Russia, Turkey, and Ukraine, the prospects for continued growth in the region looks bright.

Securitization market in Asia

But in ABS market, the issuance volume lasted only just one year (from 21761.4 million USD to 36851.9 million USD). South Korea remains the biggest issuer in Asia after Japan, although issues have declined gradually in recent years from $28bn in 2005 to $19bn in 2008. Asia experienced a 15% year-over-year increase in issuance volume for 2006.To a very large extent, this was due to the growth of China’s domestic market. There were a total of 31 public structured deals issued in the region for a volume of approximately US$10.5bn.Volume was relatively evenly split between cross-border and domestic issuance. Borrowers in Hong Kong, Singapore, and South Korea continued to access the cross-border market while borrowers in China, Taiwan and Thailand continued to access the domestic market. Cross-border issuance continues to be heavily dominated by South Korea, for which there was about US$3.5bn in issuance focused on residential mortgages, credit cards, and auto loans. Singapore was responsible for the next largest cross-border issuance, a total of US$1.3bn, focused on commercial and residential mortgages. As for the domestic markets, China experienced a staggering 65% growth in volume over 2005.This US$3.5bn was dominated by issuance of seven selective asset management plans (SAMPs), but also included a collateralised loan obligation (CLO), and two non-performing loan (NPL) securitisations. Taiwan, which saw a decline in overall issuance relative to 2005, followed in domestic issuance with about US$1.3bn primarily focused on real estate related assets.

3. Literature review

MassimilianoAffinito, EdoardoTagliaferri analysed that banks that has less capital, less liquid, less profit and lots of liability have more probability to securitize to a larger extent. Before crisis of 2007, securitization was viewed as positive vision which put emphasis on the role it played by securitizing in successful risk management, increasing transparency and liquidity, enhancing pricing and reducing controls on credit availability. The negative views about securitization, which was quiet large at the time of financial havoc (BIS 2008). In fact, many authors have put pressure on the connection between financial crisis and securitization activity. The recent study by Adrian and Shin (2008b) and Greenlaw et al. (2008) reveals that the securitization was the main cause for financial crisis in 2007.

The literature has been more stressed on four main elements of securitization which aids to make a decision of whether to securitize or not. The elements are liquidity or a new source of finance, the transfer of credit riskiness, chances of earning profit and the role of capitalization.

The first reason is that why banks securitize:

The main determinant of bank securitization is liquidity. In recent empirical studies by Agostino and Mazzuca (2008), liquidity has been specified as the most essential contributing factor of securitization. Obviously, the liquidity outcome is mainly in cash transaction. And the asset transfer to SPV (special purpose vehicle) of an underlying portfolio mainly follows a true off-balance sheet sale. Subsequently, notes are then issued by SPV which are acquired from originating bank to finance the assets. And as this transaction leads to a cash inflow, re-adjustment of balance sheet is likely to be done (Gorton and pennacchi, 1995). Secondly, the method with which bank provides loans have been changed as the securitization came into play. For example, bank have got a preference to finance a liquid loan either through securitization (with finance from capital markets) or retail deposits (Elena Loutskina, Philip Strahan, 2007). In order to back their asset, bank would sell their loans owing to their lack of resources and cost. Even recent financial distress has emphasized on significance of connection between bank liquidity and securitization.

Second common reason is the credit risk exposure of an asset.

The risk removal assumption is main characteristic of securitization as it is a mechanism to transfer risk. Securitization lets creating of high risk financial institutions for financing risky assets which reduces cost of liability (Gorton and Souleles, 2004). Therefore, banks securitize risky loans to minimise liabilities on their balance sheet. Banks who want to eliminate unwanted risk from their balance sheet need to securitize their riskiest asset by investing the earnings in less risky asset. The prospect should be interesting for those banks that hold risk than above average and that, in the event of default, would bump into huge losses. But in research paper by Benveniste and Berger (1986) gives negative recommendations about securitization is having an aim of increasing risk. As per Berger and Udell (1993), banks have stronger motivations to take on risk instead of eliminating the risk when they have high possibility of default. Therefore there is possibility that riskier banks should securitize their assets in a country with deposit insurance scheme, to increase overall risk (Detragiache, 2002). Jiangli, Pritsker and Raupach (2007) examined bank's bankruptcy risk and leverage which may also get affected by securitization if the bank involves in regulatory capital arbitrage.

Third determinant is profit opportunities:

WenyingJiangli and Matt Pritsker (2008), suggest that bank securitization methods increases bank profitability. When market value is more than book value, securitization permits bank to know accounting gains and overvaluation of the interest held that is carried out at fair market value (James, 1988). Likewise, banks can divert their sold loans to more profitable business (Greenspan, 2004).

Reduction of capital requirement:

The third determinant is the connection among regulatory capital and securitization. Banks traditionally had two ways to decide on, in order to meet both economic capital requirement connected to market discipline and compulsory capital requirement connected with regulation. The quick growth in 1980s, and the acceptance of risk-based capital standards at the end of the decade, elevated an entire of motivating issue concerning the relationship among capital and off balance sheet activities. This comprises of how securitization activity is related to capital in overall and risk based capital ratios (Georges Dionne, Tarek M. Harchaoui(2003)). Fabio Panetta and Alberto Franco Pozzolo (2010) found the results unclear and recommended that securitizations are mostly used by banks having lower capital ratios. Mason and Calomiris (2004) found that in order to set capital ratios at reliable level with market principles, banks needs securitization. To illustrate, there is at least five not equally exclusive cases where securitization is affected by bank capital.

Summary

According to (Uzun, Hatice; Webb, Elizabeth 2007) results in their study indicate that bank size is a significant determinant of whether a bank securitizes or not. Furthermore, overall securitization extent is negatively related to the bank's capital ratio (in support of capital arbitrage theory), but this result is primarily driven by credit card securitization. Secondly the results given by (Christina E. Bannier,Dennis N. Hänsel 2008) concludes that banks use loan securitization to save on regulatory capital, we find that the main factors driving banks’ securitization decisions are bank size, credit risk, liquidity and performance. Negating the above result (Alfredo Martín-Oliver, Jesús Saurina 2007) came up with a different study. That risk profile and level of capital play no role, especially for ABS. In fact, RMBS are only used to obtain liquidity and securities backed by loans must be issued to arbitrage capital. Similarly, (Barbara Casu, Andrew Clare 2010 ) shows a significant negative impact of securitization on bank credit risk taking signifying that banks with a greater amount of assets securitized are more risk-averse in their activities. (Mathias Hoffmann, Thomas Nitschka 2009) shows that developed markets for securitization shares more consumption risk than other markets. After observing different results by authors I consider that the level of significances differ according to the countries and asset classes.

In this paper analysis is being done on ABS and MBS market from countries located in each five continents of the globe. Are these determinants showing same results according to the study done by authors earlier? Many authors have done study on bank securitizing their loans on single countries but rarely any research has been done by authors earlier for global countries. As due to financial crisis many banks and financial institutions might have effected in all countries but the severity differs due to the different norms and market standards of countries. The study will be done on banks decision for securitization from 2000 to 2009. The securitization market has slumped since 2007 after success.

This paper links the empirical research, which is studied in depth in subsequent sections:

First, all the banks small and large, retail and investment banks data will be taken for securitization from securitization.net and even from balance sheet for loans of firms form banks on bank scope. The rest of the finding will be done in following sections: 3.verifying the determinants according to the country. 4. Applying several econometrics models and come up with findings. And the last part is analysing the finding and comparing it with literature review. Finally concluding our concepts and ideas.


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