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Why might a bank choose to securitise some of its loans?
Securitisation: A brief background
Securitisation has become a major technique of bank management in recent years. It
provides an alternative funding mechanism, a method for organising assets and liabilities and a
technique to manage credit risks and banks’ capital.
The basis of securitisation began to take off in the US during the 1970s to support car sales.
Customers would be provided with loans in order to finance their purchases, however this caused a
worrying expansion of the lenders’ balance sheets. In order to combat this issue, the loans were
packaged and sold off to third party investors. This became a form of ‘pass-through securitisation’
whereby the investors in the packages would take direct ownership of the loans. Its success was
enough to draw the attention of Wall Street and the mortgage industry to undertake their own form
of this ‘originate-and-distribute’ model, where a bank creates the loans but does not hold them or its
risk on its balance sheet. (Northedge, 2014).
Securitisations have exploded in the early 21st
century. In 2006, outstanding securitised
loans in the US amounted $28 trillion – a significant expansion compared to $5 trillion just 16 years
earlier in 1990 (Llewellyn, 2009). Although securitisation comes in three main forms: Primary,
Secondary and Tertiary, this discussion, will focus solely on Secondary Securitisation. This can be
defined as ‘a technique that transforms or repackages a pool of loans on the balance sheet of a bank
into securities that can be re-sold to investors in the capital market and subsequently traded.’
(Llewellyn, 2015).
The simple securitisation structure of bank loans
Securitisation deals with assets that meet 4 key
characteristics: they must be in the same asset class,
homogeneous, with similar terms and a statistical history of
calculable losses – bank loans fit this criteria. In essence, the
process makes a non-tradable loan tradable, the simple
securitisation structure of bank loans is outlined in the
adjacent diagram, figure 1. At the base of the model, there
are borrowers who require a bank loan. These borrowers
will receive their loan and will thus pay interest and
principal on it. The bank originates these loans and it will
then pool them into tradable securities which are then
eventually sold on to investors. Furthermore, it collects the
payments from the borrowers and forwards this too so, in
practise, the vast majority of borrowers are likely to be
completely unaware that their loan will be securitised, as
the process does not affect them or their contract with the
bank whatsoever. Figure 1 (Adaptation of Llewellyn, 2015)

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The portfolios created by the bank are purchased by SPVs, an organisation which exists
specifically for securitisations only. These could be formed by any company, for example a University
that may wish to purchase student loans, but commonly SPVs are subsidiaries of the bank itself.
Subsidiaries are protected by company law to ensure that, even if a subsidiary goes bust, there
would be no ‘domino’ effect for the bank to necessarily follow suit and vice versa. Hence, with this
security, it may be favourable for a bank to form its own subsidiary as opposed to using a third-party
SPV although it is not a necessity. In order to finance their purchases of portfolios, the SPV issues
asset-backed securities (ABS) to the market, such as floating rate notes, for which it receives cash.
These ABS are funded by the proceeds generated from the bank passing on its interest from the
assets to the SPV.
These ABS then continue in the process of securitisation by having their liquidity and credit
ratings enhanced. This is completed either through a third party ‘credit enhancer’ or through a
process known as ‘over-securitisation’: where the asset’s original value that is transferred is greater
than the initial value of the securities that are issued. Following their enhancements, the securities
are rated through an agency for overall credit rating, and then checked through a servicer if the
seller does not retain the servicing function. The investors are attracted to the ABS for a number of
reasons: the investors may be interested specifically in the credit risks that are being securitised, or
may be interested in investing in the assets but do not wish to deal directly with the bank itself.
Moreover, investors may be interested in the type of asset that’s securitised due to their
management requirements of their own assets and liabilities. Thus, the ABS are sold on to investors,
who are then paid debt-servicing interest from the SPV, completing the process of securitisation of a
bank loan.
Why might a bank securitise loans?
As briefly mentioned, there are many advantages for investors for the securitisation process.
However the bank itself is encouraged to securitise its loans by the numerous advantages posed that
incentivise the process. According to Llewellyn (2009), there are four key motives for a bank to
securitise of which I will use as key categories for the following explanation.
i) Asset transformation motive
The first of which is balance sheet management, or the asset transformation motive. This is
where a bank may securitise some of its loans in order to change its balance sheet position. For
example, a securitisation offers a way of diversification for the bank. It may decide that it has too
many mortgages on its balance sheet, or it is overly exposed to a risk proposed by mortgages.
Therefore, if it securitises its deemed excess it permits the bank to acquire an asset it views more
favourably, such as student loans for example, whereas without securitisation, the bank may lack
the capital required to purchase these assets or may be reluctant to expand its balance sheet to
incorporate more student loans. Whereas before the bank loan may have been illiquid and difficult
to shift from its balance sheet, securitisation can increase the liquidity of its loan assets which allows
its asset structure to be altered with greater ease.

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ii) Balance sheet constraint motive
Secondly, Llewellyn identifies the balance sheet constraint motive as a reason for the
possible securitisation of bank loans. Although the process cannot increase capital itself, this motive
demonstrates that a bank can ease a capital constraint to raise the capital ratio (narrowly:
equity/assets) such that assets are removed from the balance sheet. A bank can thus, theoretically,
originate loans and provide them to lenders while the risks they create are passed on through the
process and shifted away from the bank. In order for this to work, the SPV that purchases the
securities has to be bankruptcy-remote from the bank itself; as mentioned in the previous section
the SPVs often are subsidiaries of the bank as its bankruptcy-remoteness is protected by company
law, but can also be a third party. By securitising assets, the bank does not need to hold capital
against the risks they possess. The securitisation of bank loans could thus be seen as a form of
regulatory capital arbitrage: where the bank attempts to find loopholes in the capital requirements
as set by the Basel I capital requirements. Furthermore, after the financial crisis of 2007/08, banks
are required to hold more capital to protect from risks therefore this may encourage further
securitisation. Banks may securitise their assets in order to further increase their capital ratio, which
regulators are demanding. Moreover, a bank may struggle to increase its equity and thus the only
way to improve its ratio would be to securitise and hence reduce its assets.
iii) Fee income motive
Risk transferring is linked to another motive for securitisation: the fee income motive.
Securitising the bank loan deconstructs it so that the funding, asset holding and risk taking are
separated into different processes. Therefore the securities are able to link parties that possess
comparative advantages and thus share mutual benefits. The bank has a comparative advantage in
initialising loans, for example, but may struggle to fund them and hold them on their balance sheet.
Hence, they can outsource these relative weaknesses to the SPVs, and eventually investors, who
specialise in funding and holding loans, but may not necessarily be able to originate them as
effectively as the bank. Moreover, if the SPV is not a subsidiary of the bank, it will pay a fee to the
bank for the assets it purchases and thus this creates an additional source of income, potentially
leading to an increase in the rate of return on equity. By shifting this credit risk, the bank enhances
its capacity to lend. In addition, this increased capacity enhances the reputation a bank has with its
customers; it builds a friendly customer relationship by providing loans to those that may otherwise
struggle to obtain them.
iv) Funding motive
Finally, there is also a funding motive to encourage the securitisation of bank loans. An
investor may like the risks of the bank loans in proposal, but they may not wish to invest in the bank
itself. By securitising its bank loans, the bank widens its source of funds as these previously sceptical
investors would no longer have to invest in the bank they dislike, but just the portfolio of securities
the bank originated that the investors may consider worth investing in. The process protects the
bank from the risk of the assets, but importantly protects the investors in the assets from the risks of
the bank; the isolation of the bank loans through securities means that their rate of return depends
on its own performance and not that of the bank. Moreover, securitisation allows for segmented
funding, created by pooling the assets so that the bank can borrow money from different sources at
different rates of interest, this leads to a reduction in the marginal cost of funding; segmenting the
market ensures the bank may give different rates of interest to different investors.

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A summary of the securitisation of bank loans
Although there are many incentives for a bank to securitise its loans, it can lead to problems.
One of the main issues stems from excessive and irresponsible securitisation and the sheer amount
of risk that the bank believes it can shift. The issue of moral hazard arises, as the bank that knows it
is not subject to the risk posed by the borrower and is thus inclined to make bad loans through
‘collective euphoria’ to people who are clearly incapable of repayment – securitisation can thus
disillusion banks’ common sense. Prior to the financial crisis, banks, ultimately, stopped acting as
banks and more as brokers: no longer would a bank monitor with high quality, but they would
almost solely aim on getting assets of any quality repackaged and sold on to investors as fast as
possible. Furthermore, it is likely that risk was not shifted as much as parties believed at the time.
Banks believed that they were completely shifting the credit risk proposed by the loans it made,
however in reality, securitisation didn’t shift as much risk as they’d hoped. A key example being
Northern Rock, who became heavily dependent on securitisation and hence exposed to its risks. The
credit risk of its loans actually transformed into market, liquidity, funding and eventually solvency
risk which proved fatal for the business.
Securitisation proposes a number of benefits to the financial world, and a bank might
choose to securitise some of its loans for one of the four key motives as outlined in this discussion.
However, it is worth noting in this summary that securitisation is not always perfect and can
particularly cause problems when it is used and relied on excessively. It is no coincidence that many
people believe it to have been one of the main culprits of the 2007/08 financial crisis.

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References
Cerrato, M., Choudhry, M. and Crosby, J. (2012) Why do UK banks securitize?.
ECB (2008a) ‘Securitisation, bank risk-taking and loan supply on the euro area’, Financial Stability
Review (June).
ECB (2008b) ‘Securitisation in the Euro Area’, Financial Stability Review (December).
ECB (2008c) ‘Securitisation in the Euro Area’, Monthly Bulletin (February).
Gardener, E. P. M. (1988) Securitisation. Bangor: Institute of European Finance, University College of
North Wales.
Llewellyn, D. (2015) ‘Economics of the Financial System Lectures’.
Llewellyn, D. T. (2009) ‘Financial Innovation and the Economics of Banking and the Financial
System’, Financial Innovation in Retail and Corporate Banking
Martin-Oliver, A. and Saurina, J. (2007) Why do banks securitize assets?.
Northedge, R. (2014) ‘Securitisation: Giving it some credit’, Financialworld.co.uk.