2. Outline the Advantages and Disadvantages of the Securitisation of Bank Loans.

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Advantages
1.Gap Management

In general, banks and other financial intermediaries have longer durations of assets than liabilities. This duration mismatch exposes them to interest rate risk whenever rates are volatile. Specifically, if the duration of a bank's assets is longer than its liabilities, rising interest rates will reduce the net worth of the bank and could threaten its capital adequacy position. One obvious way to manage this duration mismatch is for the bank to either lengthen the duration of its liabilities or reduce the duration of its assets. However, such a whole scale rearrangement of the balance-sheet could be an extremely costly and lengthy process. Alternatively a bank may take a hedging position in financial futures, e.g. selling futures short, so that when interest rates rise, the fall in bank net worth on the balance-sheet is offset by profits on the futures contracts off-the-balance­ sheet.

The potential to engage in securitization provides a further alternative to direct hedging or futures contracts. Suppose a bank was to take some of its long-term mortgages off its books by issuing pass­ thru securities and/or it were to sell some of its longer term commercial and industrial loans - then one would expect to see the duration of the bank's assets shorten to better match the duration of its liabilities.

2. Liquidity

In the absence of loan selling or pass-thru's a bank is forced to act as an asset-transformer i.e. originating and holding loans until maturity. The existence of secondary loan markets and pass-thru's allow the bank to adopt an alternative mode of financial intermediation, that of broker. In addition the existence of these forms of securitization lowers the costs of intermediation by allowing banks to adjust their protfolios at a faster (perhaps more optimal) speed as interest rates, deposit flows and other macro-economic variables change.

3.Investment banking/ Under Writing

In the U.S. in particular, banks have faced restrictions on their investment banking activities. The Glass-Steagall Act of 1933 has, with the support of the Courts and the investment banking industry, limited their ability to issue corporate debt in forms other than commercial loans. In recent years there has been a very strong growth in the short-term commercial paper (debt) market. For example, BECKETT! and MORRIS (1987) show that the share of commercial paper in the composition of total short term debt of US non-financial corporations tripledfrom4% in 1973 to 14% in 1986 (equal to $82 billion) - with much of this growth at the expense of bank loans. While recently (June 1987) US banks finally gained some limited rights to underwrite commercial paper in separately capitalized affiliates, the total amount has been severely restricted as a percent of overall bank revenues and capital. It is therefore arguable (see BECKETT! and MORRIS 1987) that loan sales are a form of loan underwriting that allow banks to continue to pro-vide services to their best customers without holding all the risk on their books. Implicitly, that is, loan selling may be viewed as a form of underwriting competitive to the underwriting of commercial paper.

4. Regulatory Avoidance

In the case of loans sales and pass-thru's (though not pay-thru or asset (loan) backed securities) a bank removes assets from its books and shrinks the size of its balance-sheet. This has a number of advantages. First most countries impose minimum capital-asset (or adequacy) ratios on banks. Bankers, while accepting that capital plays an important role in guaranteeing the solvency of the bank, have long argued that capital ratios are usually set too high and that raising additional capital - through retained earnings or new equity issues - imposes a deadweight burden on their business. The ability to sell loans or originate pass-thru's provides bankers with an alternative (perhaps less costly) method of boosting their...
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