Question

It is suggested that the initial exclusion of market risk from capital requirements and high regulatory costs in the Basel I Accord, encouraged banks to shift their risk exposure (via securitisation) from priced credit risk to unpriced market risk.

(a). Do you agree? Discuss with examples.

(b). Explain the securitisation process.

Answer 1

It is suggested that the initial exclusion of market risk from capital requirements and high regulatory costs in the Basel I Accord, encouraged banks to shift their risk exposure (via securitisation) from priced credit risk to unpriced market risk by Moosa in his book 'International Finance'.

The global financial crisis has reinforced the pre-existing belief in the weaknesses of the Basel II Accord. It is argued that capital-based regulation and the Basel-style capital regulation cannot deal with financial crises and that attention should be paid to liquidity and leverage. The Accord is criticised, in view of what happened during the crisis, for allowing the use of bank internal models to determine capital charges, for boosting procyclicality of the banking industry, for reliance on rating agencies and for being an exclusionary, discriminatory and a one-size-fits-all approach. It may not be possible to salvage Basel II, and the way forward is perhaps to abandon the idea of unified international financial regulation.

Minimum capital requirements for market risk A.

The boundary between the trading book and banking book and the scope of application of the minimum capital requirements for market risk

1. Scope of application and methods of measuring market risk 1. Market risk is defined as the risk of losses arising from movements in market prices. The risks subject to market risk capital charges include but are not limited to:

(a) Default risk, interest rate risk, credit spread risk, equity risk, foreign exchange risk and commodities risk for trading book instruments; and

(b) Foreign exchange risk and commodities risk for banking book instruments.

2. In determining its market risk for regulatory capital requirements, a bank may choose between two broad methodologies: the standardised approach and internal models approach for market risk, described in paragraphs 45 to 175 and 176 to 203, respectively, subject to the approval of the national authorities.

3. All transactions, including forward sales and purchases, shall be included in the calculation of capital requirements as of the date on which they were entered into. Although regular reporting will in principle take place only at intervals (quarterly in most countries), banks are expected to manage their market risk in such a way that the capital requirements are being met on a continuous basis, including at the close of each business day. Supervisory authorities have at their disposal a number of effective measures to ensure that banks do not “window-dress” by showing significantly lower market risk positions on reporting dates. Banks will also be expected to maintain strict risk management systems to ensure that intraday exposures are not excessive. If a bank fails to meet the capital requirements at any time, the national authority shall ensure that the bank takes immediate measures to rectify the situation.

4. A matched currency risk position will protect a bank against loss from movements in exchange rates, but will not necessarily protect its capital adequacy ratio. If a bank has its capital denominated in its domestic currency and has a portfolio of foreign currency assets and liabilities that is completely matched, its capital/asset ratio will fall if the domestic currency depreciates. By running a short risk position in the domestic currency the bank can protect its capital adequacy ratio, although the risk position would lead to a loss if the domestic currency were to appreciate. Supervisory authorities are free to allow banks to protect their capital adequacy ratio in this way and exclude certain currency risk positions from the calculation of net open currency risk positions, subject to meeting each of the following conditions:

(a) The risk position is taken for the purpose of hedging partially or totally against the potential that changes in exchange rates could have an adverse effect on its capital ratio;

(b) The exclusion is limited to the maximum of: • the amount of investments in affiliated but not consolidated entities denominated in foreign currencies; and/or • the amount of investments in consolidated subsidiaries denominated in foreign currencies.

(c) The exclusion from the calculation is made for at least six months;

(d) Any changes in the amount are pre-approved by the national supervisor;

(e) Any exclusion of the risk position needs to be applied consistently, with the exclusionary treatment of the hedge remaining in place for the life of the assets or other items; and

(f) The bank is subject to a requirement by the national supervisor to document and have available for supervisory review the positions and amounts to be excluded from market risk capital requirements.

5. Holdings of the bank’s own eligible regulatory capital instruments are deducted from capital. Holdings of other banks’, securities firms’, and other financial entities’ eligible regulatory capital instruments, as well as intangible assets, will receive the same treatment as that set down by the national supervisor for such assets held in the banking book, which in many cases is deduction from capital. Where a bank demonstrates that it is an active market-maker, then a national supervisor may establish a dealer exception for holdings of other banks’, securities firms’, and other financial entities’ capital instruments in the trading book. In order to qualify for the dealer exception, the bank must have adequate systems and controls surrounding the trading of financial institutions’ eligible regulatory capital instruments. Holdings of capital instruments that are deducted or risk-weighted at 1250% are not allowed to be included in the market risk framework. The market-maker/dealer exemption set out in this paragraph is subject to change by the Basel Committee. The Basel III definition of capital requires banks to deduct their holdings of regulatory capital, subject to a threshold, but does not include an exemption for market-makers. The Basel Committee will determine, as part of a broader review, whether any adjustments or exemptions to the existing threshold requirement are warranted for certain bank activities or instruments (eg TLAC holdings).

6. In the same way as for credit risk and operational risk, the capital requirements for market risk apply on a worldwide consolidated basis. Supervisory authorities may permit banking and financial entities in a group which is running a global consolidated trading book and whose capital is being assessed on a global basis to include just the net short and net long risk positions no matter where they are booked.2 Supervisory authorities may grant this treatment only when the revised standardised approach permits a full offset of the risk position (ie risk positions of opposite sign do not attract a capital charge). Nonetheless, there will be circumstances in which supervisory authorities demand that the individual risk positions be taken into the measurement system without any offsetting or netting against risk positions in the remainder of the group. This may be needed, for example, where there are obstacles to the quick repatriation of profits from a foreign subsidiary or where there are legal and procedural difficulties in carrying out the timely management of risks on a consolidated basis. Moreover, all supervisory authorities will retain the right to continue to monitor the market risks of individual entities on a non-consolidated basis to ensure that significant imbalances within a group do not escape supervision. Supervisory authorities will be especially vigilant in ensuring that banks do not conceal risk positions on reporting dates in such a way as to escape measurement.

7. The Committee does not believe that it is necessary to allow any de minimis exemptions from the capital requirements for market risk, because the Basel Framework applies only to internationally active banks, and then essentially on a consolidated basis; all of these banks are likely to be involved in trading to some extent.

(b)Explain the securitisation process

Definition: Securitization is a process by which a company clubs its different financial assets/debts to form a consolidated financial instrument which is issued to investors. In return, the investors in such securities get interest.

Description: This process enhances liquidity in the market. This serves as a useful tool, especially for financial companies, as its helps them raise funds. If such a company has already issued a large number of loans to its customers and wants to further add to the number, then the practice of securitization can come to its rescue.

In such a case, the company can club its assets/debts, form financial instruments and then issue them to investors. This enables the firm to raise capital and provide more loans to its customers. On the other hand, investors are able to diversify their portfolios and earn quality returns.

Securitization is the method of converting the receivables of the financial institutions, i.e., loans and advances, into bonds which are then sold to the investors. In simple terms, it is the means of turning the illiquid assets into liquid assets to free up the blocked capital.

The receivables on debts against collateral assets like property, land, building and other real estate, become exchangeable financial instruments in this process of securitization.

Securitization Process

Securitization is a complex and lengthy process since it is the conversion of the receivables into bonds; it involves multiple parties.

The steps involved in the process of securitization are as follows:

Origination Function: The borrower approaches a bank or other financial institution (originator) for a loan. The respective financial institution allows a certain sum as debts in exchange for any collateral.

Pooling Function: The originator then sells off its receivables through pledge receipts to the special purpose vehicle.

Securitization: The SPV transforms these receivables into marketable securities, i.e., either Pay Through Certificate or PTC (Pass-Through Certificate). These instruments are then forwarded to the merchant banks for selling it to the investors. The investors buy these instruments to benefit in the long run.

Securitization

November 25, 2019 By Prachi M Leave a Comment

Definition: Securitization is the method of converting the receivables of the financial institutions, i.e., loans and advances, into bonds which are then sold to the investors. In simple terms, it is the means of turning the illiquid assets into liquid assets to free up the blocked capital.

The receivables on debts against collateral assets like property, land, building and other real estate, become exchangeable financial instruments in this process of securitization.

Content: Securitization

1. Process
2. Types
3. Advantages
4. Disadvantages
5. Conclusion

Securitization Process

Securitization is a complex and lengthy process since it is the conversion of the receivables into bonds; it involves multiple parties.

The steps involved in the process of securitization are as follows:

Origination Function: The borrower approaches a bank or other financial institution (originator) for a loan. The respective financial institution allows a certain sum as debts in exchange for any collateral.

Pooling Function: The originator then sells off its receivables through pledge receipts to the special purpose vehicle.

Securitization: The SPV transforms these receivables into marketable securities, i.e., either Pay Through Certificate or PTC (Pass-Through Certificate). These instruments are then forwarded to the merchant banks for selling it to the investors. The investors buy these instruments to benefit in the long run.

Since the investors extend the loan, they are liable to receive a return on investment. The borrowers are unaware of this securitization and pay timely instalments.

The originator receives a lump sum amount, though at a discounted value from the SPV. The merchant bank charges fees for its services.

Types of Securitization

The different kinds of receivables determine the type of securitization it requires. Given below are some of the most common types of securitization:

Asset-Backed Securities (ABS)

The bonds which are supported by underlying financial assets. The receivables which are converted into ABS include credit card debts, student loans, home-equity loans, auto loans, etc.

Residential Mortgage-Backed Securities (MBS)

These bonds comprise of various mortgages like of property, land, house, jewellery and other valuables.

Commercial Mortgage-Backed Securities (CMBS)

The bonds that are formed by bundling different commercial assets mortgage such as office building, industrial land, plant, factory, etc.

Collateralized Debt Obligations (CDO)

The CDOs are the bonds designed by re-bundling the personal debts, to be marketed in the secondary market for prospective investors.

Future Flow Securitization

The company issues these instruments over its debts receivable in a future period. The company meets the principal and interest through its routine business operations, though such obligations are secured against its future receivables.

Advantages of Securitization

In the securitization process, the multiple parties involved are borrowers, originator, special purpose vehicle, merchant bank and investors.

Thus, each one these parties benefit from the process, where the originator and the investor have multiple advantages as discussed below:

To the Originator

The originator derives maximum benefit from securitization since the purpose is to get the blocked funds released to take up other alluring opportunities. Let us discuss each one of these:

Unblocks Capital: Through securitization, the originator can recover the amount lent, much earlier than the prescribed period.

Provides Liquidity: The illiquid assets, such as the receivables on loans sanctioned by the bank are converted into liquid assets.

Lowers Funding Cost: With the help of securitization, even the BB grade companies can benefit by availing AAA rates if it has an AAA-rated cash flow.

Risk Management: The financial institution lending the funds can transfer the risk of bad debts by securitizing its receivables.

Overcoming Profit Uncertainty: When the recovery of debts is uncertain, its profitability, in the long run, is equally doubtful. Thus, securitization of such obligations is a suitable option to avoid loss.

Reduces Need for Financial Leverage: Securitization releases the blocked capital to maintain liquidity; therefore, the originator need not seek to financial leverage in case of any immediate requirement.

To the Investor

The investor’s aim is to accelerate the return on investment. Following are the different ways in which securitization is worth investing:

Quality Investment: The purchase of MBS and ABS are considered to be a wise investment option due to their feasibility and reliability.

Less Credit Risk: The securitized assets have higher creditworthiness since these are treated separately from their parent entity.

Better Returns: Securitization is a means of making a superior return on their investment; however, it depends more on the investor’s risk-taking ability.

Diversified Portfolio: The investor can attain a well-diversified portfolio on including the securitized bonds; since these are very different from other instruments.

Benefit Small Investors: The investors having minimal capital for investment can also make a profit out of securitized bonds.

Disadvantages of Securitization

Securitization requires proper analysis and expertise; otherwise, it may prove to be quite unsound to the investors. Let us now discuss its various drawbacks:

• Lack of Transparency: The SPV may not disclose the complete information about the assets included in a securitized bond to the investors.
• Complex to Handle: The whole process of securitization is quite complicated involving multiple parties; also, the assets need to be blended wisely.
• Quite Expensive: When compared to share flotation, the cost of a securitized bond is usually high, including underwriting, legal, administration and rating charges.
• Investor Bears Risk: The non-repayment of debts by the borrower would ultimately end up as a loss to the investors. Therefore, the investor is the sole risk-bearer in the process.
• Inaccurate Risk Assessment: Sometimes, even the originator fails to identify the value of underlying assets or the associated credit risk.
• Loss from Prepayment: If the borrower pays off the sum earlier than the defined period, the investors will not make superior gains on their investment value.