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