Financial Institution Risk Management: The Impact of Securitization
Prof. Ian H. Giddy, New York University
presented at
Seminar on "Risk Management in Financial Institutions"
Sogang University, Seoul, October 2001

The rise of the asset-backed securities market in recent years has allowed banks in Korea and elsewhere to free up their capital by packaging and selling loan portfolios. This alters the criteria for lending by forcing financial institutions to meet the market’s standards for loan quality and sufficient pricing for risk. It also reduces banks’ funding mismatch. On the other hand it offers great challenges that must be faced if banks in emerging economies are to meet world standards of competition in financial services. The following outline attempts to trace the role of securitization in the evolution of financial institutions' risk management in emerging markets, with special reference to Korea and its neighbors.

Stage 1:  Sowing the Seeds of a Banking Crisis (no ABS/CLO market because assets are not priced at market levels)

  • Government puts banks in a special position, with protections and constraints intended to steer capital in the economy to favored sectors
  • Lending according to non-market criteria
  • Biased pricing leads to overborrowing by favored companies
  • Debtor problems and failures, and rescues, weaken local financial institutions

Stage 2:  Recapitalization of Companies and Banks (outside funds managers may initiate securitization of traded assets)

  • New capital is needed by companies and banks
  • Minority investors unwilling to entrust their funds to companies with poor governance
  • Minority investors reluctant to invest in weak banks that are under pressure to assist in bailouts
  • Foreign direct investors seek control; domestic majority owners unwilling to cede control, so corporate restructuring is delayed
  • Domestic financial institutions further weakened; mergers are encouraged
  • Foreign banks, seeking a local banking franchise, purchase controlling equity stakes in domestic financial institutions if bad assets are ring fenced
  • Vulture fund investors "cherry pick" good financial assets
  • Arbitrage funds managers initiate securitization of hard currency bonds -- CBOs (Collateralized Bond Obligations) of high yielding corporate and country debt -- because these are priced very cheaply relative to their risk

Stage 3:  Restructuring of Companies and Banks (using the ABS market as a funding source)

  • Companies and banks allowed to fail with loss of assets, jobs and control
  • Public sector restructuring agency may securitize loan portfolios of troubled or failed banks
  • Securitization of good loans, initially with third-party credit enhancement
  • Securitization of bad loans, initially with recourse or substantial subordination/first loss risk held by selling institution, again initially supplemented by third-party credit enhancement
  • Separation of funding from risk-bearing -- ABS investors are willing to purchase CLOs (Collateralized Loan Obligations) as long as someone else is bearing the risk
  • Some local currency assets amy be securitized, with swaps provided by prime banks, but investors almost entirely nonresidents

Stage 4:  Initiation of Broad-Based Securitization (companies and banks use the ABS market as a means of transferring risk as well as a funding source)

  • Legal changes enable the establishment of special-purpose securitization vehicles and perfected true sale of assets
  • Select companies and banks experiment with securitization
  • Non-loan securitization begins to be used by companies as an ongoing funding source
  • Local currency securitization matures
  • Local rating agencies develop expertise in grading ABS
  • Domestic investors become familiar with the technique
  • ABS investors willing to take some credit risk by purchasing subordinated tranches or non-triple-A ABS
  • Securitization includes a widening range of assets, such as automobile loans, consumer credit (including credit cards), mortgages, leases and commercial loans

Stage 5:  Entrenched Securitization (companies and banks routinely rely on securitization of assets, and price loans on the basis of the ABS market)

  • ABS investors can choose and compare and trade, creating established market pricing for different classes and ratings of ABS
  • ABS market drives availability and pricing of loans and bonds, enabling banks to make consumer and corporate loans confidently -- they know that of they price the loans in line with the ABS market's requirements, they will be able to obtain funding and transfer the risk by securitizing the assets.
  • Securitization of primary bond issuance
  • Securitization of primary loan issuance

Supplement 1: Requirements for successful ABS
Supplement 2: Typical structures of ABS in Asia
Supplement 3: Deals illustrating evolution of the ABS market's role in Korea

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