The Basel Committee, formed under the aegis of the Bank of International Settlements (BIS), had, in 1988, suggested a requirement of 8 per cent capital for the total risk-weighted assets of a bank. Unlike Safe Bank, Risky Bank had been disbursing loans without keeping adequate capital. Safe Bank was prudent and always kept a reasonably high equity capital to ensure that the bank never ran the risk of bankruptcy. Fifteen years ago, German bank, Herstatt, became insolvent and the repercussions of its failure were felt beyond Germany, as it was an internationally active bank. In the Far East, Japanese banks were issuing loans at a very low rate of interest. They managed to do so because of their low cost of capital (due to high leverage and low equity capital). This prompted the G-10 countries, a group of mostly European countries, to formulate regulation. As a result, the Basel Committee was formed and was entrusted with the Herculean task of making the banking industry more stable.
Risky Bank’s Story
Risky Bank, as its name suggests, had an appetite for higher risks because it wanted higher returns. The board of Safe Bank was, on the other hand, conservative and invested in relatively safe projects. The returns of Safe Bank were also lower than that of Risky Bank. Both banks were sticklers of rule but Risky Bank was in deep waters as it needed to raise more equity to fulfill the capital requirements for its risky loan portfolio, as warranted by the Basel Committee. The management directed its effort towards reducing the asset base to decrease the equity capital. An ingenious idea soon found support among the board.
It was decided to float a new legal entity to which the assets were to be transferred. The legal entity could sell its new found set of assets and pass on the proceeds of the sale to the bank. Investors would be buying the assets from the new legal entity and the bank was to bear a certain amount of risk if the assets in the entity’s kitty went bad. Otherwise, the investors would have to bear the losses for the assets that went bad. This arrangement suited Risky Bank as it could wash its hands of its bad assets and, at the same time, reduce its capital requirement. A young intern working on the project found the new arrangement to be quite similar to a new tool of finance – securitization.
Securitization
Technically, securitization is defined as a transaction involving one or more underlying credit exposures from which stratified positions or tranches are created that reflect different degrees of credit risk. It may take the form of a security or of an unfunded credit derivative. The payments to investors depend upon the performance of specified underlying credit exposure(s), as opposed to being derived from an obligation of the entity originating those exposures. Credit exposures may include loans, commitments and receivables.
Securitization can be seen as the art of turning un-tradable, illiquid assets into various sects of securities, which can then be sold to different investors who have a different appetite for risk. The different types of securities with different inherent risks are known as the tranches. Suppose a bank has assets of receivables, which will be realized over a period of five years, and the bank feels that it can put the money to better use at the moment, it can securitize the loan and sell the receivables in the market to various customers.
A securitization involves the transfer of assets and other credit exposures from the ‘originator’ through pooling and re-packaging by a special purpose vehicle (SPV) into securities that can be sold to investors. It involves legally isolating the underlying exposures from the originating bank or through sub-participation. This kind of securitization, where the actually assets are transferred from the originator’s balance-sheet, came to be know as ‘true sale’ or ‘traditional securitization’. At the end of the tenure of the securitization, the residual assets are passed on to the investors. If the asset quality deteriorates then the investors have to bear the loss. The investors receive variable coupon payments depending upon the risk they decide to bear. The investors who are ready to take the first loss get the maximum spread. The originator, in this fashion, has passed on the risk associated with the assets to the investor.
Securitization – Impact on Banks
In securitization, Risky Bank saw the answer to its problem of increased regulatory capital. Securitization was an off-balance sheet activity and hence invited no capital charge. Risky Bank started securitizing its loans. By doing this, it was able to raise money from the markets and was able to reduce the size of its balance sheet. Safe Bank was also not averse to securitization, as securitization gave it the opportunity to raise money at low cost, and also decrease capital requirement to some extent. But, unlike Risky Bank which securitized risky assets, Safe Bank decided to securitize only high quality loans. Safe Bank gained less than Risky Bank in terms of the reduction of regulatory capital, as the amounts securitized were lower.
Securitization came in many forms and almost all banks started using it to reduce their capital requirements. There were various ways in which securitization was conducted:
- Project finance transactions – Method of funding in which the lender looks primarily at the revenues generated by a single project, both as the source of repayment and as security for the loan.
- Object finance transactions – Method of funding the acquisition of physical assets (e.g. ships, aircraft, satellites, railcars and fleets) where repayment is dependent on the cash flows generated by the specific assets which have been pledged to the lender.
- Commodities finance transactions – Structured short-term lending to finance reserves, inventories, or receivables of exchange-traded commodities, where the loan will be repaid from the proceeds of the sale of the commodity and the borrower has no independent capacity to repay the loan.
- Income-producing real estate transactions – Method of providing funding to real estate where the prospects for repayment and recovery on the loan depend primarily on the cash flows generated by the asset.
- High-volatility commercial real estate transactions – Financing of commercial real estate that exhibits higher loss rate volatility compared to other types of specialized lending.
A traditional securitization deal takes a long time to complete because of the complexity and various legal aspects. To reduce the time and complexity of traditional securitization a new type of securitization evolved called synthetic securitizations. Thesewere transactions that involved the transfer of credit risk through the use of funded (e.g. credit-linked notes) or unfunded (e.g. credit default swaps) credit derivatives or guaranties that serve to hedge the credit risk to which the originator is exposed.
Risky Bank also graduated from traditional securitization to synthetic securitization. It entered into so many complex credit derivative arrangements that even Risky Bank could not understand most of the transactions. The good part was that the capital requirement kept decreasing. Safe Bank didn’t understand the complex transactions and didn’t trade in credit risk; but it started losing the edge in earning fast money.
Basel I
Risky Bank and other banks were playing a dangerous game, which could result in deep crisis for the whole banking industry. Although the Basel Committee was able to capitalize the banks substantially it was not happy with these developments. The aim of the Basel Committee was to ensure that the regulatory capital of a bank was aligned with the real risk borne by the banks. There was no problem if there was a ‘true sale’ of assets in securitization but in reality the banks were bearing the risk of the assets even after securitization. The banks supported the underlying assets by providing support to the investors. The banks did not want to lose their reputation and hence were not transferring the real risk to the investors.
Risky Bank was in need of more money to meet the regulatory requirement, due to the increase in its portfolio of loans. A majority of the loans that Risky Bank had securitized comprised of real asset loans. The real estate market entered into a recession and the underlying loans that Risky Bank had securitized started defaulting. Risky Bank realized that if its securitization and credit derivative arrangements failed, it would lose face in the market and would not be able to raise money. It replenished the non-performing assets in the securitization SPV with performing assets, thus taking the hit. The complex credit swaps that it had entered into also resulted in huge losses for Risky Bank. The high leverage of the bank magnified its losses in this period of recession. All banks that were highly leveraged were running into trouble.
The crisis became so deep that it threatened a loss of confidence in the whole banking industry. The regulator had to step in and bail out Risky Bank. Risky Bank was taken over by Safe Bank and the top management of Risky Bank was replaced. The regulator came to realize that it was high time that regulations were formed to prevent the occurrence of such events. Thus, a new treatment for securitization in Basel II was envisaged where the regulatory capital would be better aligned to the underlying risk. Read ‘Basel II: ‘A Cul-de-sac for Securitization?’ next week on gtnews to find out more about how the latest banking regulations are going to ensure that this situation does not recur.