In the modern banking system, securitization has gained a significant place and become vital for banking. Global economies have considered securitization a critical factor that helps increase lending as an economic benefit to banking and economy. Asset backed securitization involves a pool where different types of loans are put together to make a tradable securities to be sold to range of investors. Over the period, role of banks as an intermediary for lending and borrowing has changed significantly. Banks are now focusing largely towards securitization as it helps to turn liquid loans into tradable securities in the market. Securitization on one hand reduces off loading of credit exposure by selling securities to outside investors whereas on the other hand new funds are raised to be used for further lending (Altunbas et al, 2014). However, overdependence on securitization over traditional funding for short term funding market might be deadly that can further lead to issues of liquidity, risk, profitability and financial stability can be seriously hampered. Northern Rock was one of the banks which nearly collapsed due to overdependence on securitization and short term funds as a means of funding its banking operations.
This study is aimed to critically examine the impact of securitization and banks’ dependence on short-term wholesale funding markets on liquidity, profitability, risk and risk management of individual banks and wider consequences on the financial stability of the global banking system.Royal Bank of Scotland has been considered as a case bank for this study to investigate the impact of overdependence on securitization on liquidity, risk and financial stability of the global banking.
2. UK Banking System
A dramatic change in the UK banking system easily witnessed where its size has grown up excessively over the past 40 years. Considering the past trend and growth in UK economy, banking system is further expected to grow in the similar pace. Total assets of UK banking have reached to 450% of nominal GDP in 2013 from a level of 100% in 1975.UK banking system is considered very large as compared to many of the major economies (Bush et al, 2014). Globalization and growing international commerce have changed the banking where on one hand foreign banks are placed significant with large share in the UK banking and on the other hand domestic UK banks are playing vital role expanding its operations in the global market. Such scenario makes UK banking system much bigger than any other economy.
Figure 1: Percent of GDP of UK Banking
Source: Bank of England Quarterly Bulletin, 2014-Q4
There are different factors or reasons behind efficient and large UK banking system. Wider financial system, people and firms being located in clusters, highly efficient workforce and technology, comparative advantages and most importantly implicit support by the government through subsidies have been backbone of the UK banking system making it too big to fail (Bush et al, 2014). From the society perspective, there is oversupply of banking services. However, there are few assumptions that there exists a material risk in present size of the UK banking system that can be fatal to economic stability. On this ground, it has been suggested widely to reduce the size. Recent financial downturn in 2007-08 has severely hit UK economic and banking system considered as the deepest since Great Depression.
3. Understanding Securitization
Among recent developments in the global financial and banking sector, securitization has been considered one of the most prominent developments (ECB, 2011). Securitizationcan be understood as a complex financial process that generates revenue by pooling assets and process the pool in the market to produce a new flow of cash in such a way that principal and interest on new range of securities can be repay (Bertay et al, 2015). Different financial assets like auto loans, asset backed mortgages, corporate loans etc are put together in a pool to be traded in the form of securities in the global financial market under securitization. Economic value generated from such securities is used to make payments further. Buyers for such tradable securities include investors, banks, insurance companies, hedge funds or other funds. Economic benefits of such securities to buyers are in the form of regular payments through interest and principal made by the borrower.
Banks depend on securitization with an intended goal to segregate the loans or other assets that is used to make payments on the assets backed securities (Bertay et al, 2015). Such dependency on securitization ensures that ABS payments are originated exclusively from the trading results of marketable securities made by pooling different loans rather depending of the performance of the originator bank that holds the loans individually. Securitizationis fundamentally similar and common in most of the countries with different legal and regulatory structures (Altunbas et al, 2014).
Figure 2: Basic Securitization Structure
In central bank’s perspective, securitizationhas wider role in providing both monetary and financial stability in the global financial market. Bank’s dependency on high quality assets backed securities can be considered for synthesizing transmission of monetary policy where lending channels of the banks may seem to be prejudiced (Watson, 2006). Securitization allows banks to increase lending without committing too much capital. Bank’s overdependence on securitization can be seen as it opens up accessibility for borrowers who are not able to take loans easily from the market like SMEs.
Though bank’s have considered securitization as vital for lending and long term benefits, today securitizationhas been suffering from stigma with adverse impacts on investors, regulators, policy makers and standard-setters (Michalak&Udhe, 2013). Before the financial crisis of 2008, incentives were misaligned that lead to adverse results of securitization post crisis in the UK banking sector. in the global financial market, analysts have pointed that securitization has huge potential to damage financial stability of any economy if banks continuously show their overdependence over to traditional banking processes of lending.
Figure 3: UK Bank Securitization between 2000-2010
From the figure above, it can be seen that banks have shown tremendous dependency on securitization during 2002-08 as a source to increase lending through pool of asset backed securities (Cerrato, et al 2013). Total value of securitization from a level of less than 10,000 million pound has reached to over 200,000 million pound in 2008. This dramatic increase in the size of securitization was the result of bank’s increasing trend of pooling different assets and converting them into tradable securities. However, financial crisis of 2008 have largely affected UK banking system that faced a downturn in economic stability. Such overdependence of bank’s on securitization was considered as the main catalyst causing to huge adverse impacts on UK financial condition from the crisis.
4. Impact of Overdependence on Securitization and Whole Sale Funding
Global capital markets have been integrated increasingly by the global banks. This can be visible in increasing shift towards secured lending transactions, rising securitization and widening collateral securities to cover complex products along with the levels of market liquidity (Praet& Herzberg, 2008). Strong and deeper symbiosis between capital markets and banks has led significantly to make efficient savings allocation through the financial system. In addition, it has supported to minimize the fundamental liquidity risk that can be seen from transmission of liquid savings into illiquid long term ABS. Banking liquidity is very crucial for securitization that represents bank’s inability to meet outstanding liabilities at a reasonable cost. In today’s global financial market, international banks are standing together to tighten policies and rules for on securitization so that capital could be tied up and credit issues can be starved from the economy.
4.1. Impact 0n Liquidity
RBS funding is considered “average” with adequate liquidity to meet out sudden obligations. Post financial crisis of 2008, RBS has made significant efforts in minimizing its dependence on securitization and short term wholesale funding to strengthen liquid position of the bank. Considering adverse impact of securitization during crisis, RBS has restructured its plans for funding and made changes in liquidity objectives. For the year 2014-2015, requirement for term funding has been put relatively modest (RBS Report, 2014).
RBS is known as the major deposit-taking bank worldwide where deposits are considered the keystone of its funding position. As of March 31, 2014, customer deposits at RBS were recorded £401 billion with loan-to-deposit ratio standing out at 98%. It was significantly lower as compared to the ratio of 151% in 2008. Securitization led to face the severe economic challenges for UK during 2008 crisis. Primary wholesale funding for RBS include debt securities, interbank deposits, repos, subordinated liabilitiesand trading liabilities that were valued at 573 billion at year-end 2009 (RBS Report, 2014). From the figure 3 above, it can be seen that UK banking system has witnessed excessive growth in securitization during 2003-2008 with highest in size in 2008. Securitization at RBS was also at highest level at the end 2009 however lending issues have forced RBS to reduce the size of wholesale funding through securitization that reached to £270.7 billion by Dec 2013. Securitization has adversely affected the position of balance sheet. According to Standard & Poor’s analysis, stable wholesale funding ratio in the end 2013 was 109.2% which indicates that assets and liabilities are matching appropriately.
Assessing impact of securitization on liquidity is very challenging due to interdependence of banks for lending and borrowing (Praet& Herzberg, 2008). Liquidity at RBS improved significantly over the years. Liquid assets for RBS consist of unencumbered cash, government bonds, central bank deposits, and supranational bonds. Total value of liquid assets was valued at £247 billion at end 2013 that represents 1.5 time higher short term wholesale funding. As an impact of securitization, short term wholesale funding, declines as compared to the year 2012 with liquid assets valued at £299 billion (RBS Report, 2014).
4.2. Impact on Profitability
One of the major impacts of securitization on global banks was the sub-prime mortgage crisis that caused to financial crisis of 2008. Economic situation of UK banking industry had negative impacts of subprime loan crisis that resulted in non recovery of loans given to borrowers. RBS was also not untouched with this crisis caused by overdependence on securitization. RBS has been operating internationally and risk of subprime mortgage and sovereign debt was higher that made the bank to book a loss of £24bn loss for 2008. This huge loss has shaken the financial industry in the UK as well as global financial market. Consequently, RBS stock prices fell to 10p. As mentioned above, UK economy is largely backed up by government funds and grants, UK government had to play major role in saving banks liquidity caused by securitization.
Post crisis of 2008 due to interdependence of banks on securitization, RBS decided to made strategic changes to recover from the financial loss and become profitable again in long term. Securitization impacts led by subprime issues on profitability were severe for RBS as the bank had reported an average loss of £2bn for three consecutive years 2009-2011 (Annual Report 2011). Bank’s possibilities to return to profitability were not easy due to slower economic recovery in the UK and other global market that have largely depended on lending of securitized assets. Post financial crisis, regulators have made very strict changes in policies and regulations for asset backed securities trading through banks in open market.
Commonly liquidity and funding difficulties arise when there is uncertain exposure to the weakening mortgage based securities market (Wagner, 2007). In addition, commitments to issue line of credits to buyers of such securities create challenges for funding and liquidity. Vehicles for securitization such as conduits and SIVs were involved in lending to long term loans or mortgages. For this purpose, short term debt instruments were issued like asset backed commercial paper. This process of securitization has severely created liquidity problems in the short term period. Along with the liquidities drying up, banks were not in a position to finance off-balance-sheet vehicles holding assets back that was to be securitized.
4.3. Risk Management Approach
In order to encounter liquidity risk and challenges due to securitization and wholesale funding, RBS has made several attempts to rebuilt financial flexibility (Annual Report, 2011). For identification and disposing of certain non-core assets, RBS initiated a program in Feb 2009under its risk management strategy. As a result, a non-core asset that was valued at £258bn in 2008 was declined to £93bn in 2011. This attempt led to reduce the risk for the bank and size of balance sheet. Overdependence on securitization has caused to higher liquidity risk from non-core assets.
Short term whole sale funding has allowed banks with surplus liquidity to lend other banks having liquidity deficits. This approach was used by the bank to strengthen long term funding to assets or loans. However, it has inherent challenge that can cause to borrower bank in case of any adverse economic situation arise or negative news comes into the market about lender. In this case, financiers withdraw the loan putting borrower bank with inefficient liquidity.
Strategic plans structure at RBS is aimed to reduce such risk exposure so that impact on balance sheet becomes free from volatility. In order to do so, RBS risk management team seeks to reduce the use of short term wholesale funding and trading of securitized assets and enhance focusing on deposits to finance lending. In 2008 when the bank was depended on securitization and excessive whole sale funding, it has to suffer from financial instability causing from financial crisis. RBS made the acquisition of ABN AMRO a wholesale bank to foster the funding but later it resulted in loss reported by the end 2008. Consequently, short-term whole sale funding was reduced by RBS by 52.6% for a period of 2009 to 2011. In this regard, RBS is further aiming to achieve loan to deposit ratio at 1:1 (Annual Report, 2011).
Figure 5: Loan TO Deposit Ratio of RBS
5. Consequences on the financial stability of the global banking system
Financial crisis in 2008-09 have brought the relations between bank’s ability and competition again to the fore. Historically, it was not the case as during 5 decades after Great Depression, there was tight regulation in the banking industry where competition was majorly limited to developed countries. However, financial system today has become global and transformed heavily by financial innovation exhibiting its strong relation to real economy and growth. According to Rajan (2006) it is not clear whether such transformation is putting benefits to financial system or not. Securitization is considered one of the most prominent financial innovations that have dramatically influenced functions of global banking and financial system. Consequences of securitization made banks which used to be holder or creator of illiquid loans to turn up as a creator and distributorof these loans. Loutskina and Strahan (2009) have stated that dependence of loan supply on existing financial situation of the lenders is largely influenced by securitization. In addition, Keys et al. (2010) have demonstratednegative consequences of securitization on screening lender’s incentives in their subprime loans. Through securitization, banks attempt to originate securities that lead to create high fixed cost of asset securitized. This can be considering as the major drawback for banks or financial institutions looking entering into the securitization market (Panetta and Pozzolo, 2010).
Positive impact can be seen as no effective barriers that restrict buying such high cost and sophisticated securities and become a buyer in the market instead of originator. Structure of the global securitization market in banking sector is almost similar but very complex that makes it difficult for analysts and policy makers to assess risk accurately. In addition, credit rating agencies finds it tough to rate an asset in proper way that can cause to global misallocation of funds (Levine, 2010). In the UK and US, several banks have wrongly assessed the positive consequences of securitization and real relation with the economic stability. Consequently, overdependence on securitization and short term whole sale funding as financial innovations have adversely contributed to the recent downturn of global financial system (Caprio et al, 2010).
In order to understand the wider consequences of securitization on global financial system various research have been made that derived possible impacts on bank incentives, bank’s liquidity and what are the alternatives to securitized assets that may generate positive financial results for banks as well as economy. Nadauld and Weisbach (2012) have found that collateral based loans or securitization is more beneficial as price and cost of capital gets lower of corporate debt. Securitization of corporate loans is seen as an alternative to securitization of asset backed loans as it has less severe problems (Benmelech et al. (2012).
Loutskina and Strahan (2009) have found that securitization on one hand helps in relaxing the constraint of loan supply to strengthen bank’s financial stability however on the other hand there are much complexities in processing allocation of loans from securitization.
In the global banking and financial sector, securitizationplay vital role in facilitating greater credit supply for borrowers and create opportunities to receive funding for small investors such as SMEs. But, it completely depends on procedure of banking system to accept such supply of credit as a whole. From the discussion made above in the study, it can be understood that overdependence on securitization has led to financial crisis in 2008 for global banking and financial market. Focusing heavily on securitization rather than traditional lending from customer deposits have resulted in loss for many investment banks. Royal Bank of Scotland had to suffer a loss due to overdependence on securitization in 2008 that ultimately changed the management focus toward traditional lending system using customer deposits. Bank’s liquidity and profitability have adversely affected being focused on securitization of ABS. at the time of downturn or economic instability, bad loans or risk of illiquid assets arises that affect the balance sheet position. Therefore, smoother and soft lending standard for both asset mortgage and loans of consumer deposits should be used by securitization in the UK banking system to strengthen financial stability of the institutions and economy.
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