Pres 2010


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Financial Innovation

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Pres 2010

  1. 1. Financial innovation, structured finance and off balance sheet financing The case of securitisation September 17th 2010 University of Manchester Pgr Conference Vincenzo Bavoso 1
  2. 2. Background and transaction development • To what extent developments in the structuring of financial transactions contributed to cause the biggest bubble since Great Crash of 1929? • Is structured finance inherently a perilous means to fund business or rather the recent development of certain transactions has led to excessive obscurity in the market and to consequential excessive risk taking? • Securitisation finds its roots in the assignment of receivables, traditionally accomplished through the employment of factoring agreements; • In the 1970s the securitisation market boomed in the US when two GSAs started to acquire home mortgages from lending institutions and to issue bonds secured on the pools of those mortgages; • Securitisation then opened up to a wide array of assets and involved corporations, banks and government agencies; 2
  3. 3. Advantages of securitisation • Means to create liquidity (transforming a loan as a financial relationship into a bond, therefore into a transaction); • Access to a cheaper and more direct source of corporate finance (no bank intermediation and also better gearing ratio); • Broader access to consumer finance for society at large; • Accounting advantages (moving liabilities off balance sheet means better financial ratio while still retaining profits from receivables); • Regulatory advantages in Basel Accords (capital adequacy rules, with banks holding minimum amount of capital against risk) but also to an extent consequence of “universal banking” and financial globalisation; • Strategic choice (managerial incentives, lower level of monitoring than within other corporate finance strategies, therefore less corporate governance constraints); 3
  4. 4. Pitfalls of securitisation • Off balance sheet character (it can affect originator’s credit and ability to issue its own bonds); • Disincentive to monitor quality of originated receivables (risk laid off to other entities down the transaction chain); • Opaqueness of certain rating methodologies and generally of rating agencies role; • Incentives to develop innovative schemes with dubious (speculation and arbitrage?) rationale (greater recognition of quantitative risk modelling, reliance on CRAs, regulatory recognition of risk mitigation techniques, like credit derivatives); • Financial globalisation and off shore entities, regulatory race to the bottom (like hedge funds or simply SPVs); • Traditional legal issues: true sale and bankruptcy remoteness of SPV; recharacterisation and substantive consolidation; 4
  5. 5. Financial innovation and development of structured finance • Macroeconomic environment: role of neoliberal influence on corporate culture, where cultural tide in 1970s led to deregulation and self regulation of financial services industry; • Regulatory incentives to carry out financial transactions aiming at specific goals; Basel Accords provided major incentive to further develop the originate to distribute model; however the Accords did not provide adequate formulas to measure capital adequacy and to supervise the level of risk involved in transactions; • Reforms affecting the functioning of the banking industry in particular and the way banks became over-dependent on financial engineering; new banking model based in fact on two premises: originate to distribute and universal banking; • Financial globalisation allowed to relocate business off shore under less burdensome regulation, where highly leveraged institutions like hedge funds could escape effective supervision; • Financial innovation driven by market players; new products escaped understanding of investors and their regulation and supervision became insufficient; 5
  6. 6. Perils behind CDO and CDS • The relative simple structure of securitisation was expanded over the last decade to encompass a wide range of new contractual scheme whose complexity and exoticness stemmed from quantitative models rather than from commercial rationale; • CDOs represent an application of securitisation technology combined with credit derivatives (possible creation of synthetic security without the actual sale of assets to SPV); based on packaging of higher risk assets into a new security. CDOs liabilities are then divided and sliced into different tranches of different credit quality and subordination; • CDOs represent a cheaper way to participate in the bond market (synthetic CDO creates new instruments instead of using assets on banks’ balance sheet; also methodologies for CDOs rating result in the combination of the tranches being worth more than the total underlying assets); • Risk of reduction of monitoring incentives; sophisticated investors can manipulate pricing of collateral (mispricing of credit); rating arbitrage; composition of assets pool (few heterogeneous assets); 6
  7. 7. Perils behind CDO and CDS • CDS contracts can be more closely associated with derivatives, the aim is to provide protection against default whereby the seller of a CDS agrees to pay the buyer if a credit event occurs, and the buyer agrees to pay a stream of payments equivalent to the payments that would be made by the borrower (credit risk of an unrelated party); parties bet in other words on debt issuer’s events; • Main benefit of CDS is the hedging function that traditionally banks accomplish through loan syndication, which is cheaper and more quickly realised through CDS contracts; • Main problem of CDS is that they hinder the incentive to perform monitoring functions on the part of banks; also common is the incentive to destroy firm’s value (hedge funds can make their short position worth more if a firm files for insolvency); overall CDS market is opaque as regards risks and exposures (OTC and largely unregulated); finally CDS bear an intrinsic systemic risk (interconnectedness of contracts and highly leveraged bets can translate small market change into an international bubble); 7
  8. 8. Concluding remarks • Over-reliance on securitised products at the heart of corporate finance strategies of most financial institutions within present crisis; this had already happened during the last decade with a number of corporate failures that concealed short term strategies based on accounting irregularities achieved through off balance sheet financing (Enron, Parmalat, WorldCom, also Leeds Utd); • Shadow banking system: financial innovation was carried out in the shape of alternative investment schemes and new structured products designed to move assets and liabilities off balance sheet and lay off credit risk; this created an unsustainable level of gearing entailing huge exposures in the global credit market; • Level of interdependency between different financial institutions active on the market: those investing at the end of the transaction chain were funding their speculations with money borrowed from banks, willing in turn to provide finance because of excessive liquidity and incentive system in place; new products could diversify risks but not insulate originators from counterparties’ risks. 8
  9. 9. Proposals • Financial innovation created increasingly internationalised markets, with changes occurring so rapidly that it became impossible for regulators and supervisors to keep pace with the proliferation of new structured products; • The need for a balance tighter regulation in the area may need to be complemented by a revisited approach to paradigms of deregulation and self regulation, of which financial innovation is direct progeny; • Necessity to set up systems of control with specific task of assessing ex ante the commercial rationale and aim behind new structured products and contractual schemes devised by market players; 9
  10. 10. Structure of typical securitisation 10