Effect Of Securitisation On The Operations And Profitability

Published Date: 02 Nov 2017

Securitisation is believed to offer extreme benefits to investors, issuers, businesses and the economy. And despite this growth it still remains the mainstream of financial mechanism. Securitisation started in the 70s, through the mortgage industry and has since transformed debt instrument and credit market. Banks and financial institutions have been given the mandate by Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 to securitize their financial assets. Bringing about different definitions by different authors, Arora and Kaul (2005) defined as a process of exchanging existing assets or future cash flows into profitable securities. While Martin (2009) defined it, ‘‘as that which involves the pooling of sets of credits or debt securities whose acquisition is financed by the issuance of new debt securities’’. And the securities he refers to in the definition, goes by the names on the type of the assets in the pool. Examples are home mortgages which are tagged mortgage backed securities; and business loans are labelled collateralized loan obligation (CLO) etc.

Also, the exchange of existing assets into marketable securities is known as ‘asset backed securitisation’, while the exchange of future cash flow into marketable security is known as the ‘future-flows securitisation’. The credit market involving securitisation has both consumer debts (examples include, mortgage loans, credit card debt etc.) and corporate debt (examples are collateralized debt obligation (CDO), collateralised loan obligation (CLO) and collateralised bond obligation (CBO) etc.). Prabhakar (2007) sees it as ‘‘a structured financial instrument that is tailored to the risk return and maturity needs of the investor rather than a simple claim on the assets’’. Securitisation involves three aspects namely:

The originator who pools the credit sensitive assets together.

The Originator transfers/de-link the credit risk to the SPV/Investor

SPV is bankruptcy remote

SPV has limited, predetermined activity

The originator transfers control

SPV can pledge/resell/exchange assets

Originator tranches the liability.

Banks were faced with disintermediation since their exposure to securitisation and since then they have moved from their traditional role of lending:

(1) Originating loan by making it available to customers

(2) Funding /maintaining the loan on their balance sheet

(3) Servicing the loan by getting the required interest and principal

(4) Monitoring, by ensuring the borrower maintains the financial ability to service the loan and if there would be a fall in the borrower’s creditworthiness.

To just, originating the loan, selling it and servicing it by removing the need to fund and monitor the loans on their balance sheets. By so doing they have moved their risk from their balance sheets to the Special Purpose Vehicle (SPV) or the investors, securitisation is a way of unlocking the blocked funds of banks holding loans till maturity. The bank which acts as the originator transfers the receivables from the borrower to the SPV/SPE (Special Purpose Vehicle/Entity), and this SPVs acts as an intermediary between the bank and the investors. The SPV is a separate entity and its role is to hold the assets on behalf of the investors or issue to the investor its own securities making it also act as an issuer. The funds transferred to the SPV needs to be homogenous that is of one type of asset and of similar maturity and this would be bundled together to bring about the securitised instrument, and this makes the SPV divide the assets of the originator into marketable securities and this would be traded to investors like banks, mutual fund, other financial institutions, governments etc.

Securitisation differs from countries to countries in respect to how developed it is in that country, but some of its outcome is stated below:

Most importantly, Securitisation helps make free the blocked assets of a bank. As banks take advantage of securitisation by not holding on to its loans till maturity.

Securitisation is said to reduce the proportion of financial assets and liability held by banks. This could make difficult the implementation of monetary policy in such countries where central bank operate minimum reserve requirement.

Since the growth in securitisation, the growth in credit off taking in banks has not matched with the growth in deposits. And since the deposit inflow is less than the credit outflow, banks would not be able to fund the credit required on loans.

As a result of the imbalance, they take the option of selling their investment in government securities to fund loans on their balance sheets. This has made their investment in government paper decline tremendously.

Also the benefit of transforming illiquid loans into liquid securities could lead to an increase in asset volatility and may be reduced through credit improvement.

Securitisation process might lead to pressure on the profitability of banks, if non bank financial institution exempt from capital requirements to gain competitive advantage in investment in securitisation assets.

Though the advantage is to enable lending take place beyond the limit of the capital base, the process could lead to a decline in the total capital employed in the banking system thereby increasing financial weakness of the financial system.

Credit risk could remain with the bank if a clean sale does not take place and the securitisation could damage the asset quality of the bank if it was the bank’s best assets that were securitised.

Securitisation may demand close attention by bank supervision in order to ensure that the banks have conducted the business in a prudent manner.

TRADING AND DEALING MECHANISM AND THE CHARACTERISTICS OF THE PRINCIPAL MARKETS

In this modern age, market is used as a mechanism for trade. Trade is a direct exchange of goods and services and it makes use of a principal medium of exchange known as money. A trade that takes place between two traders is known as bilateral trade, while between two or more traders is known as multilateral trade. Trade can take a number of ways to be made a success in the world. The function of trading mechanism is to turn the demand of investors into realized transactions, and this turnaround is effective with an appropriate market clearing price. Trading mechanisms differ in price, orders permitted, the time of trading, quantity and quality of market information the investors relied on at the time of their order, and the trust in market makers to make available liquidity. The types of trading are giving below:

Continuous trading: where an investors order is processed immediately when submitted, this trade is most times of bilateral transactions with different prices.

Periodic trading: Here, investors’ orders are accumulated for concurrent processing at pre-determined time. This system is most times referred to as call auction or batch market and it’s of multilateral transactions at one price.

Quote driven trading: Here, investors can obtain the firm price from market makers before the order submission. This is also known as continuous dealer market, reason that investor don’t need to wait for the order execution but goes ahead to trade immediately with the market maker.

Order driven trading: Here, it can operate as either a continuous or periodic auction system. Under the continuous system, investors submit orders to dealers on the exchange floor for an immediate execution. This system is continuous because the orders are treated immediately they arrive and the price is determined multilaterally. For periodic auction, investors’ orders are stored for execution at a single market clearing price.

There are two agents of the markets: traders, who trades with time and enters the market based on a random process; and the dealers or market makers, who provides liquidity by trading with the first group of traders. Trading mechanism of stock exchanges are dealership market and the clearing house. Dealership market deals with trade that are carried out continuously through market makers who quote bid and ask prices which they are willing to buy and sell i.e. for New York Stock Exchange, a specialist makes the market for security and has the obligation to provide continuous quotes. While in other markets like i.e. Over The Counter (OTC) market trades are carried out by multiple traders. For clearing house, traders here submit two types of orders to buy or sell at certain quantities of traded security, limit order stating the order quantity and minimum sale price or maximum purchase price of the order, market orders stating the quantity to be sold or bought with no price limits. Also orders mount up and remain sealed till clearing time. The sell orders are sorted according to the type of order and limit order by the increase in price, while buy orders are also sorted by the market orders first and by the decrease in price.

Amongst others the various principal markets are:

London Stock Exchange

Euromarkets

New York Stock Exchange

London Stock Exchange

The name given to London Stock Exchange trading system is TradElect and its set to enhance performance, reliability and scalability. Its platform has increased capacity, handling 3000 messages per second, processing order of 10 milliseconds. Its goal is to get more orders from hedge funds and investment banks running algorithmic trading systems, handle higher volumes of order, offer lower fees with TradElect and compete with new entrants i.e. Turguoise. Securities dealt with on London Stock Exchange are: European equity market securities, international equity market securities, domestic equity market securities, gilt edge securities, fixed interest securities, negotiated options, gilt warrants and traditional options. It makes use of the following systems: SETS (Stock Exchange Trading Service) for shares in stocks and SETSqx for non-liquid stocks; and SEAQ (Stock Exchange Automated Quotation System) for fixed interest and for AIM companies not traded on SETS or SETSqx.

EUROMARKETS

Eurobond is made use of in the Euromarkets. Eurobond is issued by the borrower in a foreign country denominated in a Eurocurrency (i.e. US Dollar, Canadian Dollar, Yen, Euro, Sterling and so on). It’s used by international financial institutions. Eurobonds are listed on the London Stock Exchange and the Luxembourg Stock Exchange and they are made over-the-counter (OTC) meaning trades are done by dealers over the phone rather than on the floor of the exchange. The markets is not affected by government restriction but are set by the rules and regulations of International Capital Markets Association (ICMA). The dealers in the markets are: market makers (they are dealers who take certain stocks in the markets and quote the bid and offer prices on them), Brokers (these are agents who acts on behalf of the clients), and reporting dealers (the criteria the market makers need to meet are registered with the reporting dealers and they make the market with a number of security).

THE NEW YORK STOCK EXCHANGE (NYSE)

This is the largest securities market place in the world. In 2007 it merged with European stock market Euronext to form NYSE Euronext. NYSE has a total of US $ 10.1 trillion market capitalisation as of 2008. Member firms (individuals or company that owns a seat on the trading floor) are the only one given authorisation to buy and sell securities on the floor. Each stock listed on the floor is apportioned to a specialist (who is responsible for maintaining market fairness, competitiveness and efficiency), a broker that trades stocks at a specified location called Trading Post. Buyers and sellers represented by the brokers meet openly to find the best price for the security. Also, people that gather around the specialist post are the trading crowd. Specialists’ acts as agents, catalysts, auctioneers, stabilise prices and provide capital.