Financial Innovation

1. Financial innovation, structured finance and
off balance sheet financing
The case of securitisation
September 17th
2010
University of Manchester Pgr Conference
Vincenzo Bavoso
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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;
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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);
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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;
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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;
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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);
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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);
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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.
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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;
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10. Structure of typical securitisation
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