Asset Securitization: Prospects and Challenges for the Financial Sector of Bangladesh
Asset securitization enables firms to obtain financing in exchange for the rights to cash flows generated by certain financial assets. In the event of a securitization transaction, a firm transfers financial assets to a special purpose entity (SPE) which is popularly known as special purpose vehicle (SPV), to separate the assets from the balance sheet of the transferor.
Different purposes of Asset securitization:
i. Carry out public policy objectives like development of financial markets particularly the capital market;
ii. Providing an alternative means of raising finance from capital market.
iii. To cope with regulatory requirements for financial institutions, especially capital adequacy and lending caps; and
iv. To transfer risk, particularly in terms of nonperforming assets and portfolio diversification;
Asset securitization shows a new direction to the traditional commercial banking in terms of not only to new low cost sources of fund but also provide an approach to minimize risk. Banks that actually want to transform their non-liquid assets into liquid assets can use asset securitization which allows them to use their capital more efficiently.
1.2 Financial System of Bangladesh
The financial system is a set of institutional arrangement through financial surpluses in the economy are mobilized from surplus units and transferred to deficit spenders. The financial system of Bangladesh consists of Bangladesh Bank (BB) as the central bank and Securities and Exchange Commission (SEC) who act as regulator. The main constituents of any financial system are: financial institutions, financial instruments and financial markets.
1.3 Financial Institutions
The modern name of financial institution is financial intermediary; it mediates or stands between ultimate borrowers and ultimate lenders. Financial institutions are generally classified under two main heads: a) Banks and b) Non-Bank Financial Institution.
There are 48 commercial banks and 29 non-bank financial institutions operating in Bangladesh. The banking financial institution includes 4 State Owned Commercial Banks (SCBs), 5 state-owned development financial institutions (DFIs), 30 private commercial banks (PCBs), and 9 foreign commercial banks (FCBs). Among the non-bank financial institutions, 1(one) is govt. owned, 15 (fifteen) are local (private) and the other 13(thirteen) are established under joint venture with foreign participation. Moreover, Micro Credit Regulatory Authority (MRA) has given license to 298 Micro-credit Organizations. The financial system also includes insurance companies, stock exchanges and co-operative banks. Insurance sector consist with 21 general insurance and 6 life insurance. It is dominated by the two large, state-owned companies, Sadharon Bima Corporation (SBC) for general insurance and Jibon Bima Corporation (JBC) for life insurance which together command most of the total assets of the insurance sector.
The commercial banking system dominates the financial sector with limited role of Non-Bank Financial Institutions and the capital market. The Banking sector alone accounts for a substantial share of assets of the financial system. The banking system is dominated by the 4 State Owned Commercial Banks, which together controlled more than 30% of deposits and operates 3394 branches as of June 30, 2010.
1.4 Financial Instruments
Financial Instrument is the financial claim of the holder against the issuer. Financial Instruments are of two types: Primary or Direct and Secondary or Indirect Financial Instruments. Primary or direct financial instruments are financial claims against real sector units. It includes loans & advances, shares, debenture. Secondary or indirect financial instruments are financial claims against financial institutions or intermediaries. It includes deposit, mutual fund, unit certificate etc.
1.5 Financial Markets
Financial market is the market where financial instruments are purchased and sold. From duration point of view the market is classified into two: money market and capital market.
Money market is a market where financial securities maturing in less than one year that is short-term fund are transacted. In Bangladesh the money market instruments are certificates of deposits, treasury bills, post office savings etc. The Capital market is a market for long-term funds. It is an important ingredient of the financial system, plays a significant role in the economy of the country. It facilitates an efficient transfer of resources from savers to investors and becomes conduits for channeling investment funds from investors to borrowers.
The SEC has issued licenses to 27 institutions to act in the capital market. Of these, 19 institutions are Merchant Banker & Portfolio Manager while 7 are Issue Managers and 1(one) acts as Issue Manager and Underwriter. There are two stock exchanges, Dhaka Stock Exchange (DSE) and the Chittagong Stock Exchange (CSE) which deal in the secondary capital market. As of March 2011 the total number of enlisted securities with DSE and CSE were 476 and 235 respectively.
Exposure of bond market is very limited though there is prospect of development of bond market. It mainly comprises with some government bonds and zero-coupon bond of different financial institutions. To promote bond market Bangladesh bank has taken many initiative like changing legal and regulatory framework and tax regime for zero-coupon bonds.
1.6 Rationale of the Study
The concept of asset securitization is very much new for the financial sector of Bangladesh. Though the concept introduced early in 2001, the actual issue of asset securitization begin through the issuance of Tk. 0.359 billion by Industrial Promotion and Development Corporation (IPDC) in 2004. Compare to other developing country Bangladesh is very much lack behind in this respect. There has been a lot of discussion about the potential of securitization in Bangladesh but little studies have been done about asset securitization. Securitization has tentatively started in the late 1970s. In 2007, Asset Backed Securities
(ABS) issuance amounted to $3,455 billion in the US and $652 billion in Europe.
- To describe the theoretical background of securitization.
- To see the current status of securitization in Bangladesh.
- To highlight the prospect of securitization in the financial sector of Bangladesh
- To identity the challenges faced by the issuers of asset securitization
- To provide some recommendation
Asset Securitization Process
2.1Asset Securitization Defined
Asset securitization is a financial instrument of structured finance in which loan interest and receivables are packed and sold in the form of asset backed securities (ABS) securities. Asset securitization maximizes capital & minimizes risk due to its diversification nature.
“Securitization” in its widest sense implies every such process which converts a financial relation into a transaction. (Kothari, 1999). It is a process of distributing risk by aggregating debt instruments in a pool, then issuing new securities backed by the pool (Dictionary of Finance and Investment Terms). It includes conversion of bank loans and other assets into marketable securities for sale to investors. Securities offered for sale can be purchased by other depository institutions or nonbank investors (Dictionary of Banking Terms). Securitization is a structured finance process that distributes risk by aggregating assets in a pool (often by selling assets to a special purpose entity), then issuing new securities backed by the assets and their cash flows. The securities are sold to investors who share the risk and reward from those assets (Wikipedia).
Generally securitization implies that it is the process where financial claims are converted into marketable securities. In the broader sense it is a process whereby cash flow or claim against third parties are recognized, combined, separated from the originator and then transformed into securities that can be offered to the investors.
So, securitization is a process by which:
- Intangible and illiquid assets are pool together
- Risks related to the specific assets are separated from the transferor’s
- Then it is sold to a special purpose entity(SPE)
- Securities are issued to investors by the SPE
Thus, the securitization concept is a combination of two aspects of today’s finance world: structured finance and capital markets. As the issued security are not in respect to generic risk of the entities all assets but to some specific asset which are bankruptcy remote from the entities balance sheet it leads to structure finance. It results into creation of security which is a capital market product.
2.2 The Cash Flow of Asset Securitization
In case of regular deal, cash flows received by the servicer of principal and interest payment are paid to the SPV. The SPV then pays the agreed interest and principal to the investors. The originating bank or company will normally continue to service the collections of receivables communicating with borrowers, collecting their payments and earning a fee for doing so.
Figure-2: Cash flow of Asset Securitization
Additionally, the originator also retains the excess of servicing that incur from the assets, minus the interest and other costs incurred by the SPV. The originator may sell the servicing rights to a third party.
2.3 Issuers of Asset Securitization
Following are the some of the common sponsors of asset securitization:
- Banking financial institution
- Non-bank financial institution
- Mortgage companies
- Insurance companies
- Quasi-government agencies
- Other companies
2.4 The Process of Asset Securitization
Description of the Structure
The above diagram shows a typical structure for a true sale securitization.
Step-1: Cash flow from obligator: The obligators/borrower remits principal and interest payments to the originator or servicer.
Step-2: Pooling and sale of asset: The originator initially owns the assets engaged in the deal. It creates a pool of assets and executes a legal true sale of the same to a special purpose vehicle (SPV). The assets will be serviced by the servicer (often the originator), for instance with respect to assets sold to the issuer, the originator will continue, on behalf of the issuer, to collect principal and interest from borrowers on such loan.
Step-3: Issue securities: The SPV funds the purchase of those assets by selling asset-backed securities with the help of underwriter. Investors will be free to sell the securities (the bonds) or retain them. Design of the instrument however would be based on the nature of interest that investors would have on the asset pool. In the case of pass-through issuances, the investors will have a direct ownership interest in the underlying assets, while pay-through are debt issued by the SPV secured by the assets and their cash flows.
Step-4: Distribution of securities: An investment bank will typically advise the originator on the business aspects of the securitization and will often structure the securitization transaction and the asset backed securities to the needs and risk profiles of the investors. The investment bank can also serve as placement agent, initial purchaser or underwriter of the asset-backed securities. Individual securities are often split into varying degrees of subordination. Each has a different level of credit protection than another: there is generally a senior (“A”) class of securities and one or more junior subordinated (“B,” “C,” etc.) classes that function as protective layers for the “A” class. The senior classes have first claim on the cash that the SPV receives, and the more junior classes only start receiving repayment after the more senior classes have repaid.
Step-5: Proceeds of issue of securities: The investors of the asset backed securities, which are typically pension funds, life insurance companies, mutual or hedge funds and other investors seek predictable and steady cash flow streams with a managed risk investment and easily tradable in a ready market purchase the securities. The investor purchases the securities, either through private placement and public offering. The proceeds are transfer to the underwriter.
Step-6: The underwriter transfers the proceeds from the investors to the special purpose vehicle (SPV).
Step-7: The SPV than paid the purchase price of the underlying asset of securitization transaction to the originator.
Step-8: A trustee or administrative agent is typically engaged to oversee the activities of the Issuing SPE. It sometime act as custodian, is typically engaged to hold the securitization assets and collateral security documents related to the transferred assets and the funds in cash reserves from the servicer and the liquidity enhancer. The servicer forward principal and interest payment of the cash flow from the securitized asset.
Step-9: The trustee forwards the proceeds from the servicer to the investors.
Step-10: The asset backed securities are often, but not always, rated by a nationally recognized statistical credit rating agency, who will evaluate the credit risk of the assets and the originator and the overall design of the securitization transaction, and recommend structural changes and credit enhancements to the securitization transaction to increase the likelihood of repayment of the asset backed securities.
Step-11: Liquidity enhancer support timely payments of interest and principal to the investor in case of hurdle to get the expected cash flow from the servicer.
Participants and Basic Elements of Asset Securitization
3.1 Brief History of Asset Securitization
Before 1970s banks generally funded their loan portfolio primarily by deposit and secondarily by debt. To cope with increasing demand of housing credit after World War II bank as well as other financial intermediaries sought ways for alternative sources of mortgage funding.
The asset securitization started in United States in February 1970 when U.S department of Housing and Urban Development created the transaction using a mortgage-backed security. The Government National Mortgage Association (GNMA or Ginnie Mae) sold securities backed by a portfolio of mortgage loans (Wiki).
Investment banker eventually establishes an investment vehicle to structure the cash flow from the isolated mortgage pools with segmented credit risk. Loan originator quickly realized that this process can be followed for other types of loan. Since 1980s the combination of superior technology and sophisticated investors helped to build up asset securitization as the fastest growing activities in the capital market.
In 1985, securitization techniques had been used for the first time to a class of non-mortgage assets like automobile loans. The marine Midland Bank made securitization of $60 million auto loan. In 1986, the first securitization of the credit portfolio of credit cards took place, amounting to 50 million dollars. In 1990s, securitization spreads to products from insurance, with issues that reach 15 billion dollars in 2006(wiki). As estimated by the Bond Market Association, in the United States, total amount outstanding at the end of 2004 at $1.8 trillion. As the result of the credit crunch precipitated by the subprime mortgage crisis the market for bonds backed by securitized loans was very weak in 2008 unless the bonds were guaranteed by Government agency.
In Europe the securitization marked developed in the late 198os. It developed rapidly in UK, Germany, Italy, France, Spain, Belgium and Netherlands in 1990s. Securitization also got attention in the Asian countries like China, Japan, Thailand, Hong Kong and India in 1990s. In Bangladesh first asset securitization were made by Industrial Promotion and Development Company (IPDC) of Bangladesh on November 08, 2004. Since then the securitization market has grown exponentially with aggregate securitization volumes exceeding $2.08 trillion worldwide at December 31, 2005.
3.2 Basic Elements of Asset Securitization
The Assets: Though mortgage loans are pioneer in the asset securitization market, but other financial claims can be securitized. Securitization can be done on any income producing assets with acceptable performance and risk. Consumer finance receivables like car loans, credit card receivables are important asset category that can be securitized. there are some other assets that are commonly used in the securitization which includes home equity loan, student loan, staff loan equipment loan and leases.
The security issued under asset securitization is a financial claim on the originator asset by the investors. It represents an accommodation between the originator’s needs, the payment characteristics of the underlying assets and investors’ preferences. The instruments may take a wide range of forms like fixed or floating rates, long and short term, fixed maturity or callable under conditions, publicly issued and privately placed.
3.3 Participants in Asset Securitization
The key parties involve in the securitization process are as follows:
Originator is the party who intends to securitize assets. They create and often service the assets that are sold to the special purpose vehicle (SPV). The originator includes commercial banks, investment banks, finance companies, thrift institutions and other companies.
Special Purpose Vehicle (SPV)
SPV is a bankruptcy remote entity, which purchases the assets that is to be securitized. It funds the purchase by issuing asset-backed securities into the capital markets. It is usually a subsidiary company with legal structure that makes its obligation secure even if the parent company goes bankrupt.
Servicer services the assets that are securitized. It includes collection of receivables from the underlying debtors. Basically originator act as servicer in most of the securitization transaction but third party can also work as servicer of the securitized assets. The servicer is paid with mutually agreed servicing fee.
The debtors are the person who has obligation to pay to the originator. They are not the active parties to the transaction, but their obligation to pay to the originator is transferred to the SPV.
The trustee is a third party retained for a fee to administer the trust that holds the underlying assets in the securitization transaction. The trustee is primarily concerned with preserving the rights of the investor as well as creditor. Generally, the trustee oversees the disbursement of cash flows as prescribed in the servicing agreement, and monitors compliance with appropriate covenants by other parties to the agreement.
Investors are buyers of the asset-backed securities. Examples of investors in the securitization market are: pension funds, banks, mutual funds, hedge funds, insurance companies, central banks, international financial institutions and corporate bodies and individuals.
The underwriter is the deal maker who undertakes to get the issuance subscribed. It is responsible for advising the seller about the structure, pricing and marketing. Underwriter has their relationships with the institutional investors and familiar with the legal and structural requirement.
The Liquidity Enhancer
The liquidity enhancer provides liquidity facility in relation to certain disruption in the cash flow from the securitized assets. When the SPV issues securities of short term nature and it is unable to refinance the maturing securities because of difficulties in getting expected amount of cash flows.
To evaluate the credit quality of the transactions, in terms of credit risk associated with the issuance of securities credit rating agencies plays an important role in case of structured finance like securitization. In case of public issue of securities credit rating is credible to investor for taking investment decision. Investors are generally accept rating by the major rating agencies. Standard & Poor’s, Moody’s and Fitch are the three reputable rating agencies. In Bangladesh there are four credit rating agencies available, Rating Information and Service Ltd. (CRISL), Credit Rating Agency of Bangladesh (CRAB), National Credit Rating Agency and Emerging Credit Rating Agency.
Cost of Asset Securitization
4.1 Cost of Asset Securitization
Benefits of securitization do not come without any costs. The cost of securitization is the cost that SPV needs to pay in order to securitize its assets successfully. We can divide the asset securitization cost into two groups: flexible cost and fixed cost.
Table-1: Cost Structure of Asset securitization
|Fixed cost:||Flexible cost:|
|Trustee fees||Interest cost|
|Servicer fees||Liquidity support fees|
|Legal fee||Underwriting fees|
|Rating agencies fee|
The fixed cost includes trustee fees payable to the trustee, legal fees payable to the regulator, audit and tax fees, rating agencies’ fees and other expenses. This part of the cost tends to be stable and it is not relevant to the quality of securitized assets.
The most direct flexible cost is the interest payment of the debt. It is the coupon payment that used to attract investors to purchase the securities. The rate of the coupon payment depends on several factors, such as the rating received for the securities, the credit and other risks inherent in the asset pool, expected prepayments and timing of the various cash flows, and other transaction risks such as servicer risk and potential forms of event risk. For interest-bearing assets, the coupon is normally paid from the interest payments, or yield, received from obligors. For assets that do not bear interest or whose yield is insufficient, the coupon is generated in the form of a discount upon issuance.
In addition to the interest cost, the transaction will incur ongoing costs for liquidity support fees. It refers to the taken by the originator in a securitization structure to enhance the security. Both of the coupon payment and liquidity enhancement are closely related to the quality of assets. As the quality of securitized asset changes, the flexible cost will change. Costs may be recognized in the financial statements of either the originator or the SPV. However, in both cases, the eventual economic obligation lies on the originator.
Probable Cost of Issuing ABS
The following table demonstrates the probable costs of securitization in Bangladesh under public issue and private placement options. It has been construed assuming issuance of 5-year maturity Asset Backed Securities (ABS) with a face value of Tk 5000 backed by a pool of assets worth Tk 200 million.
Table-2: Probable Cost Issuing ABS
|Cost Item||Rates and Tenure||Total|
|Amount(Tk. in Millions)||Accruing Period (Yr)||Percent|
|Expenses for Private Placement (Common Expenses):|
|Investment Advisor/Issue Manager (Structuring & Marketing)||2.00||One-Off||1.00%||1.00%|
|Trusteeship and facility management Fee||10.00||5||1.00%||5.00%|
|Stamp on Conveyance||10.00||One-Off||5.00%||5.00%|
|Legal Fee and Charges||0.10||One-Off||0.05%||0.05%|
|Certificate Printing & Holograms||0.28||One-Off||0.14%||0.14%|
|Stamp on Certificate||0.80||One-Off||0.40%||0.40%|
|SEC fee for capital issue||0.20||One-Off||0.10%||0.10%|
|Total (With Only Private Placement)||12.44%|
|Total Per Annum||2.49%|
|Additional Expenses for Public Issue:|
|Allotment letters, Refund Warrants, Envelops etc.||0.04||One-Off||0.02%||0.02%|
|Prospectus Publication (2 papers)||0.40||One-Off||0.20%||0.20%|
|Initial Listing Fee (2 exchanges)||4.00||One-Off||2.00%||2.00%|
|Annual Listing Fee (2 exchanges)||0.55||5||0.06%||0.28%|
|SEC fee for public issue||0.66||One-Off||0.30%||0.30%|
|Total Additional Per Annum (For Public Issue)||1.33%|
|Total for Life of Issue (Public)||19.07%|
|Total Per Annum (With Public Issue)||3.81%|
(Source: AIMS of Bangladesh)
Current Status of Asset Securitization
5.1 Current Status of Asset Securitization in Bangladesh
Asset Securitization in Bangladesh
Asset securitization provide prospect to the financial sector of Bangladesh to boost the income from better management of their idle assets. It provide efficiency in managing asset liability in terms of uncover low cost sources of funds. Now commercial bank of Bangladesh is facing difficulty in managing their liquidity. They do not have adequate long term sources of fund to meet the credit demand from the different economic sector. Asset securitization can help to work with the problem by giving an easy solution to meet the long term fund requirement. It brings together the expertise of commercial banks, investment bank, other financial institutions and even the individual investor. In Asia, securitization has taken an important place in the capital market development.
Asset Securitization in Bangladesh
|Originator||Year||Amount issued||Trustee||Types of Institute||Investors|
|IPDC||2004||Tk. 35.9 Crore||ICB||NBFI||Dhaka Bank, Jammuna Bank, Mutual Trust Bank, South East bank and International Leasing and Financial Services Ltd.|
|ULC||2005||Tk. 40 Crore||ICB||NBFI||BRAC Bank Ltd. The City Bank Ltd. Dhaka Bank Ltd. Eastern Bank Ltd. International Leasing and Financial Services Ltd. Jammuna Bank Ltd. Mercantile Bank Ltd. And United Leasing Company.|
|Tk. 19 Crore
Tk. 37 crore
|ICB||NBFI||Commercial Bank of Ceylon Ltd. BRAC Bank Ltd. The City Bank Ltd., Green Delta Insurance Company Ltd. And Reliance Insurance Ltd|
|BRAC||2007||Tk. 1260 Crore||EBL||NGO||FMO, Citi Bank N.A., The City Bank and Pubali Bank.|
Source: Annual Report of Respective Banks
From the beginning to till now securitization does not attain its proper stage of achievement in the financial sector of Bangladesh. There are many problems that are creating the hurdle like regulatory barriers, tax and incentive problems, knowledge and skill shortage and capital market problem.
5.2 Asset Securitization by IPDC
Industrial Promotion and Development Company (IPDC) of Bangladesh formally issued the country’s first asset-backed securitized bond on November 08, 2004, which opened the new window for the long term fund mobilization for the financial sector of Bangladesh. Loan and leases are transferred out from the books of accounts of IPDC to the Securitization Trust 2004-A, the Special Purpose Vehicle (SPV) created for securitization. Than the SPV issued of Zero Coupon Bonds that is backed by those pool of loan and leases. The Investment Corporation of Bangladesh (ICB) has been act as a trustee for the SPV which issued 35.9 crore worth of zero coupon bonds against debt receivables of IPDC. As the instrument is floated through private placement arrangement and credit rating is not mandatory for private placement, there is no credit rating agency involved in the process. Investors of the asset backed securities include Dhaka Bank, Jamuna Bank, Mutual Trust Bank, Southeast Bank and International Leasing and Financial Services Ltd. The move will obviate the dependency of IPDC on costly bank funds and provide it with funds at low cost. As a trustee of IPDC securitization, ICB will receive payments from the servicer and forward these to the investors.
Figure-5: Asset Securitization by IPDC
Because of high cost involvement and low demand for bond in the public placement IPDC issued the zero coupon bond in private placement. There is also legal compliance requirement from various regulatory authorities like SEC, Bangladesh Bank, NBR etc. As it a complicated instrument general investors have lack of knowledge about financial instrument like asset backed security.
5.3 Asset Securitization by IDLC
IDLC is finance company operating in Bangladesh. It at first issued Asset Backed Securitized
Zero Coupon Bonds with an issue value of BDT 19 core million on February 9, 2005 (IDLC, 2005). This was a significant achievement for the IDLC in terms of mobilizing funds, at lower cost that are using to assist in the industrial development of Bangladesh. The Investment Corporation of Bangladesh (ICB) is nominated as the trustee. IDLC Securitization Trust 2005 was formed to serve as the Special Purpose Vehicle (SPV). The SPV issued Zero Coupon Bonds against lease receivables of IDLC. ICB, being the trustee will handle the transaction receiving payments and forwarding these as per agreements. The investors under private placement includes Commercial Bank of Ceylon Limited, BRAC Bank Limited, The City Bank Limited, Green Delta Insurance Company Limited and Reliance Insurance Limited. Their drive to reduce funding costs, diversify funding sources and diminish reliance on conventional sources continued to witness significant progress in 2008. As per Trust Deed signed between IDLC Finance Limited (IDLC) and Investment Corporation of Bangladesh (ICB), a Trust named “IDLC Securitization Trust 2007-A” was formed and IDLC sold lease receivables approximately of Tk. 37 crore to the Trust to issue asset backed securitized zero coupon bonds. The Trust issued 50 class A bonds and 5 class B bonds of Tk. 5,000,000 each of which IDLC purchased all class B bonds bearing coupon rate of 7.75% per year. All class B bonds are subordinated to class A bonds. Any loss due to non-collection of lease receivables will be adjusted upto the amount of class B bonds held by IDLC.
Figure-6: Asset Securitization by IDLC
5.4 Asset Securitization by ULC
As per Trust deed dated February 7, 2005 between United Leasing Company Limited (ULC) and Investment Corporation of Bangladesh (ICB) a Trust in the name of “ULC Securitization Trust 2005-A” was formed and ULC sold lease receivable of Tk 40 Crore to the Trustee (ICB) to issue Asset Backed Zero-Coupon Bonds. Thereafter the Trustee issued 37 Class A and 3 class B Bonds of Tk 10 million each of which ULC purchased 3 class B bonds as credit enhancement to secure the interest of class A bond holders. Any loss due to non-collection of lease receivable in respect of class-A bonds held by the investors will be adjusted against the amount of class B bonds held by United Leasing Company Limited.
Figure-7: Asset Securitization by ULC
5.5 Asset Securitization by BRAC
In July 2006, BRAC entered into an asset securitization financing arrangement involving the sale of a designated pool of micro finance loan receivables (“Designated Loans”) to Eastern Bank Limited, to raise funds of up to an aggregate of Taka 1260 crore over a period of 6.5 years in return for financing through a trust formed for this purpose, known as the BRAC Micro Credit Securitization Trust. Eastern Bank Limited (EBL) is working as Trustee in the securitization arrangement. The investors are FMO, Citi Bank N.A., The City Bank and Pubali Bank. Under this arrangement, the Trust purchases the Designated Loans from BRAC and in turn, finances the purchase of the Designated Loans by issuing asset backed securities. BRAC retains the responsibility for collections and administering of the Designated Loans from VO members. Cash flows from the loan collections are remitted, based on agreed terms, to the Trustee according to the repayment patterns as per the VO loan agreements. Under the current arrangement, all the Designated Loans sold are for a maturity period of not more than 12 months.
Apart from the sale of the Designated Loans, BRAC is also obligated to ensure that collateral represented by other microfinance loan receivables (“Collateral Loans”) valued at not less than 50% of the Designated Loan outstanding balance, is maintained as additional security for the financing arrangement. In addition, BRAC is required to make a security deposit to the Trustee which may be applied towards payments for any amounts due to the Trustee in the event of insufficient funds. In the event of default by the VO members, BRAC is obliged to replace, substitute or reassign the Designated Loans or Collateral Loans in accordance with agreed pre-set criteria. As a result, the Designated Loans do not meet the derecognisation requirements and are therefore recognized in the financial statements even though they have been legally sold.
Figure-8: Asset Securitization by BRAC
Funds received from the sale of the Designated Loans are recorded as a liability in the Securitized Financing Account. Upon collection from VO members, BRAC is required to remit the collections based on the agreed terms to the Trustee, and this is accounted for through the Securitized Financing Account. Any prepayment of loans are separately accounted for, and applied as payments against the Securitized Financing Account as the loans mature.
Prospect of Asset Securitization
6.1 Scope of Asset Securitization in Bangladesh
The financial sector of Bangladesh is dominated by the banking industry, which now is facing an immense competition in terms of deposit mobilization and managing other sources of funds. Asset securitization can provide a new opportunity for the financial sector as it provide long term fund with comparable low cost. It also helps to build efficient capital market through flotation of security like bond, commercial paper etc. A vibrant secondary capital market in Bangladesh will benefit all the stakeholders in the financial chain. This includes issuers, investors, borrowers and financial sector as a whole. Recently, retail credit and mortgage-financing has been growing significantly. Specialized financial institutions and commercial banks have either started their mortgage financing. The major challenge for this financing remains with the availability of long term fund. A developed ABS market can play a great role in the development of overall financial sector of the country.
6.2 Benefits of Asset Securitization
Benefits to Issuers / Originators
Originators (the selling bank) gain from securitization by obtaining many of the benefits of high-credit quality financing without retaining the debt on their books and without forgoing profitable aspects of the assets, including origination, servicing, expansion of business, and retention of excess spread. The technique for determining the price paid can be complex and may require a significant initial investment of managerial and financial resources. Some relevant advantages include the following:
Improve balance sheet efficiency
A true sale securitization may move the assets off the originator’s balance sheet, contributing to an improvement of the relevant balance sheet ratios. For instance, to the extent that proceeds of the securitization are used to repay existing liabilities, this may reduce the originator’s leverage. Securitization can allow the originator to reduce its assets and debt, thereby increasing its scope for borrowing.
Reduce funding costs
Cost reduction is one of the most important motivations in securitization. Well-regarded pools of assets owned by a company or bank can be used to structure a security of higher credit quality, and therefore, of lower market cost than the corporate entity could issue itself. The weighted average cost of the securitization may be lower than the cost of the originator’s current composition of debt. Notably, this is often the case if the credit quality of the securitized assets is higher than the credit quality of the Originator’s balance sheet as a whole.
Sources of Financing
Funding in the form of the purchase price is to be paid by the SPV upon the sale and transfer of the securitized assets. Securitization allows the originator to diversify its funding sources away from banks and tap the capital markets (almost) directly, without having to issue securities on its own.
Retention of servicing revenues
The seller normally continues as servicer, retaining the servicing fees, the excess of the SPV’s revenue over costs, and surplus collateral once the ABS are redeemed.
Transfer of risks
Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does.
Future cash flows may simply be balance sheet items which currently are not available for spending, whereas once the book has been securitized, the cash would be available for immediate spending or investment. This also creates a reinvestment book which may well be at better rates.
Benefits to Investors
Asset-backed securities are not suitable for all investors as because they are more complex, but less liquid than other debt securities. Nevertheless, we can identify several reasons how investors in asset-backed securities can benefit in a number of ways, including the following reasons:
Asset-backed securities have been known to offer a yield premium over comparably rated government, bank and corporate bonds. The main benefit from the investor’s viewpoint is ahigher return or spread than is generally available on corporate or sovereign debt of a similar rating.
The securitization structure offers far greater liquidity than do the individual loans backing the transaction.
Asset-backed securities have historically often been less volatile as compared to corporate bonds.
Investors gain an opportunity to diversify their portfolios by participating in a different asset classes and risk trenches of their choice and generate the associated returns, which is otherwise not possible to invest in.
Mitigation of event risk
Unlike similar, high-rated corporate bonds, ABS are largely immune from event risk, which results from takeovers, restructurings and other phenomena that effectively alter the credit status of senior unsecured corporate obligations.
Coping with constraints
Many institutional investors are constrained to purchase only investment grade securities, and some are even limited to AAA rated instruments. Both requirements can be met in the ABS market.
Opportunity to invest in a specific pool of high quality credit-enhanced assets
Due to the stringent requirements for corporations (for example) to attain high ratings, there is a dearth of highly rated entities that exist. Securitizations, however, allow for the creation of large quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required to invest in only highly rated assets, have access to a larger pool of investment options.
Depending on the Securitization, hedge funds as well as other institutional investors tend to like investing in bonds created through Securitizations because they may be uncorrelated to their other bonds and securities.
Isolation of credit risk from the parent entity
Since the assets that are securitized are isolated (at least in theory) from the assets of the originating entity, under Securitization it may be possible for the Securitization to receive a higher credit rating than the “parent,” because the underlying risks are different. For example, a small bank may be considered more risky than the mortgage loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest (or, just as likely, the bank would be paying higher interest to its creditors, and hence less profitable).
Better matching with investment objectives
Securitization instrument have a great flexibility to match with the investment objectives of the investors. Those who are looking for high grade investment can invest in Class A group security but with lower yield and can get high yield from investing in Class B with lower grade security.
Benefits to Borrowers
- Securitization reduces the cost of fund which leads the bank to lend fund in lower rate.
- Greater availability of funds for credit expansion.
- Availability of funding for lower income groups.
- Creation of formalized credit scoring systems which ultimately result into a decentralized, formula-driven approach to mortgage origination and make the process extremely fast.
Benefits to Financial Industry
- Lender access to alternative funding sources
- Improved sustainability of longer term funding through long term debt market with reforms of contractual savings institutions like pension funds and insurance companies
- Potentially larger investor-base
- Lenders able to broaden target market, through risk sharing
- Long term debt market funding can help smooth financial cycles
6.3 Economic Impact of Securitization
The effect of securitization on the economies of different countries is still difficult to assess because the technique is in its infancy in many parts of the world. Nevertheless, in countries such as Australia, Canada, United Kingdom, and United States, where a high proportion of residential mortgages and other claims have been securitized, the gains to the national economy can be measured in the billions of dollars. In the United States alone, for example, at least $1,600 billion of mortgage- and asset-backed securities are outstanding. According to a conservative estimate, securitization in the United States reduces the annual cost ($1,600 billion) of financing for homeowners and others by 0.5%, freeing up $8 billion of resources each year.
But the case for securitization is actually even stronger than this. Asset securitization, if introduced in a transparent and orderly fashion, offers Asian countries additional gains from. Securitization is as necessary to the economy as any organized markets are. While this single line sums up the economic significance of securitization, the following can be seen as the economic merits in securitization:
Creation of markets for financial claims
By creating tradable securities out of financial claims, securitization helps to create markets in claims which would, in its absence, have remained bilateral deals. In the process, securitization makes financial markets more efficient, by reducing transaction costs.
Disperses holding of financial assets
The basic intent of securitization is to spread financial assets amidst as many savers as possible. With this end in view, the security is designed in minimum size marketable lots as necessary. Hence, it results into dispersion of financial assets. One should not underrate the significance of this factor just because most of the recently developed securitization has been lapped up by institutional investors. Lay investors need a certain cooling-off period before they understand a financial innovation. Recent securitization applications, viz., mortgages, receivables, etc. are, therefore, yet to become acceptable to lay investors. But given their attractive features, there is no reason why they will not.
The availability of financial claims in a marketable form, with proper assurance as to quality in form of credit ratings, and with double safety-nets in form of trustees, etc., securitization makes it possible for the lay investors to invest in direct financial claims at attractive rates. This has salubrious effect on savings.
As discussed above, securitization tends to eliminate fund-based intermediaries, and it leads to specialization in intermediation functions. This saves the end-user company from intermediation costs, since the specialized-intermediary costs are service-related, and generally lower.
Financial intermediation is a case of diffusion of risk because of accumulation by the intermediary of a portfolio of financial risks. Securitization further diffuses such diversified risk to a wide base of investors, with the result that the risk inherent in financial transactions gets very widely diffused.
Focuses on use of resources, and not their ownership
Once an entity securities its financial claims, it ceases to be the owner of such resources and becomes merely a trustee or custodian for the several investors who thereafter acquire such claim. Imagine the idea of securitization being carried further, and not only financial claims but claims in physical assets being securitized, in which case the entity needing the use of physical assets acquires such use without owning the property. The property is diffused over an investor crowd. In this sense, securitization carries Gandhi’s idea of a capitalist being a trustee of resources and not the owner. Securitization in its logical extension will enable enterprises to use physical assets even without owning them, and to disperse the ownership to the real owner thereof: the society.
Bank Regulation and Securitization
Regulation of bank capital began to link required minimums to a bank’s asset risk with agreement among international regulatory authorities in 1988 to the Bank of International Settlements (BIS) Capital Accord (implemented in 1992). According to the regulation bank needs to hold a minimum level of regulatory capital. Under Basel I framework, that capital was a very rough function of the level of risk held in their assets. For instance, a loan to a firm needed 8% of capital, no matters what the risk of the firm was. That is one of the main reasons why banking supervisors engaged in 1999 in a thorough revision of the current capital regulatory framework. That process ended up in the so-called Basel II framework2, in which the capital requirements of banks will be better aligned with the risk profile of their portfolios. In this way, they will be obliged to hold a higher level of capital for loans granted to high-risk borrowers. The commercial banks may attempt to reduce their required regulatory capital-asset ratio by securitizing assets. Thus, capital regulation may be driving the increase in securitization.
Capital requirements and mandatory reserves give financial institutions an incentive to fund assets at a lower cost and free up their capital. On this basis, securitization has been adopted by many banks and savings institutions — as a means of reducing regulatory capital requirements without noticeably raising their cost of capital. In general, regulatory costs or rigidities create an incentive for banks to shrink their balance sheets by securitizing loans. Yet regulatory factors alone cannot explain why securitization has grown so fast. Many non-bank financial institutions and corporations have also chosen to finance their assets off the balance sheet. Where investors have poor information about the issuing company, or do not like its management, or where the capital market suffers other imperfections, asset securitization can be a technique that benefits both issuer and investor. The key lies in the idea that investors often prefer assets (and hence are satisfied with a lower rate of return) that have been legally removed from the company’s ownership and/or control.
6.4 Securitization and Risk Management
Securitization is more than just a financial tool. It is an important tool of risk management for banks that primarily works through risk removal but also permits banks to acquire securitized assets with potential diversification benefits. When assets are removed from a bank’s balance sheet, without recourse, all the risks associated with the asset are eliminated, save the risks retained by the bank. Credit risk and interest-rate risk are the key uncertainties that concern domestic lenders. By passing on these risks to investors, or to third parties when credit enhancements are involved, financial firms are better able to manage their risk exposures.
In today’s banking, securitization is increasingly being resorted to by banks, along with other innovations such as credit derivatives to manage credit risks.
Challenges of Securitization
7.1 Challenges of Securitization for FSB
The concept of securitization is complex and sophisticated in terms of its legal aspect and administration aspect. It legally isolates securitized assets from the books of originator to the SPV-a bankruptcy remote entity. To successfully achieve the goals of securitization it must be true sale-the originator does not retain any residual beneficial interest in the underlying asset. True sale mainly focuses on whether the transaction has transferred the economic benefits and risks to the SPV. This includes fulfillment of conditions like the fair value of assigned assets and payments for them to be matched, and the originator having no repurchase obligation and has no recourse to the assigned assets. Besides being unaffected by the originator’s bankruptcy, it is imperative that the SPV be remote from its own bankruptcy. This is accomplished by restricting the scope of operations of the SPV in order to secure its independence. Usually the central bank or other respective authority has laid down certain criteria to secure the independence of SPV. This includes clauses such as originator holding of equity in the SPV or having any of its directors, officers, or employees on the board of SPV. To cover all those issues, it is better to have a separate law for asset securitization. In Bangladesh, there is no such law. India has enacted a separate law titled Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests Act, 2002.Bangladesh Bank, SEC, and NBR have already settled a number of crucial issues to facilitate the launching of securitized bond in the country. To establish bond market, government has drastically cut interest rate on different government securities. The stamp duty and registration fess for transfer of assets to the SPV have been substantially lowered. NBR has cut down tax rate on return on investments (ROI) for the instrument. But these initiatives are insufficient for the development of a bond market.
7.2 General Impediments for Securitization
Credit Rating Agencies
There are four credit rating agencies operate in Bangladesh. It includes Credit Rating Information Services Limited (CRISL), Credit Rating Agency of Bangladesh (CRAB), National Credit Rating Agency, and Emerging Credit Rating Agency. Ratings are paid for by the issuers of bonds and other forms of tradable debt, not by investors. So there is prospect that higher rating is given with the influence from the originator. Charge of the credit rating also increases the cost of the securitized funds. Issuers can do little but grouse quietly because they need the rating in order to issue bonds (The Economist, 2005). This is a global problem regarding the rating agencies. The credit rating agencies operating in Bangladesh lack the required experience and sometimes fall short of international standard. Basically credit rating is done by the banking industry of the country on the basis of overall balance sheet exposure. But the individual corporation is lack behind in this perspective.
Third Party Servicers
There are no third party servicers available for securitization in Bangladesh. Servicers are required to provide customer service and payment processing for the borrowers in the securitized pool and collection actions in accordance with the pooling and servicing agreement. Servicers also provide default management and collateral liquidation. It becomes crucial if the originator fails to act as the servicer in a proper and timely manner.
Secondary Market for Securities
The bond and debenture market in Bangladesh is very