What is Securitization?

“Securitization is a process by which financial institutions create additional

liquidity on the backing of their existing assets through the sale of financial
instruments”.

As business expands the need for various types for finance also increases.
Financial institutions throughout the world are raising their resources, in the
money market, capital market and debt instrument market. Governments are
raising their finances by issuing various types of instruments. Thus, Securitization
is a new concept by which financial institutions are able to acquire additional
resources by using their existing long-term assets.

Example: Housing loan, vehicle loan, etc.

When banks and financial institutions provide long-term loans, the interest
earned from them over a period. of time may decline due to the floating rate
of interest. By way of Hedge, i.e., an insurance against the risk of declining
interest rate, against these long-term assets, credit instruments are issued in the
market for a lesser rate of interest and additional funds are added. The funds
raised by the sale of the debt instruments such as CoD (Certificate of Deposits)
will be utilized for providing short-term or medium-term loans.

Stages involved in Securitization process:

 First stage in Securitization:

In the first stage, the financial institution or the banker, is called
the ORIGINATOR. The ORIGINATOR will pool his lending like mortgages, or
account receivables into a homogeneous type based on interest rate,
maturity period, etc. Thus, the first stage is called Identification process stage.

 Second stage in Securitization:

The originator will transfer all his assets to another institution which helps in the
process of securitization. The assets are converted into securities by SPECIAL
PURPOSE VEHICLE (S.P.V) or Trust. The Trustees may be retired high court judges
who may have knowledge of valuation of assets and finance. There are also
merchant bankers who act as SPV and as agents for issue. The reputation of
merchant bankers will help in the issue of debt instruments by which the debt
instruments will be oversubscribed.
 Issue stage in Securitization:
The SPV splits various assets into different types of securities according to their
maturity date and interest rate.

The SPV issues securities to investors which are as follows:

 Pass through certificates

 Pay through certificates
 Interest only certificates
 Principal only certificates

Pass through certificates:

In the case of Pass through certificates, payments are received from assets
such as housing loan from out of which payment for certificate of deposits are
met as and when they are due.

Pay Through certificates:

In this case, multiple maturity structure certificates depending upon maturing
pattern of various assets will be issued, so that as and when the assets mature
the respective certificates will be paid.

Interest only certificates:

The interest for these certificates will be paid as per the earnings from the assets
securitised.

Principal only certificates:

Only the principal amount will be paid on the certificates from the realization
of assets.

 Redemption stage in Securitization:

Payments received from various assets are used for redeeming various credit
instruments issued. This is done by the originator himself. In some cases, a
separate servicing agent may be appointed who will undertake collection
work for which adequate commission will be paid. The job of the servicing
agent will be to discharge the assets through the collection of principal and
interest and settle the debt instruments.

For example, the housing loan may be collected with principal and interest
and fi.om its collection, debt instruments such as certificate of deposits will be
met.

A pass through certificate which we have mentioned already may be a with

recourse or without recourse certificate. In the case of with recourse certificate,
if payment is defaulted, the originator will be held liable by the SPV. Hence,
SPV plays a major role in settling the claims of the investors.
 Credit rating stage in Securitization:
The pass through certificate issued by SPV has to be credit rated as they are
debt instruments which are issued to the public. The financial institutions issuing
these debt instruments will have to undergo credit rating which is statutorily
mandated in certain countries. The debt instruments are also traded in the
secondary market especially for interest swap.
The following are the various assets which can be used for Securitization by
financial institutions.

1. Housing loan granted to individuals or institutions

2. Hypothecation of vehicle loan
3. Leasing finance, especially financial lease
4. Supply bills belonging to government departments
5. Outstanding on credit cards
6. Long-term loans granted to reputed parties.

Diagrammatic Representation of Stages involved in Securitization Process:

The stages discussed above can be diagrammatically represented as follows:
Merits of Securitization:
1. It enables the lending institutions to improve their liquidity by converting
their long-term assets for Securitization.
2. With increasing turn-over of the raised liquidity, the earnings of the
originator go up.
3. Financial institutions can gain in Securitization by interest swap
4. As the assets structure and volume are reduced, the capital adequacy
ratio is increased and it reduces risk on the assets.
5. From the long-term assets, funds are raised and invested in various debt
instruments which brings diversification of risks.
6. The financial institution is able to get a better credit rating and this
enables them to obtain funds at lower cost.
7. Mutual funds and other financial institutions such as insurance companies
will be benefited due to different portfolio investments.
8. Increasing demand in the money market can be met from out of the
long-term assets and this will make the capital market more dynamic.

Benefits of Securitization to banks:

Commercial banks have an important responsibility of protecting the interests
of depositors and at the same time provide them with attractive interest rates.
This balancing act can be done only when commercial banks undertake
Securitization. Precisely, the commercial banks enjoy the following benefits
due to Securitization.

1. They obtain better source of funds.

2. They are able to maintain capital adequacy norms wherein high risks
assets are countered by lower risks weighted assets.
3. Banks can create more credit since they can shift from one portfolio of
investment to other, especially during selective credit control.
4. By interest swap and by turn over, the earnings of the banks increase by
which profitability goes up.
5. Benefits to Assets Liability Management: When there is floating rate of
interest, the income of the bank may be affected. This may be countered
by the bank switching over to higher interest earnings so that its income
will be sufficient to meet the claims of depositors.
Reasons why the Indian Nationalised Banks are still finding
it difficult to raise funds from the market regarding
Securitization

The growth of Securitisation in India is very slow compared to countries like

United Kingdom and United States of America where it is very popular.
Securitization is yet to pick up some momentum in India. There are still certain
inherent defects for its slow growth in India.

Reasons or inherent defects for slow growth of securitization in India:

1. Lack of debt instrument market:

This market has not very much developed. Even the existing institutions such as
United Trust of India (UTI) have not impressed the public.

2. Financial institution support is lacking.

There is a lack of support from the financial institution. This is due to inadequate
development of the money market.

3. Absence of agencies such as SPV.

The Special Purpose Vehicle (SPV) which plays a crucial role in the securitisation
is absent in India.

4. Difficulty in Transfer of Assets:

Only Transfer of Property Act enables easy transfer of assets, while the other
assets of commercial banks cannot be so easily transferred.

5. Higher Stamp and Transfer charges:

This hampers securitisation process as it increases the cost of securitisation.

In addition to the above, Financial institutions should come forward to create

securitisation through a common arrangement which is not sufficient for the
growth of securitization in India.

Future of Securitisation in India:

Improvement in the functioning of commercial banks and the increasing
number of foreign commercial banks provide more scope for the creation of
securitisation in future. If RBI could, on the lines of DHFC, create a permanent
organization then there is more scope for Securitisation in India.