The Role of Securitization in Bank Liquidity and Financial Stability

What is Securitization?

Securitization – the pooling and repackaging of loans into securities that are then sold to investors – provides an additional funding source and potentially eliminates assets from a loan originator's balance sheet. Financial asset securitization involves the packaging of certain kinds of financial assets and the subsequent distribution of securities to finance these assets.

A basic form of securitization involves a two-step process. Firstly, the originator true sells its assets portfolio to an issuer, typically a special purpose vehicle (SPV) established to achieve credit risk isolation and bankruptcy remoteness purposes between the assets portfolio and the originator. Secondly, the issuer issues interest-bearing securities to investors in capital markets. The investors receive regular payments from a trustee account, which is funded by the cash flows generated by the reference portfolio.

Figure 1: How Securitization Works

Incentives for Banks to Securitize Assets

Banks may be incentivized to securitize assets based on the following motives:

Obtaining a Lower Cost of Funds. Securitization allows banks to transfer the credit risk associated with a pool of assets to a broader group of investors. This reduces the risk and cost of holding the assets on the banks' balance sheet, transforms illiquid assets into transferrable securities, reduces reliance on customer deposits, and frees up capital for new lending. This can lead to the cost of gaining liquidity in securitization being lower than that of traditional lending.

Matching Assets and Liabilities. Securitization provides a more efficient mechanism for matching the duration of assets and liabilities. In traditional lending, a bank may issue a loan with a fixed maturity but then have to hold that loan on its balance sheet until maturity, which can create an asset-liability mismatch. With securitization, the pool of assets is transferred to an SPV, which issues asset-backed securities with different maturities. This allows investors with different investment horizons to invest in the securities that best match their needs.

Removing Assets and Associated Financing From an Originator's Balance Sheet. Securitization can provide greater flexibility for lenders in terms of managing their balance sheets. Unlike traditional lending, where banks may have to hold a certain amount of capital against loans on their balance sheets, securitization allows lenders to reduce their regulatory capital requirements by transferring the assets to an SPV.

Agency Problems

The complicated securitization process involves many principal-agent relationships, which provide opportunities for agency costs to arise. Some examples of agency problems in securitization transactions include:

1. Information Asymmetry: Originators may have access to information about the underlying assets that is not available to investors, giving them an unfair advantage in pricing and structuring the securitization.

2. Adverse Selection: Banks may have reduced incentives to screen borrowers since they are partially separated from the consequences of the borrower’s default.

3. Moral Hazard: Originators may engage in risky lending practices, knowing that they can offload the risk to investors through securitization.

4. Credit Rating Failure: Due to a lack of transparency and availability of loan-level information, investors rely heavily on rating agencies to conduct risk assessments of securitization pools.

Securitization Regulatory Framework

To avoid increased financial fragility, regulatory authorities rely on policies that implement loan-level reporting initiatives and incentives aligning mechanisms such as risk retention requirements and credit ratings reform.

Loan-Level Reporting Initiative. The European Central Bank (“ECB”) introduced the loan-level reporting initiative, obliging originators to disclose quarterly loan-by-loan information for ABS to be accepted as collateral in Eurosystem credit operations. Since 2013, banks that use their ABS for repo borrowing are required to report quarterly loan-level data on the structure and performance of their securitized loan portfolios in a detailed and standardized format set by the ECB.

Investors indeed benefit from the implementation of a transparency regime: increased transparency can alleviate agency costs inherent in securitization. Loans that originate under transparency regimes are of better quality in terms of their default probability, loss given default, delinquencies, and number of days in delinquency. Further, data from European DataWarehouse (the first and only central repository of all loan-level information under the ECB’s loan-level reporting initiative), indicates that pools affected by the transparency regime are more diversified than others with respect to single-name concentration, business types, and industries.

Risk Retention Requirements. In 2014, pursuant to the requirements of the Dodd-Frank Act, the SEC and various federal banking and housing agencies adopted credit risk retention rules for securitizations.

Section 15G generally requires the applicable agencies to jointly prescribe regulations to (i) require a securitizer to retain at least five percent of the credit risk of any asset it transfers, sells, or conveys to a third-party through the issuance of ABS, and (ii) prohibit a securitizer from directly or indirectly hedging or otherwise transferring the credit risk that the securitizer is required to retain under Section 15G and the rules implemented thereunder.

Credit Ratings Reform. In order to improve the transparency of the ratings process and realign the incentives of credit rating organizations, issuers, regulators, and investors, the SEC requires NRSROs to make public disclosures about the methods used in rating structured finance instruments, to publish histories of their ratings, and to maintain internal records to help strengthen examinations by the SEC. The European Union requests credit rating agencies whose headquarters are located outside the Community to set up a subsidiary in the Community to allow for the efficient supervision of their activities and the effective use of the endorsement regime.

Criticisms and Possible Solutions

As for the question of whether these reforms are enough to address the agency problems inherent in securitization, we can look at the banks that were originating and securitizing poorly underwritten sub-prime and Alt-A loans prior to the 2008 financial crisis. These banks were not merely transferring these risky assets to other parties, but were also retaining considerable exposure themselves. In the run-up to the credit crisis, certain major securitizers in the RMBS market retained hundreds of billions of dollars of risky RMBS assets and suffered massive losses. Therefore, to the extent that a bubble economy is based on unrealistically optimistic expectations pervading the market, regulation seeking to mediate alignment of incentives and “fairness” between the parties to a deal is largely ineffective.

Imposing bright-line limits on mortgage debt-to-equity ratios and on the debt-to-income ratios of mortgagors could be an alternative. Such limits would reduce the amount of leverage available to the mortgage market and would therefore slow down and foreshorten the expansion of bubbles. During a bubble, the growth in prices generally outpaces the ability of borrowers to make down payments on loans, and, hence, a sustained boom market generally relies on easy credit. Applying a mandatory limit on debt-to-equity ratios would be a relatively straightforward and effective way to dampen the bubble effect and, accordingly, the tail risk of a panic run and hard landing resulting from a bursting bubble.

In conclusion, securitization is a complex financial technique that has nuanced advantages and disadvantages. While it can effectively provide liquidity to the market and reduce risk for originating institutions, it can also lead to the creation of complex financial instruments that contribute to systemic risk and financial instability. As such, it is worthwhile for regulators to carefully monitor the securitization market and ensure that appropriate safeguards are in place to protect investors and prevent excessive risk-taking.

Zixuan Luo is an LL.M. candidate at NYU and serves as a Graduate Editor of the NYU Journal of Law & Business. Zixuan is licensed to practice law in China and, prior to attending NYU, she practiced for almost four years at two prestigious financial institutions in Hong Kong. Her practice is focused on Banking & Finance, OTC Derivatives and Structured Products.