Understanding Securitisation Process And Its Implication On Financial Stability

Definition of Securitisation

Securitisation can be defined as a process in the issuers with merging or pooling different types of financial assets, designs the market instruments into one group. The process also involves the acquisition of liquid asset of the Group And Transformation of the same into the security of the company. The process of securitisation started in the year 1970 and it was pooled back by the US government agencies. Further, the process again came into consideration in the year 1980 when different income producing assets stated to get securitised. Further, it has been also evident that the along with the growth of the market the securitisation process has evolved significantly. However, there are many studies which contend that the securitisation process can significantly affect the financial stability of a system since the process involves different orientation of poor credit as well as inadequacy of the valuation methods. Further, it has been also evident that there were various regulatory oversight related inefficiencies which affected the process of securitisation to significant extent. Moreover, it is also evident that the increase in the number of financial organisations employing securitisation process has allowed in the transfer of credit risk of the asset from the balance sheet. Firms has initiated the process of securitisation due to various reasons. Primarily, it is cheaper for them to gather funds with the securitisation process and it becomes less costly for financial institutions to hold the financial regulatory standards. As per the principal, it was evident that the process of securitisation allowed in improvement in different economic benefits for the organisation [2]. With the help of securitisation, it was evident that organisations were able to spread its credit exposures which further diffused the risk concentration and allowed in the reduction in system vulnerability present within the system. In the initial period, the process of securitisation was very much positive and firms expected that the process would bring future economic benefits towards them. However, after the subprime crisis, it was quite evident that the process of securitisation had massively affected the overall economic situation of firms and has massively affected their lending capabilities and investments. Post the subprime crisis, investors were more encouraged to take risks in order to yield higher return for them. Therefore, the loans that were taken and securitised was not mentioned in the balance sheet which might have caused a significant amount of deuteriation of the overall lending as well as the collateral standards. It is also evident that the process of securitisation has encouraged the originators to cut back borrowers thereby affecting the overall financial system to significant extent. The following section of the analysis will discuss about the process of securitisation, its importance, involved parties of the securitisation process as well as will also denote the legal risks associated with securitisation. Afterwards, an analysis and evaluation of the discussion section will be carried out to understand the topic.  

Securitisation process is very simple and involves two steps. Simply put, the process involves the entity to securitise the assets and sell stream of cash flows but not borrows it. The issues create a financial product which is combined by other financial assets and provides them to investors for the issuance of funding. It is also noteworthy to mention that the performance of such security is entirely dependant on the asset’s performance. The process is entailed via a diagram below 

Process of Securitisation

In the first step, it has been evident that a firm which has loans or any asset that produces income for them identifies the type of asset that they want to remove from the balance sheet of the company. The company then moves the asset into the reference portfolio. The asset afterwards is sold to the issuer which may comprise a special purpose vehicle (SPV). SPV is an entity set up of financial institutions who purchase the assets and realise the balance sheet treatment for the asset for accounting purpose. Further, in the second step, the acquisition of the pooled asset gets financed by the issuer who issues the asset as tradable and thereafter sells them to the capital market investors. From the trustee account of the reference portfolio, the investors get the fixed or floating rate payments. Generally, such payments are funded from the cash flow of reference portfolio and most of the times, the originator can service the loans in the portfolio, collects money from the borrowers and passes them to the trustee or the SPV.

The securitisation process in fact can represent a diversified source of funding which is based on the transfer of credit risk including the currency and interest rate risks. This type of risks gets transferred from the issuer to the borrower with the securitisation process. After the recent refinement of the securitisation, there has been several tranches of the reference portfolio which includes the levels of risks associated and those are sold separately. According to the researchers, any number of returns and losses allocated in different types of tranches. The first tranches include the call on the generated income while the foremost tranches were found to get last claimed on the income. There is a three-tier structure included within the process of securitisation which includes the junior, mezzanine as well as senior tranches. In the junior tranches, the expected portfolio structure is involved however it faces the higher return and risks related to credit exposure. Further, the senior tranches are sensitive towards the changes. Further, it has been also evident that in the senior tranches, the amount of loss is very minimal since with the help of borrowing, the investors finance their purchase. However, it is also noteworthy to mention that whenever there are high risks along with repayment related issues in the initial tranches, it has been seen that lack of confidence across investors of senior tranches are found which caused panic across them and thereby significant amount of sale of the securitised debt or receivables.

In the initial stage, the process of securitisation was just used to finance different types assets including trade receivables as well as mortgage payments. However, it has been also evident based on the current set of assumptions that any assets which has stabilised cash flow generation can be structured into the reference portfolio thereby supporting the securitisation process. In this process one entity pools their interest in future cash flows and thereafter transfers the claims of the future cash flow to another party. The purpose of the asset securitisation is to hold the claims and other entity’s issued security are usually back up by the future cash flow of the business. After the period of realisation, it has been perceived that the cash flow can pay principal amount as well as interest rate towards the stakeholders of the business over time. However, the investors will not get paid from the different credit support sources. Any entity including private and public corporation can begin the process of securitisation and the process entails a financing where one part of entity securitises its assets and other entity gets the claims of the asset.

Types of Tranches

The securitisation process starts with an organisation which takes loan from financial institutions or firms. The financial institution which provides the loan always expects that the borrower has significant amount of asset in their balance sheet and they will be able to pay off the loan over time and with the payment of interest and principal amount in a timely manner. The company which originates the loan is known as originator who can be banks or any financial institutions. Originator can identify pool of trade receivables or other receivables that meet the criteria of another entity who is known as Special Purpose Vehicle or Special Purpose Entity. The pool of trade receivables is always transferred at the par value and the SPV always tend to hold the asset and pay the originator (banks or any financial institutions) from the issuance of securities. This indicates that the SPV will always issue securities to off the financial institutions for the trade receivable or asset pool that they have borrowed.

Credit rating agencies always evaluates the securities that have been issued by the SPV to the general public. Further, credit rating is always obtained from the originator or the financial instructions. The credit rating is primarily based on the quality of the trade receivable pool and not on the credit condition of the firm. After the SPV issues the securities, the SPV is liable towards the investors for their securities and they must pay the principal amount along with the interest rate in future in order to make the process seamless. Further, it is also understood that at the later stage when the cash flow of asset or receivables pool are realised, the SPV will have to use the same amount of cash flow to pay off its investors for the securities that have been priorly issued by them. In this way, the previously issued securities gets backed up with the trade receivables or asset pool. The investors to whom securities are issued includes insurance companies, pension funds as well as the mutual funds.

In order to understand the acceptability of the statement ‘It is undoubtedly true that any receivables can be repackaged through the process of securitisation as a means to raise finance from the public’, it is essential to comprehend the importance of the securitisation of trade receivables without which it will not be clear about how trade receivables can improve public financing. The following section of the analysis denotes the importance of securitisation of trade receivables.

Accounts receivable or trade receivable securitisation involves the conversion of accounts receivable into cash and individual trade receivables are added as a new security which thereafter are sold as an investment instrument. With the help of trade receivable securitisation, the cost to the issuer will be low due to the fact that the SPE or SPV can isolate the trade receivables from any other existing risks with the organisation. Therefore, the credit rating for the SPV will remain high with this process however it is noteworthy to mention that the credit rating needs to be issues by a credit rating agency .The credit rating agency will analyse various factors such as the historical performance of the receivables, debtors’ concentration of the pool as well as will analyse the conservatism of issuer firms’ credit along with collection policies. It has been also apparent that as the debt passes through the SPV, the same amount of debt is not recorded within the balance sheet of an organisation. Instead of wating for customers to pay for their bills, an organisation can improve the cash inflow within their business with the help of securitisation of trade receivables. It is also noteworthy to mention that if there is a considerable amount of separation between the SPV and the firm, the low interest cost of receivable securitisation will be able to get achieved.  The same will be accompanies with the transfer of trade receivable to the SPV as nonrecourse sale when the creditors of the firm will not be able to access the transferred amount of trade receivables.

Importance of Securitisation

As compared to the cost of corporate debt, the trade receivable securitisation can allow an organisation to legally isolate an asset from the bankruptcy estate of a firm and transactions thereby reducing the risk profile of the organisation. Further, it has been also evident that the securitisation process will allow banks to commit significant amount of funding as compared to the conventional credit facilities therefore firms can benefit from banks with the process of trade receivables securitisation [9]. In addition to this, it can be also noted that the securitisation process can also improve the capacity of banks as well as other financial institutions to provide different forms of credit related commitments. With the help of securitisation, an organisation can be able to improve its liquidity position as well as will be able to diversify the funding sources. Further, it can be also noted that the process of securitisation can allow an organisation to enhance the enterprise value of an organisation therefore the process of securitisation can be one of the best decisions for firms to raise finance from public.

The originator or the financial institutions gains the maximum number of benefits from the securitisation process and it has been found that the originator can recover the amount that has been lent with the help of securitisation. Further, the illiquidity assets such as the trade receivables are converted into liquid assets with the process of securitisation. The risk of bad debts can be also get transferred with the help of the trade receivable securitisation process and if in any case the recovery of the debt remains uncertain, the securitisation of the same needs to be made in order to reduce the number of losses. From the point of view of an investor the process of trade receivables securitisation can improve the return on investment and purchasing quality investments will provide the investors with feasible and reliable amount of investments. Further, it is also evident that the securitised assets carry lesser amount of credit risk as they are treated separately from the parent company. As per the risk-taking ability of an investors, the trade receivable securitisation can provide better returns to the investors. With the securitisation of bonds, an investor will be able to make significant amount of return from their investments and the securitisation process can also benefit small investors.

The process of securitisation includes the following parties

Originator- the originator are the parties such as the lenders as well as financial institutions which creates the asset that is going to be securitised.

Aggregator- an aggregator purchases the similar asset from the originator to create a asset pool which will be securitised during the process

Depositor- the depositor creates the SPV for the securitized transaction of the asset. The role of the depositor is to acquire the pooled asset from the aggregator and deposit them in the SPV.

Issuer- the issuer acquires the asset that has been pooled and a certificate is issued after which the asset gets sold to investors. The investors are not directly offered with the certificates during the sale process instead the issuer provides the certificate to the depositor in exchange of the pooled asset. Simply put, the issuer is the SPV holding the pool of asset and has a role to play as a conduit for the cash flow of the asset that has been pooled.

Legal Risks Associated with Securitisation

Underwriter- the underwriter is the investment bank which purchase the SPV certificates from depositors. The underwriter has the responsibility to offer the SPV certification for sale to the ultimate investors who are purchasing the asset. During the process, the amount of money paid by the underwriter is provided to the depositor then to the aggregator and finally to the originator as a purchase value of the asset that has been pooled.

Investor- the investors usually purchase the certificate issued by the SPV and every investor should receive monthly payments of the principal as well as interest amount from the SPV. Further, the interest rate that is paid to the investors usually depends on the class of certificates that has been purchased. The SPV primarily plays a role in distributing the cash flow of the pooled asset to the investors.

Trustee- the trustee is primarily concerned to understand the issuance of the SPV and also plays a key part in protecting the investors interest with the calculation of cash flows from the pool of assets.

Servicer- the service is a party which collect the amount of money that has been due from the borrower for each individual loans of the asset pool. The collected funds are then transferred to the trustee for the distribution. The collection fees related to servicing of pooled loans are collected by the servicers.

It is noteworthy to mention that SPV does not have a physical appearance and it does not involve any physical location. The goal of SPV is to transfer the asset through the process of securitisation as well as create some financial instruments. For the purpose of holding the transferred asset and issuance of securities backed by the pooled assets, the SPV are created. It is also noteworthy to mention that the credit rating agency will have to assign a credit rating for the issuance to be marked as marketable. Credit rating agency then provides their opinion on the quality of the asset pool and the credit rating is provided on the basis of the asset pool. The securitisation transaction needs to have AAA rating in order to remain attractive to the investors.

Due to the vast number of regulations and judicial decisions affects the process of securitisation, it has been evident that the securitisation process can require facilitation of the creation of transparent and well established criteria for each and every transactions. Further, it is also evident that there is an absence of well-established standard and criteria’s concerning securitisation which further can affect the process significantly. In many developing countries, it is evident that the process of securitisation is still structured within the property, trust and contract law which significantly broadens the problem.

One of the key legal issue concerning the securitisation process lies in understanding the true sale of receivables. Often, it gets difficult to understand whether the transfer of the receivables has created a true sale or not and whether the originator has any further claim over the receivables or not. Without true sale, it is also not possible to understand whether the true sale of asset has made the bankruptcy from the originator implying that the originator will not have any affect towards the claims of investors in relation to the securitised asset pool. Further, studies have also denoted that if there are any legal disputes raised over the creation of asset, the same can result in uncertain situation which further can create uncertainty in the pay-out of an investors. Investors will have to face outweigh loss if there is a lack of legal framework or issues associated with legal framework. Further, it is also often difficult to comprehend whether the securitisation process has made a perfection of sale. Perfection of sale can be only relate to the rights of the seller and does not relate to the obligations of the receivables.

Evaluation of the Impact of Securitisation on Financial Stability

In the securitisation process, it has been also evident that the risk related to the securitisation process depends within the securitisation process as well as the collateralised lending. The jurisdiction which is not associated with the securitisation process can create a legal separation of the originator from the true sale of the asset. However an originator always have the right to make the sale perfect when they proceed with U.S filling of the UCC financial statement and performs his administrative duties on the basis of the sale. Further, it has been also evident that the transfer of the asset can enhance the corporate tax liability of the originator in relation to the accounting treatment which is applicable to the asset that have been transferred and are applicable to the asset]. As compared to the traditional securitisation process, the traditional securitisation process can include different types of operational issues in relation to the transfer of exposures.  In order to improve the remoteness of bankruptcy, it is essential for the SPV organisations to limit the business activities and improve the legal framework. Further, from the incurrence of the indebt ness, the SPV can be prohibited in issuing guarantees or indemnities.

Despite conventional as well as synthetic securitizations have similar structures and are frequently used to attain the same purposes, the legal dangers are not the same. The fundamental purpose of a bank's securitization is to eliminate the risk of borrowers defaulting on their loan payments towards the bank. Because the danger of borrowers defaulting no longer affects the bank's risk estimates of future prospective obligations, the bank is able to free up additional capital that may be utilised for new loans. Securitization thus acts as a type of insurance for the bank: if the borrower defaults on his payments, another third party will cover the loss.  Traditional securitization is based on the concept of legally transferring a number of specified assets, as well as all potential consequences, from the originator and his balance sheet. Presumably, the formation of a formal separation and a real sale of the assets will be the source of the bulk of the legal dangers involved with this operation. Synthetic securitisation is predicated on contractual agreements between multiple parties that transfer some of the financial interests of the assets through this so derivatives trading, rather than on the real transfer of the physical assets. The legal concerns of synthetic securitisation will consequently be more reliant on the contractual wording and credit derivatives definitions than on the development of a judicial separation of the assets . With the distinct legal dangers of conventional and synthetic securitization in mind, a link can be drawn between the continental European securitisation market's stalling development and the legal base provided by civil law states. As a result, these financial structures have been tailored to match common law jurisdictions' rules and practises. Legal issues are sure to occur when merely integrating the Anglo-American securitisation paradigm into the civil law legal system.

However, because traditional securitisation, more than synthetic securitisation, is based on common law notions and legal tools that are unfamiliar to some civil law countries, the synthetic structure's more flexible attributes work to its benefit. The universal concept of contract freedom protects the parties to a synthetic securitisation from legal hazards posed by jurisdictional differences, whereas the parties to a traditional securitisation are more constrained in their development by statutory restrictions. Although there are various legal dangers and uncertainties associated with synthetic securitization, these are unrelated to the civil law legal framework, and hence the civil law initiator of a synthetic structure can compete on the same terms as the rest of the world.

In recent times, it has been evident that the process of securitisation has been significantly evolved and it is now not focused only on the trade receivables saucerisation. It has been found that the traditional asset with bank loans as well as mortgages were no longer needed. Further, it has been also evident that the improvement in the modelling as well as risk quantification has allowed in greater availability of data and information with which the issuers were encouraged to issue variety of assets. The assets include lease receivables, home equity loans as well as other small business loans. Securitisation has perceived rapid growth not only in the matured market but also in the emerging market which shows that the corporate entities as well as banks has used the securitisation process to improve their future cash flows. In future times, it can be ascertained that the securitised products will get simpler and there will be no capital reserves against the high rated securitized debt which will allow the issuer to improve the valuation and will require them additional amount of capital. However, it is also evident that the securitisation process revival would require the issuer to retain their interest based on their securitised asset at every seniority levels.

Based on the analysis it can be noted that the trade receivable securitisation can be one of the best options for firms to get public financing however the firm must have to maintain total receivables of $50 million dollars or more in order to become profitable. With the help of differentiated innovative structuring, the process of securitisation can allow an organisation to get direct access to capital markets. Further, the process can also allow an organisation to improve the value of asset and support the current operations which will allow the firm in future growth.

Further, the improvement of SPV’s operation can be only achieved with the proper coordination and operations with the minimization of risk, it can reduce the risk that might swept to the bankruptcy. While the risk level of conventional bank remains structured, the risk level can also be higher and when the bank arranges the process of securitisation, the primary gaol of the securitisation process will be also achieved with the transfer of specific assets. When compared to the cost of corporate debt, trade receivable securitization allows an organisation to legally separate an asset from a firm's bankruptcy estate and transactions, lowering the organization's risk profile. Furthermore, it is clear that the securitisation process will allow banks to commit a large amount of money in comparison to traditional credit facilities, allowing enterprises to profit from banks' trade receivables securitization process. Furthermore, the securitisation procedure can strengthen the capacity of banks and other financial institutions to issue various types of credit-related commitments. Securitization allows a company to strengthen its liquidity position while also diversifying its funding sources. Furthermore, it should be highlighted that the process of securitisation may help an organisation increase its enterprise value, making it one of the finest ways for a company to obtain funds from the public.

Conclusion

On a concluding note, this paper has established the process of securitisation as well as analysed how the securitisation of trade receivables has allowed in raising finance from public. It has ben also found from the analysis that securitisation process contains different parties and there have been various types of legal risks associated with the securitisation process. In recent years, it has been clear that the securitization process has grown dramatically, and it is no longer only centred on the saucerization of trade receivables. It was discovered that traditional assets such as bank loans and mortgages were no longer required. Furthermore, it is clear that advances in modelling and risk quantification have resulted in a larger availability of data and information, that has enabled issuers to issue a wider range of assets. Lease receivables, home equity loans, and other small company loans are among the assets. Securitisation has seen tremendous development not just in the developed market but also in the emerging market, indicating that business entities and banks have exploited the process to strengthen their future cash flows. It may be predicted that securitized products will become easier in the future, and that there will be no capital reserves against high-rated securitized debt, allowing the issuer to raise the value while requiring extra money. However, it is clear that the resurrection of the securitisation process would need the issuer retaining their stake in their securitized asset at all levels of seniority. According to the findings, trade receivable securitization may be one of the best solutions for businesses seeking public funding, but the company must have total receivables of $50 million or more in order to be successful. The practice of securitisation can provide an institution with direct access to financial markets via the use of distinctive creative structure. Further, the method may also assist an organisation to boost the value of asset and support the existing operations which will allow the company in future growth. Furthermore, the enhancement of SPV operations can only be accomplished by good coordination and operations with risk reduction, which can lower the chance of bankruptcy. While a traditional bank's risk level remains organized, the risk level may also be greater, and when the bank organises a securitisation process, the primary purpose of the securitisation method will also be met with the transfer of particular assets. When compared to the cost of corporate debt, trade receivable securitization allows a company to legally segregate an asset from the bankruptcy estate and transactions of a company, lowering its risk profile. Besides this, it is apparent that, in comparison to the traditional credit facilities, the securitization system will enable banks to invest a substantial amount of money, allowing businesses to profit from the banks' trade receivables securitization process. Additionally, the securitisation process can help banks and other financial institutions increase their ability to issue various forms of credit-related commitments. Securitization enables a business to improve its stability while also diversifying its funding sources for public. Moreover, the method of securitisation may assist an organisation grow its enterprise value, making it one of the most effective ways for a corporation to raise cash from the general public.

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