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May 1, 1992

eCONOMIC
GOMMeNTORY
Federal Reserve Bank of Cleveland

Securitization: More than
Just a Regulatory Artifact
by Charles T. Carlstrom and Katherine A. Samolyk

^competitive and regulatory pressures
have prompted banks and other financial
intermediaries to participate in credit markets in ways that are not directly reflected
on their balance sheets. This poses a problem for regulators, who must assess the
risks of these off-balance-sheet lending
activities. One such activity is the packaging of loans into marketable securities,
which is known as asset-backed lending or
securitization.
For example, banks and other loan
originators often sell fixed-rate
mortgages to government-sponsored
agencies, which in turn package these
loans with those acquired from other institutions into mortgage pools. The
agency sells securities that are claims
to these pools to investors in the bond
market. In the past several years,
securitization has spread beyond
government-sponsored activity to
private asset-backed pools that fund a
wide range of loans.
The recent proliferation of asset-backed
lending has raised questions about its impact on the performance of banks. This
concern reflects the fact that banks are involved in many aspects of the securitization process, such as packaging, servicing, or enhancing the creditworthiness of
these securities. Regulators must determine what risks securitization poses to the
participating institutions and how these
risks should be reflected in the assessment
of bank capital requirements.

ISSN 0428-1276

This Economic Commentary explores
banks' incentives to engage in securitization. Part of the dramatic increase in
this activity can be traced to banking
regulations that raise the cost of funding loans with deposits. However,
another important factor driving assetbacked lending by banks is the improvement in information technology
that has made securitization cost effective. Indeed, the proliferation of assetbacked lending to nonbank firms indicates that this mode of funding has
become efficient for firms not subject
to these regulatory costs.
From this perspective, we contend that
securitization itself is not undesirable,
and in fact is an efficient response by
banks to their changing financial environment. Securitization serves as a
vehicle for institutions to mitigate both
credit and interest-rate risks, while
generating fee income for participating
banks. Moreover, the securitization
process enables banks to attract investors who would otherwise not hold
bank liabilities. Nevertheless, securitization poses a challenge to regulators,
as they must assess how this activity affects risk in the banking industry.
• Securitization and Diversification
As their name suggests, depository institutions, such as commercial banks
and savings and loans (thrifts), have
traditionally funded their lending activities by attracting deposits. However, until 1986, deposit-rate ceilings

The recent surge in the volume of
asset-backed lending has prompted
regulators to scrutinize its effects on the
banking industry. Although popular
wisdom holds that securitization has
been regulatory driven, much of the
boom in this funding process has been
the result of improvements in information technology, which have made
securitization highly cost effective for
banks and nonbanks alike.

limited the ability of these institutions
to attract funds when market rates rose
above regulated maximums. Banks and
thrifts also tended to operate in fairly
localized markets because of information costs and regulations limiting the
scale and scope of banking activities.
Depositories were therefore vulnerable
to local credit-market conditions, such
as the health of the local real-estate
market. This was particularly true of
thrifts, which were required to hold a
certain fraction of their portfolios as
residential mortgages.
Indeed, asset-backed lending began as
an outgrowth of the government's
effort to increase the flow of funds to
the mortgage market. In the late 1960s,
government-sponsored credit agencies
such as the Federal National Mortgage
Association (Fannie Mae) and the
Government National Mortgage Association (Ginnie Mae) were established
to create a secondary market in which

existing mortgages could be sold.
These agencies operated as intermediaries, buying government-guaranteed
mortgages and funding these acquisitions by issuing securities. In 1970,
Ginnie Mae issued a new type of creditmarket instrument: the mortgage "passthrough," which was a claim to the
return on a specified pool of mortgages.
Hence, securitization was bom.
Today, the asset-backed market is a viable entity in its own right Pools of
securitized mortgages currently fund
nearly 40 percent of home mortgages
outstanding (see figure 1). Although
government-sponsored mortgage-backed
securities account for the largest share
of this market, the past decade has witnessed the growth of securitization by
private firms packaging mortgages as
well as other loans such as credit-card
and auto receivables. Depository institutions and nonbank firms are now able
to originate and sell a wide variety of
loans to asset-backed pools, rather than
funding them on their balance sheets.
Asset pooling increases the liquidity of
the underlying loans to the point where
they can be sold to investors who are
willing to hold direct claims on a diversified portfolio (see box). Because
these claims increase the diversification
and liquidity of loan portfolios, the associated securities are often bought by
banks as well as by other investors.
Securitization allows banks to avoid the
risks associated with deposit funding.
When depository institutions fund loans
with deposits, the liabilities they are issuing (deposits) have very different characteristics from the assets they are acquiring (loans). Individual loans, such as
mortgages, are illiquid: They have a relatively long term to maturity and are generally not individually marketable to investors. Alternatively, deposit liabilities,
such as checking and savings accounts,
are short-term, liquid assets.
The differences in the maturity of banks'
assets and liabilities cause depository institutions to be vulnerable to interest-rate
risk. When interest rates rise, banks must
pay higher deposit rates while being

effectively locked into the return on
their existing portfolios. An unexpected increase in interest rates will
therefore reduce their net income. This
risk is asymmetric, however: When interest rates drop unexpectedly, banks
do not gain by an equal amount. In this
case, banks are not as locked into the
return on their loan portfolios, because
borrowers can often refinance their
terms of credit.
Securitization in effect allows depository institutions to mitigate both the
credit risks and the funding risks associated with lending, especially in the
case of fixed-rate mortgages.3 Indeed,
an increasingly large number of home
mortgages are being earmarked for sale
into mortgage pools (see figure 1).
• Regulatory Motives
for Asset Securitization
Although securitization can help banks to
manage both credit risk and interest-rate
risk, the recent surge in asset-backed
lending has been more commonly attributed to the regulatory costs of traditional
bank funding.
Capital requirements, which stipulate
that depository institutions must back a
certain fraction of their loans with equity capital, are an important regulatory
incentive for securitization. Because
they increase the amount of losses that
equity holders can bear, capital requirements tend to reduce the risk of bank
failure. Alternatively, nonbank lenders
(such as finance companies) are not
subject to regulated capital requirements. Instead, they evaluate the inherent risk of borrowers to determine
the terms at which they are willing to
extend credit.
The growth in asset-backed lending by
banks can therefore be viewed as a
response to increased competition from
nonbank lenders. If the regulatory capital requirement on a particular class of
loans is greater than merited by the inherent risk of the claims, then in order
to compete with nonbank lenders,
banks must securitize these loans—that
is, move them off their balance sheets,
where they are not subject to capital

CREDIT ENHANCEMENT
OF ASSET-BACKED POOLS
The growth of asset-backed lend*
ing other man government-hacked
mortgages raises the question of
how securitization is able to market Illiquid loans. Asset securitization involves the issuance of
private-rated (asset-backed) seGuntfes as, c&ims against a poof
of assets held in a bust, fo addi • tkm to relying on cash flow* of
the; underlying assets to pay inasset-backed pools is enhanced
many of is«yeral ways.
:
Ota such enhancement i»a bank
standby feue* of sifcjit (SLO.

isstte art SJ.C. in which they
p^rty ur/ta'a pjfespecirfed amount
fij» any tosses incurred on the
secbritizing loans.'However, before loans are securitize*!, both
the foams and the bank issuing
the: SLC are rate4 Because th$
r^tirtg of a pool can be affected
b^i the rating of the bank guaranl&eiflg the loajas, this form of enhancement: has become somewhat less widespread.
An increasingly popular, enhancement, the cash-collateral-account
method, has die borrowers covering potential tosses with cash
placed in an escrow account1
Another method is for these
securities to be overcollateralized, That is, extra loans are
added to the pobls so that the
value of the loans exceeds the
value of the securities that are
claims to the pool.

a. See Suzanne Wittebort, "AssetBackeds Come of Age," Institutional
Investor, December 1991, pp. 77-80.

FIGURE 1

producing information. This has enabled

HOME MORTGAGES HELD BY MORTGAGE POOLS
VS. COMMERCIAL BANKS AND THRIFTS

firms to transfer information about individual accounts, making securitization

Percent of home mortgages

much more cost effective.
Held by mortgage pools

60

Held by commercial banks and thrifts

50
40
30
20
10
0

1981

1983

1985

1987

1989

1991

NOTE: All data are for the fourth quarter. The two categories do not add to 100 percent because other institutions, such as finance companies, also hold home mortgages.
SOURCE: Board of Governors of the Federal Reserve System.

requirements. An unavoidable consequence, however, is that the loans
which remain on bank balance sheets
are likely to be those for which the
market's assessment of risk premiums
is greater than the regulated assessment.
Two other regulatory taxes that have
been cited as potential inducements for
asset-backed lending by depository institutions are fractional reserve requirements and flat-rate FDIC insurance
premiums on deposit liabilities. These
assessments are viewed as raising the
cost of deposit funding, thus encouraging depository institutions to fund loans
off-balance-sheet. However, securitization has continued to expand in spite of
decreases in the reserve requirements
set by the Board of Governors of the
Federal Reserve System. In addition,
deposit insurance is subsidized to the
extent that flat-rate deposit insurance
premiums are unlikely to be a major
factor in the growth of securitization.
But, since deposit insurance premiums
are currently not risk based, they may
still have the undesirable effect of causing banks to securitize their safest and
most liquid loans.

(SLCs) to enhance securitized loans,
because SLCs are senior claims in the
event of bank failure (see box). 4 This
incentive to shift risk to the FDIC,
however, may not be too important. Because the creditworthiness of both die
loans being securitized and the bank issuing the credit-enhancing SLC affects the
credit rating of the pool, banks that issue
SLCs are generally lower-risk institutions. Thus, it is doubtful that the current deposit insurance scheme is a major
reason why banks issue SLCs, because
the seniority of claims is important only
in the event of bank failure.

• Securitization
and Loan Financing
While regulatory costs and portfolio
risks associated with deposit funding
may help to explain asset-backed lending by banks, the increase in securitization by nonbank. firms is evidence that
this financing method has become a viable alternative to other sources of credit
—including bank finance. Indeed, nonbank securitization is just one example of
the growing competition banks face from
nonbank suppliers of credit.

These innovations provide another important rationale for the growth of
securitization, since asset-backed lending may reduce the costs associated
with monitoring certain types of credit.
The basic intuition is as follows. The
cost of funding a portfolio is related to
the costs of monitoring its performance.
By issuing asset-backed securities
through a separate subsidiary (called a
special-purpose vehicle), a firm can
separate these claims from other claims
on its balance sheet. Investors, therefore, need assess only the performance
of the asset pool rather than the general
creditworthiness of the borrowing firm.
If the assessment of the pool is less
costly to monitor than that of the entire
firm, the ability to separate these
claims from the remainder of the firm's
balance sheet enables the firm to obtain
better credit terms on the pool.
For example, when Macy's extends consumer installment credit to its customers,
it obtains credit-card receivables that it
must finance. If the store funds these
receivables on its overall balance sheet,
the funding costs will reflect Macy's
general creditworthiness. Alternatively, if
Macy's securitizes its credit-card receivables through a special-purpose vehicle,
it may be able to obtain lower financing
costs, as the credit quality of these receivables alone may be less costly to assess.

•

Conclusion

The proliferation of asset-backed lending
is merely one indication of how the financial scene is changing. As evidenced by
the involvement of nonbanks in this market, securitization is clearly more than an
artifact of banking regulations. Although
off-balance-sheet lending by depository
institutions may be more efficient than
traditional bank intermediation for some
types of loans, these activities may also
impact the risk of banks' balance sheets.

A prominent factor underlying the evolu-

Because of the potential for increased

tion of the financial sector, especially that

FDIC exposure to bank failures, policy-

surance may increase the incentive for

of asset-backed securities markets, has

makers are understandably concerned

banks to issue standby letters of credit

been the improvement in technology for

about the rapid growth of this practice.

It has also been argued that deposit in-

In its role as an insurer, the government
aims to maintain the solvency of the insurance fund by setting deposit insurance
premiums and capital requirements.
But it is precisely these assessments
that can affect the risks undertaken by
depository institutions. Such regulatory
taxes create incentives for banks to
shrink their balance sheets through
securitization.
Unfortunately, when regulated capital requirements and deposit insurance premiums do not reflect the riskiness of a
bank's portfolio, they create the incentive
for banks to securitize their safest loans
and to hold the riskier ones. Thus, risk is
shifted to the FDIC (and ultimately to taxpayers). Regulatory changes that more
accurately price an institution's risk will
tend to diminish the adverse incentives
for bank asset securitization.
The risk-based capital guidelines currently being implemented, as well as
the risk-based deposit insurance premiums recently legislated by Congress,
are attempts to link regulatory costs to
an institution's risk. Risk-based capital
standards will be phased in by yearend. Banks will then be charged different deposit insurance premiums
depending on the overall quality of
their asset portfolios.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

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Material may be reprinted provided that
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Because the new risk-based guidelines
stipulate higher capital requirements on
all bank loans other than home mortgages, they may actually increase the
volume of securitization. However, the
trend toward asset-backed lending is not
entirely adverse for the FDIC. Depository
institutions can earn fee income for participating in various dimensions of the
securitization process, such as by enhancing asset-backed pools. Moreover,
with appropriate regulatory supervision of
banks' off-balance-sheet activities, assetbacked lending can mitigate the rising
costs of the federal safety net as it reduces
the share of credit funded on the balance
sheets of depository institutions. Thus,
securitization is better viewed as an important innovation in the financial sector—
one that allows new suppliers of credit to
enter the market and existing ones to intermediate credit more efficiently.

• Footnotes
1. See Christine Pavel, "Securitization,"
Federal Reserve Bank of Chicago, Economic
Perspectives, vol. 10, no. 4 (July/August
1986), pp. 16-31.
2. The growth of variable-rate mortgages has
also helped to reduce the dangers of interestrate variability.
3. Consider the role of interest-rate volatility
during the 1980s in the thrift crisis. The
interest-rate increases in the early part of the
decade, and the subsequent sharp drop in
rates in the mid-1980s, severely weakened
the position of thrifts and, to a lesser extent,

banks. This volatility was further aggravated by
interest-rate ceilings, such as Regulation Q.
4. Current banking regulations do not allow
a bank to issue any claims senior to those of
the FDIC: When a bank fails, no individual
or institution can receive its funds ahead of
the federal insurance agency. However, the
SLCs used as credit enhancements in effect
give asset-backed security holders a senior
claim on the bank's assets, thus maximizing
the subsidy that banks receive from deposit
insurance. See Lawrence M. Benveniste and
Allen N. Berger, "Securitization with Recourse: An Instrument that Offers Uninsured
Bank Depositors Sequential Claims," Journal of Banking and Finance, vol. 11, no. 3
(September 1987), pp. 403-24.
5. See Robert B.Avery and Allen N. Berger,
"Loan Commitments and Bank Risk Exposure," Federal Reserve Bank of Cleveland,
Working Paper 9015, December 1990.
6. See Howard W. Albert, "Asset Securitization: Benefits for All Banks," The Bankers
Magazine, vol. 174, no. 6 (November/
December 1991), pp. 16-20.

Charles T. Carlstrom and Kalherine A.
Samolyk are economists at the Federal
Reserve Bank of Cleveland.
The views stated herein are those of the
authors and not necessarily those of the
Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.

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