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Securitization is an instrument for the refinancing of banks and for their portfolio risk management, which has been widely used in the past, especially in the US, mainly for mortgages and, to a certain extent for corporate loans. Through securitization, various types of contractual debt are pooled and sold to investors. These acquire rights to receive the cash collected from the financial instruments that underlie the security.
In the case of SME loan securitization, a bank extends loans to its SME, bundles them in a pool and sells the portfolio to capital market investors through the issuance of notes, by a Special Purpose Vehicle backed by the loan portfolio. These asset-backed notes, rated by agencies, are placed with capital market investors, but can also be retained, at least in part, by the originator banks.
Once the assets are transferred by the originator to the SPV, there is normally no recourse to the originator itself. Through the securitization process, assets are taken off the balance sheet of the originator. Thus, with this “originator to distribute” model, the bank becomes a “conduit”, which derives its income from originating and servicing loans ultimately funded by third parties. This model is changing the relationship of banks with customers, which is fading, in favor of a transaction-based bank whose main proceeds come from the fees they earn originating and packaging loans.
An alternative securitization model, the “synthetic securitization”, combines the above described mechanism with credit derivatives, whereby the loans remain in the balance sheet of the originator, whereas the credit risk of the loan portfolio is transferred to a SPV, which places credit-linked notes, classified by risk categories, in the capital market.
Debt securitization presents some advantages for banks, and, indirectly, for SME lending. First of all, securitization reduces the bank’s exposure to credit risk, which is transferred to the capital market. This has important implications also in the light of the recent financial reforms, as risky assets are taken out of the banks’ balance sheets and the capital to risk-weighted asset ratios is improved. In other terms, securitization can represent an instrument for risk-reduction and “regulatory capital arbitrage”. Ultimately, by giving capital relief, securitization reduces the bank’s total cost of financing.
Securitization allows banks to transform SME loans in their balance sheets into liquidity assets, which can be used to increase lending itself. In an empirical study of loan securitization by Spanish banks, show that liquidity needs have been a key driver of securitization, with higher probability of using this mechanism for banks with rapid credit growth, less interbank funding and a higher loan-deposit gap. Securitization can be especially important for smaller banks, which face lending restrictions due to their size. Transferring risks to the capital market increases their lending capacity. Furthermore, securitization of SME loans can be an effective option for them, as their closer customer relations and better monitoring capabilities give them a competitive edge in lending to smaller companies.
Covered bonds work similarly to securitized debt, as they are debt securities (corporate bonds) backed by the cash flows from mortgages or loans. In the European Union, the Capital Requirements Directive limits the range of accepted collateral to debts of (highly rated) public entities, residential, 50 commercial and ship mortgage loans with a maximum loan-to-value ratio of 80% (residential) or 60% (commercial), and bank debt or mortgage-backed securities.
An important difference with respect to securitization is that covered bond assets remain on the issuer’s consolidated balance sheet, except under specific variants of the general model. Thus, they cannot help to strengthen the issuer’s capital ratio. As the investor does not own the assets, the interest is paid to them from the issuer’s cash flow, as in the case of traditional corporate bonds. If the underlying assets default, the issuer continues to pay interest to investors. However, in case of default by the issuer that is unrelated to these underlying assets, the lender can take possession of them. As covered bonds are secured, they are considered to be less risky than unsecured bank bonds, which imply low-cost funding for the issuer. At the same time, asset encumbrance implies that they are seen as a complement, rather than as substitute to securitization.
On the demand side, securitized debt has some desirable risk characteristics for investors. Mainly, as secured assets, these investment options may present lower risk than other market offers. In addition, as they have limited correlation with the more traditional asset classes in the financial market, they can improve the risk return profile of the investors’ portfolio. In itself, the bundling of different assets into the securitized portfolio is an element for risk diversification. In the case of covered bonds, the fact that they remain on the balance sheet of the originator may provide investors with more confidence with regard to the assessment of risks and backup for their claims. In fact, in case of default, investors have a double recourse, to the issuer and the cover pool. For this reason, covered bonds benefit from a more favorable regulatory treatment than securitized debt, and greater liquidity in the market. It should be noted, however, that in most cases, the market for SME covered bonds is relatively new. Indeed, the use of SME loans as an asset class in covered bonds is not permitted in the legislation of most countries with an active covered bond market. In some others, changes in regulation that allow this form are recent.
Measures that help strengthen SME debt securitization