Securitisation and the banking industry

 

Financial innovation is key in a constantly evolving market. It has become a tool which shapes and redefines economies as financial markets constantly seek innovative ways to transact and sophisticated instruments to meet the demands of the more discerning investor. Markets expand and deepen with the introduction of new investment instruments and the creation of new financial solutions. Securitisation is a product of financial innovation that boosts market growth and profitability. Furthermore, it promotes financial stability due to one of its basic functions, the reallocation and diversification of risk. In recent years, as governments work to improve economic performance, developed economies have returned to the use of securitisation to boost domestic market, albeit, ensuring that the necessary market and investor protection rules and policies are provided. However, the development of securitisation in Nigeria has been stunted. Despite the introduction of rules on Asset-Backed Securities (ABS) and Mortgage-Backed Securities (MBS) by regulators, the Nigerian market has been very slow in its response.

 

Securitisation is an arrangement involving the pooling together of assets by an entity (commonly referred to as the Originator) and the transfer of same to a Special Purpose Vehicle (SPV) to be repackaged and issued as interest bearing tradeable securities and sold to investors. The cash flows of the underlying assets are used to meet interest payments. The use of an SPV isolates the transferred assets from the insolvency of the originator. The introduction of securitisation has altered the role of banks and their lending objective. In other words, the traditional lending role of banks is typically structured as an “originate to hold” model, which requires banks to conduct rigorous screening of all loan applications and also monitor debtors to mitigate counter-party risk. However, with securitisation, banks can elect to package and sell off some of their loan portfolio before maturity under the “originate to distribute” model.

 

It has been argued that the “originate to distribute” model could lead to lax screening and monitoring process because banks lose the incentive to adopt stricter processes. Also, by making illiquid loans liquid, the risk appetite of banks could be enhanced. Indeed, securitisation of the loan portfolio of banks can generate a moral hazard incentive for the banks to take on more risk, the banks have no motivation to undertake careful screening of loan applications and are willing to invest in riskier assets, knowing always that they will eventually transfer the risk to investors. Another probable risk is that banks, in securitising, would securitise the prime loans, and keep the riskier loans on their books and this will lead to loan portfolio imbalance and a vulnerability to an internal crisis in the case of an economic instability. Finally, the risk of counterparty default is high because the banks no longer monitor the borrowers upon transfer of the assets to the SPV.

 

Conversely, retaining the riskier loans aligns the interest of the bank with that of the investors and negates any concerns regarding moral hazard. Furthermore, if the originator holds a percentage of interest in the securities issued by the SPV will ensure that the banks will maintain strict loan policies. Ultimately, the securitisation of the loan book allows banks to maximise profits by leveraging on capital efficiently; banks can extend long term loans, hold for the short to mid-term and then sell off. This serves as an additional source of funding for the banks and, because capital is not tied up in long term loans, the liquidity position is improved. The transfer of assets off balance sheet also provides regulatory and economic capital relief. In addition, banks can better manage their risk by transferring some of their credit exposure outside the banking system to other financial and non-financial institutions and private investors in return for liquidity, which is used to create more credit.

 

On the macroeconomic level, securitisation plays an important role as a macroeconomic tool with regards to money creation within the domestic economy. Lending by commercial banks plays an important role in the money creation process. The cycle of securitisation means that liquidity is created in the economy and used to on-lend to other borrowers. Another macroeconomic benefit are the varying structures that ABS can assume to meet government economic goals, for example a Small and Medium Enterprise (SME) ABS backed by the Nigerian Federal Government guarantee will encourage bank lending to SMEs.

 

Banking securitisation will deepen our market, provide liquidity, create more options for capital raising and satisfy the appetite of the sophisticated investors. In recognition of this, the FSS2020 Committee of the Central Bank of Nigeria is working on a Securitisation Bill to give the necessary support to existing rules by providing the necessary legal and regulatory governance over the structure, issue and trade in these instruments. The committee has drawn together the different stakeholders to review and make the necessary input to ensure that the Bill, once passed into law, is enforceable. It is hoped that this will be the first of many initiatives to introduce liquidity enhancement instruments into the market for the benefit of the economy.

 

 

Elisabet Ekpenyong