1.

INTRODUCTION

Securitisation is a process whereby a pool of similar loans(e.g. residential mortgages) or

other financial assets is pack-aged and sold in the form of marketable securities. This has
the effect of transforming long-term illiquid assets into tradable liquid assets. Typically
much of a bank’s business relates to the borrowing and lending of money. Banks take
deposits, and lend the proceeds to customers at a higher interest rate, thereby making a
profit. In most cases the bulk of a bank’s borrowing will be in the form of short-term
deposits, while its loans will be for relatively long terms, e.g., residential mortgages
which have a nominal term of, say, 20 years. Interest rates on some products will be
floating, i.e. able to be adjusted at any time. On other products the rates will only be able
to be adjusted after a specified period. Banks face a number of risks from this type of
business. These include credit risk (the risk that borrowers will not repay the money they
have borrowed), interest rate risk(the risk that the relationship between the interest rate on
lending and borrowing will shift because asset and liability reprising dates differ) and
funding risk (the risk that deposits cannot be replaced as they mature or are with-drawn,
leaving the bank with insufficient funds to finance long-term loans).Banks, particularly
those in the United States, are increasingly reducing their involvement in traditional “on
balance sheet” borrowing and lending in favour of securitisation. This allows them to
reduce the risks which arise from traditional bank borrowing and lending activities and
enables them to concentrate on activities such as loan origination.

2. MEANING OF SECURITY:

In connection with securitisation, the word "security" does not mean what it traditionally
might have meant under corporate laws or commerce: a secured instrument. The word
"security" here means a financial claim which is generally manifested in form of a
document, its essential feature being marketability. To ensure marketability, the
instrument must have general acceptability as a store of value. Hence, it is generally
either rated by credit rating agencies, or it is secured by charge over substantial assets.
Further, to ensure liquidity, the instrument is generally made in homogenous lots.

3. NEED FOR SECURITISATION:

The generic need for securitisation is as old as that for organised financial markets. The
relation invariably needs the coming together and remaining together of two entities. Not
that the two entities would necessarily come together of their own, or directly. They
might involve a number of financial intermediaries in the process, but nevertheless, a
relation involves a fixity over a certain time. Generally, financial relations are created to
back another financial relation, such as a loan being taken to acquire an asset, and in that
case, the needed fixed period of the relation hinges on the other which it seeks to back-
up.

Financial markets developed in response to the need to involve a large number of

investors in the market place. As the number of investors keeps on increasing, the
average size per investors keeps on coming down -this is a simple rule of the
marketplace, because growing size means involvement of a wider base of investors. The
small investor is not a professional investor: he is not as such in the business of
investments. Hence, he needs an instrument which is easier to understand, and is liquid.
These two needs set the stage for evolution of financial instruments which would convert
financial claims into liquid, easy to understand and homogenous products, at times
carrying certified quality labels (credit-ratings or security ) , which would be available in
small denominations to suit every one's purse. Thus, securitisation in a generic sense is
basic to the world of finance, and it is a truism to say that securitisation envelopes the
entire range of financial instruments, and hence, the entire range of financial markets.

There are a variety of benefits that arise to the issuers and investors associated with the
process of securitisation. In the following sub sections, we consider some of the factors
that may contribute towards the economic gains from structured financing
3.1. Cost Savings By Minimising Capital Adequacy Requirements : In the case of a
financial institution such as a bank, a factor that is well known to practitioners as
contributing to the gains from securitisation is the savings in the cost of capital through
optimising their capital structure and minimising capital adequacy requirements. Central
Bank requires commercial banks to maintain certain minimum ratios between the value
of assets in the balance sheet and the level of issued capital and designated reserves.
Funding assets with capital and reserves rather than by loan capital is however, costly for
banks. When a bank’s assets are securitised as pass through securities, these assets no
longer appear on its balance sheet. Then the bank is not required to hold capital and
reserve requirements against these assets. The bank can thus reduce its overall cost of
capital and improve its reported return on equity by securitisation. The advantage to the
bank in securitising assets such as credit card loans is even greater, because these assets
are regarded as high risk weighted assets and require even higher capital and reserve
requirements when they appear in the Balance sheet1.

3.2. Funding Alternative :Being distinct and different from the originators, a well
structured assets backed securities stands on its own credit rating and thus generates
genuine incremental funding. This is so as the originator’s existing creditors may invest
in the ABS in addition to providing lines of credit to the originator. Further, they may
also be other investors in the ABS who do not have a lending relationship with the
originator.

It is also possible to achieve a superior credit rating for the ABS than the originator's own
through appropriate structuring and credit enhancement. This could mean accessing an
investor base focusing on high grades, which otherwise may not be possible for an
originator. Also, where the originator is not permitted to issue capital market instruments
on his own ABS could help overcome such constraints

1
3.3. Balance Sheet Management : Fundamental benefit of a true sale, i.e., freeing up the
capital of the originator would apply in the case of all securitization transactions. In
response, the balance sheet gets compressed and becomes more robust. Its ratios improve.
Alternately, reduction in leverage post-securitised sale can be restored by adding on new
assets to the balance sheet. Thus the asset through-put of the originator's balance sheet
increases. Securitization can also generate matched funding for balance sheet assets.
Further, it may also enable the disposal of non-core assets through suitable structuring

3.4. Re-Allocation Of Risks : Securitization transfers much of the credit risk in the
portfolio to the ABS investors and helps to quantify the residual credit risk that the
originator is exposed to. This is very useful, as the originator can then take larger
exposure to individual obligors as well as provide a higher degree of comfort to his
creditors. Securitization also transfers the originator's market risks, i.e., liquidity, interest
rate and prepayment risks, to ABS investors and reduces risk capital requirement. This
can lead to more competitive pricing of the underlying asset products

3.5. Operating Process Efficiency : The extent of portfolio analysis and information
demanded by securitization programs often lead to serious re-examination and
consequent re-engineering of operating processes within the originator organisation.
Further, specialist handling of various functional components, such as origination,
funding, risk management and administration, often achieved through outsourcing,
promotes efficiency across operating processes

3.6. Securitization Improves Operating Leverage : The originator usually assumes the
function of the servicer, the issuing and paying agent, and sometimes that of the credit
enhancer. Fees accrue on account of all of these. Excess servicing, i.e., the difference
between the asset yield and the cost of funds, is also normally extracted by the originator.
These income streams can push up the operating leverage of the originator generating
income from a larger asset base than what may be otherwise possible for a given capital
structure

3.7. Increases The Liquidity Of The Asset Portfolio : Securitisation increases the
liquidity of the asset portfolio of financial institutions. Once a certain asset class is
securitised, any unsecuritised assets of the same class remaining on the financial
institution's balance sheet become a more liquid asset.

4. ECONOMIC IMPACT OF SECURITISATION:

Securitisation is as necessary to the economy as any organised markets are. While this
single line sums up the economic significance of securitisation, the following can be seen
as the economic merits in securitisation:

4.1. Facilitates creation of markets in financial claims: By creating tradeable securities

out of financial claims, securitisation helps to create markets in claims which would, in
its absence, have remained bilateral deals. In the process, securitisation makes financial
markets more efficient, by reducing transaction costs.

4.2. Disperses holding of financial assets: The basic intent of securitisation is to spread
financial assets amidst as many savers as possible. With this end in view, the security is
designed in minimum size marketable lots as necessary. Hence, it results into dispersion
of financial assets.One should not underrate the significance of this factor just because
most of the recently developed securitisations have been lapped up by institutional
investors. Lay investors need a certain cooling-off period before they understand a
financial innovation. Recent securitisation applications, viz., mortgages, receivables, etc.
are, therefore, yet to become acceptable to lay investors. But given their attractive
features, there is no reason why they will not.

4.3. Promotes savings : The availability of financial claims in a marketable form, with
proper assurance as to quality in form of credit ratings, and with double safety-nets in
form of trustees, etc., securitisation makes it possible for the lay investors to invest in
direct financial claims at attractive rates. This has salubrious effect on savings.

4.4. Reduces costs: Securitisation tends to eliminate fund-based intermediaries, and it

leads to specialisation in intermediation functions. This saves the end-user company from
intermediation costs, since the specialised-intermediary costs are service-related, and
generally lower.

4.5. Diversifies risks: Financial intermediation is a case of diffusion of risk because of

accumulation by the intermediary of a portfolio of financial risks. Securitisation further
diffuses such diversified risk to a wide base of investors, with the result that the risk
inherent in financial transactions gets very widely diffused.

4.6. Focuses on use of resources, and not their ownership: Once an entity securitises
its financial claims, it ceases to be the owner of such resources and becomes merely a
trustee or custodian for the several investors who thereafter acquire such claim. Imagine
the idea of securitisation being carried further, and not only financial claims but claims in
physical assets being securitised, in which case the entity needing the use of physical
assets acquires such use without owning the property. The property is diffused over an
investor crowd. Securitisation in its logical extension will enable enterprises to use
physical assets even without owning them, and to disperse the ownership to the real
owner thereof: the society.

5. HOW ASSET SECURITISATION WORKS

Securitisation can be described as a process by which new classes of securities are
created and issued to the public, backed by the collateral of a pool of similar assets. To
illustrate this process, consider a financial institution, a bank for example, which has
various types of assets such as mortgage loans, credit card loans, vehicle loans, leasing
contracts etc. on its balance sheet. Unlike traded assets such as Treasury bills, bonds etc.,
these assets are not marketable, and therefore regarded as illiquid assets.
The bank will always prefer to hold liquid assets rather than illiquid assets. Securitisation
is a means of converting a class of illiquid assets to liquid assets. Assume the bank
decides to securitise one class of assets, the mortgage loans for example. The process of
securitisation will work as follows. What are described are the basic elements of just one
way in which an asset class can be securitised.

→ The bank, who is the asset originator in this case, collects the mortgage loans into a
pool and sells the pool of mortgage loans to a trust or a separate entity usually
described as the Special Purpose Vehicle (SPV) which is created for the purpose of
asset securitisation.
→ The SPV in turn issues new securities such as bonds to the public using the mortgage
loans as collateral. Since the bonds are backed by the mortgages, the market in which
the new securities are traded is called the secondary market for mortgage backed
bonds.

→ The proceeds from the sale of securities will be utilised to pay for the mortgages
bought from the bank.
→ These new securities may typically be coupon-paying bonds where coupon interest is
paid periodically, and the capital repaid at maturity or amortised bonds where the
principal and interest is passed through on the coupon dates. To service these
payments, the trustee will utilise the interest and capital repayments received on the
mortgage loans from the original mortgage borrowers.

6. SECURITISATION:CHANGES THE FUNCTION OF INTERMEDIATION

It is true to say that securitisation leads to a degree of disintermediation.
Disintermediation is one of the important aims of a present-day corporate treasurer, since
by leapfrogging the intermediary, the company intends to reduce the cost of its finances.
Hence, securitisation has been employed to disintermediate.

It is, however, important to understand that securitisation does not eliminate the need for
the intermediary: it merely redefines the intermediary's loan. Let us revert to the above
example. If the company in the above case is issuing debentures to the public to replace a
bank loan, is it eliminating the intermediary altogether ? It would possibly be avoiding
the bank as an intermediary in the financial flow, but would still need the services of an
investment banker to successfully conclude the issue of debentures.

Hence, securitisation changes the basic role of financial intermediaries. Traditionally,

financial intermediaries have emerged to make a transaction possible by performing a
pooling function, and have contributed to reduce the investors' perceived risk by
substituting their own security for that of the end user. Securitisation puts these services
of the intermediary in a background by making it possible for the end-user to offer these
features in form of the security, in which case, the focus shifts to the more essential
function of a financial intermediary: that of distributing a financial product. For example,
in the above case, where the bank being the earlier intermediary was eliminated and
instead the services of an investment banker were sought to distribute a debenture issue,
the focus shifted from the pooling utility provided by the banker to the distribution utility
provided by the investment banker.

This has happened to physical products as well. With standardisation, packaging and
branding of physical products, the role of intermediary traders, particularly retailers,
shifted from those who packaged smaller qualities or provided to the customer assurance
as to quality, to the ones who basically performed the distribution function.

Securitisation seeks to eliminate funds-based financial intermediaries by fee-based

distributors. In the above example, the bank was a fund-based intermediary, a reservoir of
funds, whereas the investment banker was a fee-based intermediary, a catalyst, a pipeline
of funds. Hence, with increasing trend towards securitisation, the role of fee-based
financial services has been brought into the focus.

In case of a direct loan, the lending bank was performing several intermediation
functions noted above: it was distributor in the sense that it raised its own finances from a
large number of small investors; it was appraising and assessing the credit risks in
extending the corporate loan, and having extended it, it was managing the same.
Securitisation splits each of these intermediary functions apart, each to be performed by
separate specialised agencies. The distribution function will be performed by the
investment bank, appraisal function by a credit-rating agency, and management function
possibly by a mutual fund who manages the portfolio of security investments by the
investors. Hence, securitisation replaces fund-based services by several fee-based
services.

7. SECURITISATION: CHANGING THE FACE OF BANKING:

Securitisation is slowly but definitely changing the face of modern banking and by the
turn of the new millennium, securitisation would have transformed banking into a new-
look function.

Banks are increasingly facing the threat of disintermediation. When asked why he
robbed banks, the infamous American criminal Willie Sutton replied "that's where the
money is." No more so, a bank would say ! In a world of securitized assets, banks have
diminished roles. The distinction between traditional bank lending and securitized
lending clarifies this situation.

Traditional bank lending has four functions: originating, funding, servicing, and
monitoring. Originating means making the loan, funding implies that the loan is held on
the balance sheet, servicing means collecting the payments of interest and principal, and
monitoring refers to conducting periodic surveillance to ensure that the borrower has
maintained the financial ability to service the loan. Securitized lending introduces the
possibility of selling assets on a bigger scale and eliminating the need for funding and
monitoring.

The securitized lending function has only three steps: originate, sell, and service. This
change from a four-step process to a three-step function has been described as the
fragmentation or separation of traditional lending.

REFERENCES :

Marsh, J. R. (John R.) 1988: Practice of banking 2 /J.R. Marsh, D.G. Wild.
London: Pitman.

Bhattacharya,A.K and fabozzi (1996), Assets Backed Securities, wiley

Europe

Alles,Lakshman, Assets Securitisation In Australia,How it works

Kothari,Vinod : Securitisation-the financial instrument of the

future,wiley Finance

Web References :

http://en.wikipedia.org

www.mises.org/mysteryofbanking/mysteryofbanking.pdf

www.emeraldinsight.com

http://www.bis.org