More securitisation will help
Business Standard, 29 June 2020
Securitisation is a valuable element of the modern financial system. It is particularly useful under Indian conditions, and in addressing the present Indian situation. Some things went wrong with securitisation in the US, prior to the 2008 crisis. The remedies for this are well understood. RBI is on a useful incremental process of addressing the regulatory difficulties. More work is required, particularly on taxation, in order to remove the barriers that hold back private persons. There is an important line between central planning and addressing market failure.
Consider a firm which has given out 1000 home loans of Rs.1 million each. The idea of securitisation is to assemble these into an asset pool of Rs.1 billion, cut this into a billion pieces which are securities, and convert an opaque illiquid asset into something that trades on the securities market, with properties like liquidity and transparency.
The cashflow from the 1000 home loans can be cut up and directed into two kinds of securities: the "senior" (who get cash first) and the "subordinated" (who get whatever residual cash is left after the senior securities have been paid). The subordinated securities then bear all the credit risk, while the senior securities are extremely safe. By doing this, we convert a homogeneous pool of 1000 home loans into a higher risk security and a lower risk security.
While this example is phrased in terms of home loans, securitisation can be done for a very wide array of assets. The key insight is to achieve the size thresholds at which liquidity can be obtained on the securities markets, by pooling multiple assets.
The original idea of securitisation was motivated by the idea that banks are wobbly and highly leveraged firms. As Nobel laureate Merton Miller puts it, banks are a disaster-prone 19th century industry. Securitisation is a way for banks to use their branches and give out loans, and then the securities are sold off to the institutional investors. The institutional investors get to choose between low risk and high risk bond-like assets. Banks benefit as they earn a services fee for their work of giving out home loans, but avoid the balance sheet size of holding the assets for long years.
In the Indian context, there are a few important dimensions in which securitisation is a useful solution. Public sector banks get large deposits owing to the sovereign guarantee, and find it difficult to interact with the economy and giving out loans. If public sector banks will purchase securitisation assets, then this puts their large assets to a good use.
A large part of India is underserved by the formal financial system. A variety of innovative business models, including fintech innovations, can be built by private firms. They are called "originators". They can reach out all across India, and give out loans to households and small firms. Securitisation is a key technology through which these assets can be funded by the wholesale debt market in Bombay, thus avoiding the requirement for these innovators to build up large balance sheets. When a foreign investor buys Indian securitisation paper, this is a way of avoiding the difficulties that hamper a significant subset of the Indian financial system. In India today, balance sheets of households and small firms all across India are under stress, and these activities would be particularly valuable.
In the 2008 crisis, some things went very wrong in the US with securitisation. The investors in securitisation paper used credit rating agencies to thoroughly analyse the paper that was being rated, and blindly trusted the rating. But it turned out that credit rating agencies were taking fees for rating this paper and were not doing the work that they were supposed to do. When the behaviour of originators was not checked by the credit rating agencies, originators found higher profits by giving out a larger quantity of poor loans.
These problems can be addressed through two lines of attack. First, a small slice of the first loss should be held by the originator. If, for example, the originator suffers the full loss for the first 5% of the defaults in the pool, this ensures that the originator has skin in the game and will not recklessly give out loans. The second line of attack lies in improving information access for the end investors. In this computer age, it is possible for originators and investors to establish daily flows of information, through which the investor has access to continuous facts about performance of the pool.
Despite these important benefits from organising loans, originators, and institutional investors including FIIs, the evolution of these activities in India so far has been disappointing. In recent months, RBI has made good progress with a pair of expert committee reports (led by Bahram Vakil and Harsh Vardhan), and has come out with a draft of regulations for securitisation which makes many incremental improvements. Particularly given the difficulties in the economy, this work is important and valuable.
While RBI regulation of banks and NBFCs shapes securitisation, there are numerous other constraints that are posed by taxes, capital controls, regulation and law. In the journey of Indian finance, the policy landscape is a maze of constraints. Many pieces of policy work have to all be done before significant market activity can arise. While it appears disheartening to push on one piece (e.g. the new RBI draft regulations), while knowing that the other pieces are not yet in place, we have to find the fortitude to chip away in this fashion. The Ministry of Finance needs to bring together the multiple pieces of the puzzle, particularly tax policy, and coordinate progress on all of them.
There is a temptation, in regulation making, to pin down business models, for officials to play finance practitioners. This temptation should be resisted. There are only two big ideas for policy with securitisation: originators should have skin, and investors should have data. Apart from this, private firms know best how to organise their business.
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