II. Asset-backed securitisation--motivation and advantages of collateralised debt obligations (CDOs).

The development of CDOs is closely associated with imperfections in capital markets, the management of credit risk exposure, the acquisition of an alternative method of asset funding and the illiquidity of asset claims held by banks due to an inherent absence of transparency. While securitisation is not an omnipotent antidote to remedy all these shortcomings and frictions in capital markets, it serves as a flexible vehicle to mitigate the efficiency reducing effect of these factors through a creative application of structured finance via a reduction in regulatory capital or an improvement of asset liquidity. Otherwise, the presence of perfect information would render obsolete the benefits gained from CDOs as the administrative cost of structuring and marketing such a securitisation transaction would have no counterbalancing benefit.

These benefits from the securitisation of bonds and bank loans have resulted in different forms of CDO structures in the bid to eradicate allocational inefficiencies emanating from certain properties of bonds and bank loans. An arbitrage CDO (see Exhibit 5) is a popular form of securitisation structure undertaken by investment banks to capture pricing differences between the acquisition cost of collateral assets in the secondary market and their aggregate valuation when bundled in a reference portfolio underlying the sale of the associated CDO structure. An arbitrage CDO will be undertaken once netting this marginal pricing difference by management fees yields profit. This arbitrage incentive applies to debt securities whose securitisation has either a cash flow or market-value structure. While an arbitrage CDO suggests mispricing in imperfect capital markets, a balance sheet CDO specifically aims to remove performing loans from the balance sheet in order to provide capital relief by reducing minimum capital requirements on credit risk exposure through a subsequent securitisation. Duffle and Garleanu (2001) point out that such securitisation might also increase the valuation of the assets through a possible increase of liquidity. If the collateral portfolio of this asset-backed securitisation is made up of corporate and/or sovereign loans, such a balance sheet CDO is called a collateralised loan obligation (CLO), i.e. the securitisation of corporate and sovereign loans (Eck, 1998; Kohler, 1998). Conversely, this means that we do not observe an arbitrage CDO structure in combination with an underlying reference portfolio made up of loans.

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Issuers administer most CLO transactions--as a subset of CDOs--in order to release risk-based capital and improve regulatory capital ratios rather than to make most efficient use of their capital. Such restructuring frequently allows the issuer to adjust the composition of the loan book, for example the granularity of debtors and credit risk concentrations. Unfortunately, large credit portfolios with a substantial degree of illiquidity defy an outright loan sale as banks incur substantial cost in negotiating technical details of internal credit risk assessments, barring any irritation in the client relationship due to changes in loan servicing.

In CLO transactions issuers combine a selection of loans of similar characteristics to create credit-enhanced claims (see section V) against the cash flow proceeds originating from this loan portfolio, which are sold as securities to investors. Since investors in a CLO transaction acquire a claim on the cash flow generated from a collateral pool, a loan securitisation provides a contractual repartition of the interest (transmission mechanism) generated from underlying loans, i.e. interest income and repayments of principal are allocated to prioritised tranches of securities. Credit losses from possible loan default are first assigned to the most junior claimants of the collateral portfolio before senior claimants are affected. Both interest and losses are allotted according to investor seniority. This allows banks to securitise a significant portion of their loan books to capital market investors who do not participate directly in the primary lending markets due either to contractual restrictions (e.g. investment funds, pension funds and other institutional investors), statutory covenants (e.g. insurance companies) or market barriers to entry (e.g. private investors).

In conventional loan securitisation, a sponsoring bank or another type of issuer forms a special purpose, bankruptcy-remote (18) vehicle (SPV), commonly referred to as a securitisation conduit. This conduit purchases loans from the sponsor of the transaction or from others, or might even originate the loans directly, and funds these loan purchases, or originations, by issuing various classes (tranches) of asset-backed securities with different levels of seniority and asset rating as a structured claim on the underlying loan pool.

Most of conduit's debt securities are issued to public investors, who are contractually bound to demand senior securities of highly rated investment grade. Consequently, the transformation process of loan securitisation via CLO effects a redistribution of credit risk such that the structured claim on a non-investment grade collateral pool could be enhanced to an investment-grade product.

While precise motivations for the completion of CLO transactions vary, the securitisation of loans allows for greater flexibility of originators in managing their portfolio and in slimming their minimum capital requirement on the loan book. Active credit portfolio management is frequently cited in this context as sponsors of CLOs adopt a comprehensive lending process that culminates in securitisation as an expedient and economic value adding means of refinancing (see Exhibit 7 above). Hence, banks are able to improve risk-adjusted efficiency after removing risky assets off-balance from the loan book by redeploying freed-up resources in higher-yielding and/or more diversified investments. In Exhibit 8 the major benefits from loan securitisation are broken down by stakeholder.

A. General Benefits From Asset Securitisation

Issuers reap significant advantages that emerge from securitising assets. From an economic standpoint, securitisation was principally motivated by the ability of financial institutions and corporates to convert illiquid assets into tradable debt securities, which primarily served as an arbitrage tool, flaunting the gap between internal default provisions and external risk assessment methods of stringent regulatory requirements by offering "regulatory overcharged" asset holdings/exposures to capital market investors.

Hence, securitisation goes a long way in advancing the following objectives:

* curtail balance sheet growth and ease the regulatory capital charge (by moving assets off their books) and/or

* reduce economic cost of capital as a proportion of asset exposure (by lower bad debt provisions through risk transfer).

Most commonly, a balanced mix of both objectives and further operational and strategic considerations determine the type of securitisation--traditional or synthetic--in the way financial institutions envisage securitisation as a method to shed excessive asset exposures.

Many issuers move assets off their balance sheet, using special purpose vehicles known as conduits, in the wake of traditional, true-sale transactions in order to exploit anomalies in the regulatory system governing securitisation. Nonetheless, also the mere transfer of asset risk through derivative transactions (synthetic transactions) can establish an asset-backed security that qualifies for a top rating and enables the issuing party to raise funds at a very attractive rate, while freeing up capital and retaining customer relationships and servicing revenues.

B. Regulatory Capital Relief

In order to obtain capital relief and gain liquidity by exploiting regulatory capital arbitrage opportunities, CLOs have evolved into an important balance sheet management tool. Thus, the argumentation about the meaning of securitisation extends to balance sheet issues. The use of CLO transactions is endorsed by regulatory incentives as the securitisation of loans caters to the bank's interests in resolving long-standing problems of avoiding "intermediation taxes", such as reserve requirements. Excessive capital requirements are contrary to bankers' interests as they drain resources from the loan book. Securitisation bears the possibility to moderate the adverse effects of imperfections in capital markets on the loan book of banks. That is, loan securitisation exposes those provisions mandated by financial regulators, which result in regulatory constraints beyond what should be deemed economically sensible based on individualised risk assessment.

C. Refinancing And Private Economic Rents

Banks are adept at originating credit exposures due to their long experience of assessing credit risk and strong client relationships. (19) The benefits from such relationships do not as much result from economic rents in revolving loan commitments as they rather allow improved debtor screening, which leads to higher margins from loan origination. (20) As banks are required to maintain regulatory capital against credit losses of their loan books, additional loans on their balance sheet would, however, result in diminishing marginal benefit. Hence, the sale of a portion of the loan portfolio allows banks to lower their regulatory capital requirements. Consequently, issuing banks can use their capital base more efficiently to support credit business, as attractive lending opportunities can be addressed without incurring balance sheet growth. Especially, informational rents from SME lending in heavily bank-based financial systems and rather unfavourable rating grade distribution of SME loan portfolios (in contrast to corporate loans, see Exhibit 9 below) make loan securitisation an perfect candidate for adjusting portfolio balances as to efficient capital management, so that lumps of concentrated "bad risks" could be removed from the loan book.

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From a broader economic and systemic perspective, loan securitisation does not only contribute to the sustainability of client relationships, but it also leads to an increased availability of credit finance at lower cost in the primary lending markets. According to the European Securitisation Forum (The Bond Market Association, 2001) efficient securitisation markets help to reduce disparities in availability and cost of loan finance, as the credit extension function of individual banks is conditioned on the pricing and valuation discipline of broader capital market systems. Consequently, financial institutions that engage in securitisation arguably promote the efficient allocation of capital and allay exposure to credit risk, whilst mitigating systemic risk throughout the financial system as a whole.

The economic feasibility of securitisation as vehicle of capital market efficiency is explained by the incentives of issuers to expand the scope of activity without diminishing returns. On the one hand, with controlled balance sheet growth of the loan book freeing up credit lines, banks can broaden their services by steering increased activity from traditional bank lending towards fee-based services. Improvements in long-term profitability might ensue without reliance on the generation of profits from regulatory arbitrage. On the other hand, their embeddedness in broader capital market systems allows borrowers to profit directly from increased supply and lower cost of funds. However, both banks and borrowers will only profit from the micro- and macroeconomic benefits associated with loan securitisation unless regulators avoid imposing capital adequacy requirements that curtail the beneficial application of securitisation techniques to fund their lending operations efficiently.

D. Regulatory Arbitrage

The current regulatory regime of the Basle Accord (21) imposes the same risk-based capital charge on differently rated loans. Such a broad treatment of credit risk has led to a problematic outcome. Under the current regulatory framework the prime objective is to shed high quality but low yielding loan claims (for whom opportunity cost of regulatory capital is higher than with higher yielding assets) in order to reduce the banks capital requirements. Since it is less efficient for banks to retain highly rated loans on the loan book due to their tight spreads relative to the regulatory capital charge (unlike high-risk loans with a margin closer to the same capital charge), most balance sheet CLO transactions are collateralised by investment grade loans in the reference portfolio. (22) The result would appear to be a continuous drain of high-quality loans from the loan book, which increases the probability of bank insolvency.

The new proposals for the revision of the Basle Accord remedy this shortcoming through the implementation of discriminatory risk-weightings across rating categories. Under theses approaches risk weights will be more closely related to loan grades in the loan book. If the broad-brushed regulatory treatment of loans disappears, banks will increasingly resort to non-investment loan assets to support their CLO transaction and by doing so, they will put a premium on an adequate allocation of as credit cover (such as credit enhancement) for first losses arising from the transaction. Consequently, the incentive to securitise non-investment grade loans adds topical significance to the issue of credit enhancement, (23) as the differences between collateral (reference portfolio) quality and desired structured rating is expected to widen in the future. The Basle Committee on Banking Supervision (2002a) defines credit enhancement as a contractual arrangement in which the bank retains or assumes a securitisation exposure and, in substance, provides some degree of added protection to other parties to the transaction. Credit enhancements may take various forms [...]."

However, the example of credit enhancement as credit risk coverage illustrates that loan securitisation does not cast banks free from what is generally considered their traditional function in financial intermediation, namely to measure, assume and manage credit risk. Even though the improvement of internal credit risk management is a frequently cited advantage of CLOs, by common consent, securitisation can potentially carry as much or more credit risk exposure as traditional lending, if banks pursue the mitigation of loan portfolio risk in an unbalanced and single-sided fashion without consideration of concentrated credit risk and systemic risk of asset correlation. For all practical purposes, perennial credit risk does not suggest that the administration of a securitisation transaction does not qualify as a remedy for issuers caught in the throes of mounting pressure over diminishing asset returns or the growing plight of excessive regulatory burdens, i.e. it does not serve to resolve systemic issues of credit risk management or inefficiencies in loan origination and financial intermediation per se. To the contrary, it rather rewards the general capacity of superior credit risk management as an amplifier of efficient financial intermediation.

E. Interest Risk And Liquidity Management

Notwithstanding the prohibitive consequences of ill-guided regulatory efforts and inhibiting effect of insufficient internal credit risk management, CLO transactions also offer the possibility of balance sheet restructuring for purposes of an improved management of interest rate risk. As banks decompose the loan function in the course of securitisation, interest rate sensitivity of the loan book is reduced in its wake, as the restructuring of credit exposure entails improved resilience to financial distress from unanticipated interest rate changes. Given that the securitisation of loans alters the composition of the loan book, lower provisions for regulatory capital to cover expected default losses from the reduced book balance permit the fundamental value of the loan portfolio to appreciate. As restructuring engenders a significant reduction of large exposures to credit default risk or sectoral concentrations, improved financial ratios are not only confined to the issuer perspective. As investor in securitisation transactions, banks are able to augment their portfolios with different asset types from diverse geographical areas (Basle Committee, 2001).

Finally, loan securitisation can also serve as a means of injecting liquidity in loan books of banks. Despite the advantages associated with a growing sophistication in lending business, since 1980 declining margins have found banks militating towards fee-based services in approaching capital markets by offering derivatives and advisory services as well as traditional banking products, such as loans, credit facilities and trade finance (Anonymous, 1998). Banks quickly realised that there is much to be gained by acting as intermediaries between corporate clients and capital market investors in expanding capital markets Shelled by the growth of institutionally managed funds.

Exhibit 8. Stakeholder benefits in loan securitisation

Asset         * favourable economic                 banks,
Originator/     and regulatory                 non bank financial
Sponsoring      capital treatment                intermediaries
Entity        * lower costs of funding            (investment
                and term financing              banks/managers,
              * capitalisation of             finance companies),
                private (informational)      governments/agencies,
                rents [??]                       corporations,
                transformation of            real estate operators
                illiquid, individual
                financial assets into
                liquid and tradable
                securities
              * removal of credit
                exposures (true sale/
                cash) or credit
                risk (synthetic)
                from balance sheet [??]
                increased liquidity and
                improved financial
                ratios due to risk
                adjusted lending
                policy and prudent
                risk management
                credit

Issuing       * creation of additional               banks,
Vehicle/        business segment and           non-bank financial
Arranger        specialist role                  intermediaries
(Portfolio      (learning curve,            (e.g. investment-banks)
Manager)        scale economies)

              * generation of income
                by distribution and
                advisory (management
                fees)

Capital       * customised rate of          institutional investors
Market          return with respect to        (e.g. mutual funds,
Investors       individual risk                 pension funds,
(Primary/       proportion                      education funds,
Secondary     * extended horizon             insurance firms) money
Market)         of asset classes             managers, hedge funds,
              [??] increased                private investment funds
                possibility of asset        commercial banks (asset
                diversification               side of the balance
                and maturity                  sheet) non-financial
                transformation                    corporations
              * yield premiums (above
                sovereign government
                issues)

General       * value creation from
Benefits        non-correlated assets
              * uncovers excess
                returns of credit
                exposures
              * contribution to "market
                perfection" [??]
                "more complete market"

Andreas A. Jobst

London School of Economics and Political Science (LSE) and J.W. Goethe Universitat Frankfurt am Main