“The recent turmoil in credit markets has highlighted how securitisation has changed in only a few years from being a relatively niche market in the euro area to being a major force behind capital market developments”. This growth in securitisation reflects the increased pace of financial innovation in the financial markets. It is rational to say that this global trend of the growth in securitisation is a result of the advantages that are derived by the different parties engaged in the transaction. Securitisation has become an important tool for many companies and a key part of the global capital markets. However, while securitisation has benefited the financial system as a whole through enhancing its ability in performing its various functions, it has concurrently changed the underlying economics of the banking system, which brought consequences as those experienced in the 2007 financial crisis. Whether the gains exceed the losses is a debatable issue in itself as some intellectuals believe that securitisation has “contributed to the development of a far more flexible, efficient, and resilient financial system than existed just a quarter-century ago”, while others believe the opposite. The significance of securitisation has led to there has been talks by influential bodies about how securitisation can be regulated or changed as to maximise the benefits and minimize the costs. In this essay, to answer the above question I will define securitisation, explain its mechanics and nature and lastly discuss its advantages and disadvantages for the different parties engaged in it and the financial system as a whole. The scope of this essay is secondary securitisation, so the above will be discussed specifically to this type and not primary and tertiary.
1.2 Definition of key terms
Securitisation in general is the “creation and issuance of debt securities, or bonds, whose payments of principal and interest derive from cash flows generated by separate pools of assets”. There 2 types of securities that can be issued. When the securitised assets are mortgages, the securities issued are known as Mortgage -Backed Securities (MBS) and where it is other assets which are non-mortgage loans then Asset-backed securities (ABS) are issued. In the latter type, assets included are such as consumer loans, credit card receivables and car loans. These securities are marketable financial instruments, and tradable. In every securitisation transaction the capital markets are displacing the banks regardless of its type, whether primary secondary or tertiary, i.e. disintermediation. Secondary securitisation is Asset Backed. Bank of England defines this type as “a transaction or scheme whereby the credit risk of an asset or a pool of assets such is transferred to an external undertaking (the securitisation special purpose vehicle or structure), which then transfers this credit risk onwards to investors in fixed-income securities known as asset backed securities issued by that undertaking. The investors in the securities may be either external investors or the institution that originated the underlying assets”. Another way to look at this process is through Professor Llewellyn definition which explicitly high lightens the benefits. He defines secondary securitisation as ‘the conversion of cash flows from a portfolio of assets into negotiable instruments or assignable debts which are sold to investors, are secured on the underlying assets and carry a variety of credit enhancement”. To clearly outline the pros and cons of the participants in the process, one needs to understand their roles as shown below in figure 1.
1.3 How it works
When a bank transforms a portfolio of loans that it is currently holding on the balance sheet into tradable securities issued by a bankruptcy-remote special purpose vehicle it follows a...