10 – The Origins of Asset Backed Securities (ABS) – Part III

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In the Part I and Part II of the origins of ABS, it’s shown:

  1. The difference between traditional banks that practiced deposit financing and shadow banks that practice market financing.
  2. ABS, MBS, CDS, CDO, ABCP are liabilities issued by shadow banks such as SPVs to raise fund from investors to acquire different types of assets.
  3. Issuing liabilities such as ABS and its variants such as CDO secured by loans as collateral is known as “securitization of loans”.

In this article, we’ll discuss in detailed about two things: Credit intermediation and why shadow bank exists.  

Here’s two points brought up in this article:

  1. Credit intermediation is the fundamental activities carried out by bank. Traditional banks carry out credit intermediation with “public safety net”, but shadow banks don’t.
  2. The rise of shadow banks is the innovation of commercial banks in response to stringent capital requirement imposed by law on commercial/traditional banks.

Section I: Credit Intermediation – Using savings of people to extend loans to other people 

Traditional banking system involves three actors: savers, borrowers, and banks. Savers entrust their savings to banks in the form of deposits, which banks use to fund the extension of loans to borrowers. A fancy way of saving it is: “The banks issue deposit liabilities to depositors (who bought the deposit liabilities) to raise fund to finance the acquisition of assets such as loans.”

So, the bank basically intermediates between savers who have savings and wanted to save and borrowers who wanted a loan. This is credit intermediation.

Credit intermediation process usually involves credit, maturity and liquidity transformation. 

Credit transformation refers to the attempts of bank to generate returns during the credit intermediation process through credit mismatches between assets and liabilities. A good example of this attempt is a bank will acquire assets with lower credit rating (and therefore paid higher yield) by issuing liabilities with high credit rating (such as deposit) and therefore pledged to pay lower yield. Another example of this attempts would be shadow banks increase the credit rating of the liabilities issued by separating them into different tranches and risk.

Maturity transformation refers to the attempts of bank to generate returns during the credit intermediation process through maturity mismatches between assets and liabilities. A good example of this attempt is bank will issue short-term liabilities such as deposits to raise fund to acquire long-term assets such as loans.

Liquidity transformation refers to the attempts of bank to generate returns during the credit intermediation process through liquidity mismatches between assets and liabilities. A good example of this attempt is bank will issue highly liquid liabilities such as deposits to raise fund to acquire illiquid assets such as loans.

Traditional banks such as commercial banks are protected by public safety net: public liquidity and credit guarantee. Liquidity guarantee is offered by central banks who pledged to borrow reserve to banks via discount window to settle the liabilities they owed to other banks on demand or to meet cash withdrawals by depositors since banks hold most long-term assets which is illiquid.

Credit guarantee is offered by government via deposit insurance such as FDIC insurance to insure the deposits of household and firms against the default risk of the loans asset acquire by the banks. In other words, the public credit guarantee is equivalent to saying: The deposit liabilities issued by the banks is not just secured by the asset’s the bank acquired using the proceeds of deposit liabilities issuance, in case of default, it will be secured by the government (which is the issuer of currency who always have money). 

Public liquidity and credit guarantee is what traditional banks such as commercial banks that accept public deposits enjoyed and these guarantees are exactly what shadow banks lack.

Hence, shadow bank is often defined as: “Shadow banks are banks that conduct credit, maturity and liquidity transformation without public safety net.”

Section II: Why Shadow bank exists?

As shared in “The Origin of ABS – Part I”, shadow banks raise funds to acquire assets by issuing their liabilities to the market investors such as pension fund, money market manager like mutual fund etc.

There are many rationales that led to the mushrooming of shadow banks being examined by researcher, here I shared a few of them:

  1. Regulatory capital requirement. The 1988 Basel Accord applied a minimum capital requirement to bank balance sheets and required more capital (also known as equity) protection for riskier assets. If the banks wanted to hold more risker assets, they need to have more capital or equity reserved. This constrains the growth of the balance sheet of the banks and therefore reduce the leverage the bank could apply to have a higher return on equity (roe). As a result, the banks innovate by setting up off-balance sheet shadow bank. The shadow banks raise funds from the market by issuing liabilities and use the proceeds to buy the risky assets from the banks to help the bank to shift risky assets they acquire away from their balance sheet to meet the capital requirement.
  2. The rise of money manager. The rise of money manager such as pension fund and mutual fund who held large pools of funds are struggling to find high yield for their funds in a low interest rate environment. The ABS issued by shadow banks which offer higher yield and received high ratings from credit rating agency is thus welcomed by the money managers. This leads to a huge demand for these instruments like ABS issued by the shadow banks. More and more shadow banks are established to join the wagon.

Conclusion:

  1. Credit intermediation is carried out by traditional banks with public safety net. Shadow bank carry out credit intermediation without public safety net.
  2. The rise of shadow banks that carry out maturity, credit and liquidity transformation without public safety net is motivated by stringent capital requirement which compress bank’s ROE and strong demand for higher yield by money market investors who has large pools of funds.

In the next article, we’ll see HOW shadow banks intermediates credit and HOW they’re involved in the securitization of loans in details! In fact, there’re more steps involved in securitization of loans apart from what we discussed in Part I!

*** This article is written based on my reading on the cited research paper. Any correction and improvements are welcomed!

References:

  1. Shadow Banking
  2. Investment and Finance: Banking/Credit Transformation

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