Financial Innovation in the Banking Industry

The Case of Asset Securitization

Lamia Obay

• Publisher: Routledge
• Year: 2014
• Topic: Business
• eBook ISBN:
  9781135690410
• Subtopic: Business General
• Index: Business

This book investigates the motivations behind the adoption of the technique of asset securitization by US commercial banks and its effects on the financial performances.

CHAPTER 1

Introduction

BACKGROUND

Financial innovation refers to several phenomena. It includes new financial instruments, which are the objects of transactions, new financial markets, which are the fields of transactions, and new media to effect transfers (Yumoto et al. 1986, p.45). While financial innovation is by no means a recent phenomenon, it has become one of the most significant economic phenomena of the last decades. It has exerted considerable influence on the workings of the financial system, the conduct of the monetary policy in a number of countries and on the management of costs and risks by governments, financial institutions, and corporations.

Prominent factors that have been working as common catalysts to financial innovation have been identified as several. First, there was the worldwide trend toward deregulation of capital, currency and money centers which is creating opportunities for corporations, banks, and governments to raise funds and manage risk in new ways. Second, high inflation rates in the United States during the eighties caused not only financial innovation at home but also triggered innovation and deregulation internationally through the indirect impact of high and volatile U.S. dollar interest rates and exchange rates. A third factor that has greatly increased the pace of financial innovation is technical progress particularly in the computer and telecommunication fields.

Other factors have been recognized as contributing to the rise of financial innovation during the last two decades. Among them are 1) the progress in international economic integration; especially growing international capital flows, 2) the persistence of large public deficits and the need for efficient means of financing such deficits, 3) the new trends in corporate organization, 4) the changing dynamics of the international banking system through the redefinition of the role of banks and the evolution of their relationship with the corporate community and the structure of their balance sheet, and 5) the need to improve profitability and/or minimize the cost of regulation.

Despite these common forces, the process of financial innovation and deregulation has differed between countries depending in particular on the maturity of financial markets, the previous regulatory framework, and on the openness of the economy. Indeed, the highest degree of financial innovation has occurred in the United States essentially because all the factors that tend to induce financial innovations were present. Accordingly, in this research, the author will concentrate on the innovative behavior of U.S. commercial banks. One particular innovation that has redefined the process of bank intermediation is asset securitization, that is the repackaging of loans into securitizable assets. In this case, a closer look will be paid to the regulatory framework governing asset securitization and to the adoption and diffusion process of the issuance of asset-backed securities across foreign markets as well.

When analyzing the environment that has greatly conditioned the current pace of financial innovativeness, one question is frequently raised: “To what extent does the dramatic growth of markets in new financial instruments represent long-lasting features of the innovation process and to what extent are the factors behind change temporary and reversible?” (BIS, 1986, p. 184). Commentators agree that, while the pace of change in recent years was to an important extent due to “exceptional dislocations” in the economic and financial conditions, there are powerful, long-lasting forces that support the growth and development of innovations even in a more stable environment (BIS, 1986). Technological advance, both in its hardware aspect—computer and communications systems—and its software aspect—sophisticated financial models and financial product designs—is a major long-term determinant. The global integration of financial markets and the institutionalization of financial innovation are other examples of long lasting determinants.

Global integration of financial markets and financial innovations are closely intertwined and are driven in part by similar deregulatory and technological changes. Financial integration is affecting the development of new products as well as their diffusion in international markets. The increased liberalization of financial markets in Europe and Japan can, in fact, be seen as an aspect greatly favoring the diffusion of innovations generated by the globalization of markets.

Put in a much broader context, financial innovation is, albeit indirectly, very much affected by the overall global integration of overall economic structures. “The integration of national financial markets is related to, and supported by, the broader force of the global integration of overall economic structures. These linkages through increased trade, investment and travel are a long-lasting process, working not only among the industrial nations but among them and the rest of the world as well. So, closer economic integration leads to greater financial integration, which in turn, creates opportunity for new instruments to emerge, and eventually leads to lower cost of intermediation. These connections provide a fundamental, more permanent, support for the process of financial innovation” (BIS, 1986, p. 185).

A third important development affecting the character of financial innovations is the institutionalization of the process at the firm level. “[I]n the past few years a number of the major international financial institutions, both investment and commercial banks, have established within their organizational structures “new products” or “product development” groups” (BIS, 1986). If the institutionalization of financial innovations persists, it may change the nature of the economics of future innovations. The pace of financial innovation may become primarily a function of the quantity and quality of resources committed to product development. This may lead to innovations generated by a dynamic that works independently of the kind of developments in the economy that generated innovations in the past.

With respect to the implications of the recent wave of innovations for the stability of the financial system, several points of concern are often mentioned. They include an over-leveraging of the capital, the apparent under-pricing of new instruments, the scope for an undue concentration of risks, and the possibility that the apparent liquidity of marketable instruments could prove illusory under adverse circumstances (European Investment Bank, 1988).

In the specific case of the banking industry, it has been claimed that the adoption and diffusion of financial innovation has allowed banks to operate on much thinner margins of safety. An understanding of why this is possible would require the analysis of the structure of balance sheets, payment commitments and position-making activities of banks. Position making for a bank consists of the transactions undertaken to bring the cash position to the level required by regulation or bank management. Such transactions involve selling assets off the bank's portfolio and raising cash through money market instruments. Increase in banks' riskiness is due to the interdependence of payment commitments and position-making transactions across institutions.

The shift in position making from trading in liquid assets in the 1960s to transaction in liabilities in the 1970s was accompanied by a decrease in the margins of safety used to cushion fluctuation in the cash flows. As a result, payment commitments have become more closely coordinated with payment receipts so that small changes in conditions can cause a large increase in the need for institutions (and economic units in general) to acquire cash by selling assets that may have thin markets. As asset sales in thin markets become necessary and while the value of liquidity—or marketability—is enhanced, the relative value of assets become subject to change, which change becomes responsible for the institutions' balance sheet instability.

It is these evolved characteristics of asset-liability management that are responsible for deposit institutions' fragility. Indeed, in the position-making view, fragile financial characteristics of debtors, creditors and deposit institutions result from the evolution of asset and liability structure over periods of good economic conditions. The effect of bad economic conditions is to put aspects of balance sheet mismanagement in the open. Weak management can get by during good economic times, but when economic conditions are adverse, problems that existed all along unravel and become significant.

Other ways in which innovation may contribute to systemic vulnerabilities derive from the difficulties in pricing new instruments and the possibility that many new instruments appear to be under-priced, therefore, not allowing for a full compensation for their inherent risk (BIS, 1986, p. 3). Moreover, the general trend toward increased off-balance sheet activities and “unbundling” (which involves separating market risk from credit risk), as well as the complexity of multiple linked transactions, can conceal the interlocking of risks for banks management, regulators, and market participant alike (BIS, 1986). A subsequent point is that the new instruments shift price or market risk from one economic agent to another but do not eliminate that risk.

John G. Heimann, in his address to the 23rd Conference on Bank Structure and Competition held by the Federal reserve Bank of Chicago, expressed his concern as follows: “The bottom line is that everyone is now operating in an environment of increased risk. That is because the velocity and volatility of global markets have created the potential for a case of—or recurrent cases of—global jitters. Also, velocity and volatility are the quivering backbone of a new generation of financial instruments which—let's be frank-are not fully understood either by their creators or their users. Today, with so many new, computer-based products on the market, it is evident that some managers may not have a profound grasp of what they are really managing” (1987, p. 29).

An article in the Washington Post (April 24, 1994,H1) highlights the risks involved with this 'new generation of financial instruments' when it reported that the private derivatives deals made by corporations, banks, brokerages and others to speculate and hedge now total more than $10 trillion and three-fourths of them are tied to interest rates. “When underlying interest rates change, the value of these deals are affected dramatically. Thus the recent spurt in interest rates set off bombs on the balance sheets of some companies that had tried to play the derivative game¹.” The article further adds that these financial instruments are often so complicated “that even the chief financial officers of Fortune 500 companies confess that they don't fully comprehend them.” The facts, however, that financial innovation is neither fully comprehended nor its risks fully assessed does not seem to deter its growth or its pervasiveness.

ORGANIZATION

This book is a study of the diffusion among, and adoption of financial innovations by, U.S. multinational banks and the relationship of such an adoption behavior to their financial characteristics and performances as reported on their financial statements with the proper regulatory agencies. It also is an examination of the characteristics of adopters versus non-adopters of financial innovations. An important aspect of financial innovation has been in the field of asset securitization, an area that despite its well-publicized benefits and potential for growth, has been the subject of little empirical investigation. Accordingly, the author has chosen to use asset-backed securities (ABSs) as an illustration of the adoption and diffusion process of financial innovations. In the remainder of Chapter 1, a statement of the objective, research questions, and scope of the study are presented.

In Chapter 2, the field of financial innovation is briefly surveyed. Securitization being an off-balance sheet activity, special interest is paid to the topic of off-balance sheet activities and the regulatory response to the proliferation to such activities. In Chapter 3, an examination of 1) the process of asset securitization, 2) the accounting and regulatory issues pertaining to ABS activities, and 3) the diffusion of asset securitization to foreign markets are covered.

In Chapter 4, a description of the research design and methodology for the investigation of the relationship between banking performances and financial innovation, proxied by asset securitization, are presented. Findings and conclusions of the research will be presented in Chapter 5 of this study.

Objectives of the Research

The focus of this study is on the securitization of bank assets, a new financial product, which after a decade of its introduction, is still at its growth stage. The study objectives are:

1. to present the field and environment of asset securitization,

2. to identify the differentiating characteristics between securitizing and non-securitizing banks, and

3. to investigate the relationship between the volume of assets securitized during the reporting period and the financial...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Table of Contents
• List of Tables and Figures
• Chapter 1: Introduction
• Chapter 2: Financial Innovation and Regulatory Issues
• Chapter 3: Financial Innovation in the Case of Asset Securitization
• Chapter 4: Research Design and Methodology
• Chapter 5: Findings and Conclusion
• Appendix A: Schedule RC-L
• Appendix B: Schedule RC-R
• Bibliography
• Index