Question

Securitization is claimed to be significantly associated with bank profitability. (i) Define securitization since it acts as an important tool to banks and financial markets. (ii) Identify the contribution of FOUR transmission channels impact on bank profitability.

Answer 1

SECURITIZATION

Securitization is a technique used by banks and financial institutions to lower their exposure to risk. It is a process by which the bank clubs its financial assets to form a consolidated financial instrument. This helps the banks to raise more capital and to provide more loans to its customers. Thus it improves the profitability of the banks.

Contribution of FOUR transmission channels on bank profitability

The Securitization activities tend to improve profitability. The impact of Securitization on profitability is transmitted through the following four channels.

1. Bank Risk Channel : Most important bank risk is the credit risk. It arises when there is default in the repayment of loan by the customer. This channel has negative effect on profitability. Higher credit risk increases the chance of loss for loans given by the banks. Thus it reduces profitability.
2. Cost of Funding Channel : Each sources of fund used banks has its own cost. The main source of fund the bank rely on is deposits collected fro the depositors. If the cost of fund is higher, the profitability will be lower.
3. Regulatory Capital Channel : This channel has a positive impact on profitability. Securitization is used to minimize capital requirements. Banks keep adequate level of capital to reduce the probability of risk of bankruptcy. But in some cases, the large capital requirement may reduce profitability.
4. Liquidity Channel : Securitization is used by the banks to liquidate the assets. Thus the bank reduces the liquidity risk. This will lead to profitability. Thus liquidity channel has positive relationship with bank's profitability.