genesis institute of business managementpune

8/14/2019 Genesis Institute of Business ManagementPune

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Manoj Kumar JaiswalPGPMM-1

Genesis Institute of business Management-Pune

SecuritizationAct in IndiaAnd its impact


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ACKNOWLEDGEMENT

I take this opportunity to express my gratitude to all, those how helped me in making this Dissertation

where it stands today. Since in the beginning I am very thankful to Prof. Parikshit Vaid, Faculty of

Finance from GIBM Pune. Who have gives me a wonderful opportunity to work on this paper. Sir I am

very-very thankful to you.

ABSTRACT

Securitization has emerged globally as an important technique for bundling assets and segregating risks

into marketable securities. This paper discusses the present nascent state of the securitization market in

India, and its impact on borrowers in India.

[Securitization act in India & its impact] Page 2


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Introduction

After liberalization the Indian banking sector developed very appreciate. The RBI also nationalizedgood amount of commercial banks for proving socio economic services to the people of the nation.

The Public Sector Banks have shown very good performance as far as the financial operations areconcerned. If we look to the glance of the financial operations, we may find that deposits of public to thePublic Sector Banks have increased from 859,461.95crore to 1,079,393.81crore in 2003, the investmentsof the Public Sector Banks have increased from 349,107.81crore to 545,509.00crore, and however theadvances have also been increased to 549,351.16crore from 414,989.36crore in 2003.

The total income of the public sector banks have also shown good performance since the last few yearsand currently it is 128,464.40crore. The Public Sector Banks have also shown comparatively goodresult. The gross profits of the Public Sector Banks currently 29,715.26crore which has been doubled tothe last to last year, and the net profit of the Public Sector Banks is 12,295,47crore.

However, the only problem of the Public Sector Banks these days are the increasing level of the nonperforming assets. The non performing assets of the Public Sector Banks have been increasing regularlyyear by year. If we glance on the numbers of nonperforming assets we may come to know that in theyear 1997 the NPAs were 47,300crore and reached to 80,246crore in 2002.

The only problem that hampers the possible financial performance of the Public Sector Banks is theincreasing results of the non performing assets. The non performing assets impacts drastically to theworking of the banks. The efficiency of a bank is not always reflected only by the size of its balancesheet but by the level of return on its assets. NPAs do not generate interest income for the banks, but atthe same time banks are required to make provisions for such NPAs from their current profits.

NPAs have a deleterious effect on the return on assets in several ways

They erode current profits through provisioning requirements

They result in reduced interest income



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They require higher provisioning requirements affecting profits and accretion to capital funds andcapacity to increase good quality risk assets in future, and

They limit recycling of funds, set in asset-liability mismatches, etc.

The RBI has also tried to develop many schemes and tools to reduce the non performing assets byintroducing internal checks and control scheme, relationship managers as stated by RBI who havecomplete knowledge of the borrowers, credit rating system, and early warning system and so on. TheRBI has also tried to improve the securitization Act and SRFAESI Act and other acts related to thepattern of the borrowings.

Though RBI has taken number of measures to reduce the level of the non performing assets the results isnot up to the expectations. To improve NPAs each bank should be motivated to introduce their own precautionary steps. Before lending the banks must evaluate the feasible financial and operational prospective results of the borrowing companies. They must evaluate the business of borrowingcompanies by keeping in considerations the overall impacts of all the factors that influence the business.

Significance of the study: - The main aim of any person is the utilization money in the best mannersince the India is country were more than half of the population has problem of running the family in themost efficient manner. However Indian people faced large number of problem till the development of

the full-fledged banking sector. The Indian banking sector came into the developing nature mostly afterthe 1991 government policy. The banking sector has really helped the Indian people to utilize the singlemoney in the best manner as they want. People now have started investing their money in the banks andbanks also provide good returns on the deposited amount. The people now have at the most understoodthat banks provide them good security to their deposits and so excess amounts are invested in the banks.Thus, banks have helped the people to achieve their socio economic objectives.The banks not only accept the deposits of the people but also provide them credit facility for theirdevelopment. Indian banking sector has the nation in developing the business and service sectors. Butrecently the banks are facing the problem of credit risk.It is found that many general people and business people borrow from the banks but due to somegenuine or other reasons are not able to repay back the amount drawn to the banks. The amount which isnot given back to the banks is known as the non performing assets. Many banks are facing the problem

of nonperforming assets which hampers the business of the banks. Due to NPAs the income of the banksis reduced and the banks have to make the large number of the provisions that would curtail the profit ofthe banks and due to that the financial performance of the banks would not show good resultsThe main aim behind making this report is to know how Public Sector Banks are operating theirbusiness and how NPAs play its role to the operations of the Public Sector Banks. The report NPAs are



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classified according to the sector, industry, and state wise. The present study also focuses on the existingsystem in India to solve the problem of NPAs and comparative analysis to understand which bank is playing what role with concerned to NPAs .Thus, the study would help the decision makers tounderstand the financial performance and growth of Public Sector Banks as compared to the NPAs. &

To overcome from NPAs, securitization comes into the picture.

Securitization in India

Securitization in India began in the early nineties, with CRISIL rating the first securitization program in1991-92. Initially it started as a device for bilateral acquisitions of portfolios of finance companies.These were forms of quasi-securitizations, with portfolios moving from the balance sheet of oneoriginator to that of another. Originally these transactions included provisions that provided recourse tothe originator as well as new loan sales through the direct assignment route, which was structured usingthe true sale concept. Through most of the 90s, securitization of auto loans was the mainstay of theIndian markets. But since 2000, Residential Mortgage Backed Securities (RMBS) have fuelled the

growth of the market.The need for securitization in India exists in three major areas - Mortgage Backed Securities (MBS), theinfrastructure Sector and other Asset Backed Securities (ABS). It has been observed that FinancialInstitutions/banks have made considerable progress in financing of projects in the housing andinfrastructure sector. It is therefore necessary that securitization and other allied modalities getdeveloped so that Financial Institutions/Banks can offload their initial exposure and make room forfinancing new projects. With the introduction of financial sector reforms in the early nineties, FinancialInstitutions/banks, particularly the Non-Banking Financial Companies (NBFCs), have entered into theretail business in a big way, generating large volumes of homogeneous classes of assets (such as autoloans, credit cards). This has led to attempts being made by a few players to get into the ABS market aswell. However, still a number of legal, regulatory, psychological and other issues need to be sorted outto facilitate the growth of securitization in India.

Current Scenario in India

Securitization in India adopts a trust structure with the underlying assets being transferred by way of asale to a trustee. Albeit a trust is not a legal entity, a trustee is entitled to hold property, which is distinct



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from the property of the trustee or other trust properties held by him. Thus, the trust is termed as aSpecial Purpose Vehicle (SPV). The SPV issues securities that are either Pass Through Securities orPay Through Securities (PTS). In case of Pass Through Securities, the investors holding them acquirebeneficial interest in the underlying assets held by the trustee. Whereas, in case of PTS, investors

holding them acquire beneficial interest only in the cash flows realised from the underlying assets andthat too in order of and to the extent of the obligation contracted with the holders of the respective seniorand subordinated branches of PTS. Under either scenario, the legal ownership of the underlying assetscontinues to vest in the trustee.

The broader meaning of securitization:

1) Securitization is the process of commoditization. The basic idea is to take the outcome of thisprocess into the market, the capital market. Thus, the result of every securitization process, whatevermight be the area to which it is applied, is to create certain instruments, which can be placed in themarket.

2) Securitization is the process of integration and differentiation: The entity that securitizes its assetsfirst pools them together into a common hotchpot (assuming it is not one asset but several assets, as isnormally the case). This process of integration. Then, the pool itself is broken into instruments of fixed

denomination. This is the process of differentiation.

3) Securitization is the process of de-construction of an entity. If we think of an entity's assets asbeing composed of claims to various cash flows, the process of securitization would split apart thesecash flows into different units .We classify these units, and sell these classified units to differentinvestors as per their needs. Therefore, securitization breaks the entity into various sub-sets. We willdiscuss further the present-day meaning of securitization after some more understanding of genericmeaning of the term. The process of converting an asset or arelationship into a security or a commodity.Meaning of security:The meaning of security in the context of securitization is not static but dynamic. With respect tosecuritization, the word "security" does not mean what it traditionally might have meant under corporate

laws or commerce: a secured instrument. The word security" here means a financial claim that isgenerally manifested in form of a document, its essential feature being marketability. To ensuremarketability, the instrument must have general acceptability as a store of value. Therefore, it isgenerally rated by credit rating agencies, or it is secured by charge over assets. In addition, to ensureliquidity, the instrument is generally made in homogenous lots.



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Need for securitization:The generic need for securitization is similar to that of organized financial markets. From the distinctionbetween a financial relation and a financial transaction earlier, we understand that a relation invariablyneeds the coming together and remaining together of two entities. Not that the two entities would

necessarily come together of their own, or directly. They might involve a number of financialintermediaries in the process, but a relation involves fixity over a certain time. Financial relations arecreated to back another financial relation, such as a loan being taken to acquire an asset, and in that case,the needed fixed period of the relation hinges on the other that it seeks to back-up.Financial markets developed in response to the need to involve a large number of investors. As thenumber of investors keeps on increasing, the average size per investors keeps on coming down, becausegrowing number means involvement of a wider base of investors.

The small investor is not a professional investor. He needs an instrument, which is easier to understand,and provides liquidity and legal sanction. These needs set the stage for evolution of financialinstruments which would convert financial claims into liquid, easy to understand and homogenousproducts. They would be available in small denominations to suit even a small investor. Therefore,securitization in a generic sense is basic to the world of finance, and it is right for us to say thatsecuritization envelopes the entire range of financial instruments, and the range of financial markets.Reasons for Growth of securitization

1. Financial claims often involve large sums of money, which is outside the reach of the small investorwho lacks expertise. In order to cater to this need development of financial intermediation. In a simplecase an intermediary such as a bank obtains resources of the small investors and uses the same for thelarger investment need of the user.2. Small investors are typically not in the business of investments, and hence, liquidity of investments ismost critical for them. Underlying financial transactions need fixity of investments over a fixed time,ranging from a few months to may be a number of years. This problem could not even be sorted out byfinancial intermediation, since, the intermediary provided a fixed investment option to the seeker, anditself requires funds with an option for liquidity. Or else, it would be into serious problems of amismatch. Hence, the answer is a marketable instrument.3. Generally, instruments are easier understood than financial transactions. An instrument ishomogenous, usually made in a standard form, and generally containing standard issuer obligations.

Hence, it can be understood generically. Besides, an important part of investor information is the qualityand price of the instrument, and both are difficult to be ascertained.

The need for securitization was almost inescapable, and present day's financial markets would not havebeen what they are, unless some standard thing that market players could buy and sell, that is, financial



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securities, were available. Therefore, there is large scope for development in this area. Capital marketsare today a place where we can trade, claims over entities, claims over assets, risks, and rewards. Let usconsider certain types of securitization.

Securitization of receivables:One of the applications of the securitization technique has been in creation of marketable securities outof or based on receivables. The intention of this application is to afford marketability to financial claimsin the form of receivables. This application has been applied to those entities where receivables form alarge part of the total assets of the entity. Besides, to be packaged as a security, the ideal receivable isone, which is repayable over or after a certain period, and there is contractual certainty as to itspayment.

Hence, the application is directed towards housing/ mortgage finance companies, car rental companies,leasing and hire purchase companies, credit cards companies, hotels, etc. Soon, electricity companies,telephone companies, real estate hiring companies, aviation companies etc. joined as users ofsecuritization. Insurance companies are the latest to join this innovative use of securitization of risk andreceivables. The generic meaning of securitization is every such process whereby financial claims aretransformed into marketable securities. Securitization is a process by which cash flows or claims againstthird parties of an entity, either existing or future, are identified, consolidated, separated from the

originating entity, and then fragmented into "securities" to be offered to investors.

Securitization of receivables is one of the applications of the concept of securitization. For most othersecuritizations, a claim on the issuer himself is being securitized. For example, in case of issuance ofdebenture, the claim is on the issuing company only. In case of receivable, what is being securitized is aclaim on the third party /parties, on whom the issuer has a claim. Hence, what the investor in receivable-securitized product gets is a claim on the debtors of the originator. This may by implication a claim onthe originator himself. The involvement of the debtors in receivable securitization process adds newdimensions to the concept. One, the legal possibility of transforming a claim on a third party as amarketable document. It is easy to understand that this dimension is unique to securitization ofreceivables. Since there is no legal difficulty where an entity creates a claim on itself, but the scenariochanges when rights on other parties are being turned into a tradeable commodity. Two, it affords to the

issuer the rare ability to originate an instrument which hinges on the quality of the underlying asset. Tostate it simply, as the issuer is essentially marketing claims on others, the quality of his owncommitment becomes irrelevant if the claim on the debtors of the issuer is either market acceptable or isduly secured. Hence, it allows the issuer to make his own credit rating insignificant or less significantand the intrinsic quality of the asset becomes important.



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Various terms used in securitization process:

The entity that securitizes its assets is called the originator. The name signifies the fact that the entity

was responsible for originating the claims that are to be ultimately securitized. There is no distinctivename for the investors who invest their money in the instrument. Therefore, they are generally called asinvestors. The claims that the originator securitizes could either be existing claims, or existing assets (inform of claims), or expected claims over time. In other words, the securitized assets could be eitherexisting receivables, or receivables to arise in future. The latter, for the sake of distinction, is calledfuture flow securitization, in which case the former is a case of asset backed securitization.Another distinction is between mortgage-backed securities and asset-backed securities. This only is toindicate the distinct application: the former relates to the market for securities based on mortgagereceivables.

Since it is important for the entire exercise to be a case of transfer of receivables by the originator, not aborrowing on the security of the receivables, there is a legal transfer of the receivables to a separateentity. Transfer of receivables is called assignment of receivables. It is also necessary to ensure that thetransfer of receivables is respected by the legal system as a genuine transfer, and not as a mere papertransaction where in reality it is a mode of borrowing. In other words, the transfer of receivables has tobe a true sale of the receivables, and not merely a financing against the security of the receivables.

Since securitization involves a transfer of receivables from the originator, it would be inconvenient, tothe extent of being impossible, to transfer such receivables to the investors directly, since the receivablesare as diverse as the investors themselves. Besides, the base of investors could keep changing, as theresulting security is a marketable security. Therefore, there is a need for intermediary. This intermediarywill hold the receivables on behalf of the end investors. This entity is created solely for the purpose ofthe transaction: therefore, it is called a special purpose vehicle (SPV) or a special purpose entity (SPE)or, if such entity is a company, special purpose company (SPC). The function of the SPV in asecuritization transaction could stretch from being a pure conduit or intermediary vehicle, to a moreactive role in reinvesting or reshaping the cash flows arising from the assets transferred to it, which issomething that would depend on the end objectives of the securitization exercise. Therefore, theoriginator transfers the

assets to the SPV, which holds the assets on behalf of the investors, and issues to the investors its ownsecurities. Therefore, the special purpose vehicle is also called the issuer.

There is no uniform name for the securities issued by the SPV as such securities take different forms.These securities could either represent a direct claim of the investors on all that the SPV collects from



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the receivables transferred to it. In this case, the securities are known as beneficial interest certificates asthey imply certificates of proportional beneficial interest in the assets held by the SPV. The SPV mightbe reconfiguring the cash flows by reinvesting it, so as to pay to the investors on fixed dates, notmatching with the dates on which the transferred receivables are collected by the SPV. In this case, the

securities held by the investors are called pay through certificates.The securities issued by the SPV could also be named based on their risk or other features, such assenior notes or junior notes, floating rate notes, etc. Another word commonly used in securitizationexercises is bankruptcy remote transfer. What it means is that the transfer of the assets by the originatorto the SPV is such that even if the originator were to go bankrupt, or get into other financial difficulties,the rights of the investors on the assets held by the SPV is not affected. In other words, the investorswould continue to have a paramount interest in the assets irrespective of the difficulties, distress orbankruptcy of the originator.

Features of securitization:

A securitized instrument, as compared to a direct claim on the issuer, will generally have the followingfeatures.

Marketability:

The very purpose of securitization is to ensure marketability to financial claims. Hence, the instrument isstructured to be marketable. This is one of the most important features of a securitized instrument, andthe others that follow are mostly imported only to ensure this one. The concept of marketability involvestwo postulates:

(a) The legal and systemic possibility of marketing the instrument(b) The existence of a market for the instrument.

Legal aspect with respect to marketing instrument is concerned; traditional law relating to businesspractices has not evolved much. Negotiable instruments were mostly limited in application to what were

then in circulation as such. Besides, the corporate laws mostly defined and sought to regulate issuance ofusual corporate financial claims, such as shares, bonds and debentures. This gives raise to the need for acodified system of law for security and credibility of operations. We need to note that when law is not inexistence, we should not conclude that it is not permitted.



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The second issue is marketability of the instrument. . The purpose of securitization is to broaden theinvestor base and bring the average investor into the capital markets. Either liquidity to a securitizedinstrument is obtained by introducing it into an organized market (such as securities exchanges) or byone or more agencies acting as market makers. That is, agreeing to buy and sell the instrument at either

predetermined or market-determined prices.

Quality of security:

To be accepted in the market, a securitized product has to have a merchantable quality. The concept ofquality in case of physical goods is something, which is acceptable in normal trade. When applied tofinancial products, it would mean the financial commitments embodied in the instruments are secured tothe investors' satisfaction. "To the investors' satisfaction" is a relative term, and therefore, theoriginator of the securitized instrument secures the instrument based on the needs of the investors. Therule of thumb is the more broad the base of the investors, the less is the investors' ability to absorb therisk, and hence, the more the need to securitize. For widely distributed securitized instruments,evaluation of the quality, and its certification by an independent expert, for example, rating is common.

The rating servesfor the benefit of the lay investor, who is not expected to appraise the risk involved.

In case of securitization of receivables, the concept of quality undergoes drastic change; making rating is

a universal requirement for securitizations. Securitization is a case where a claim on the debtors of theoriginator is being bought by the investors. Hence, the quality of the claim of the debtors assumessignificance. This at times enables investors to rely on the credit rating of debtors (or a portfolio ofdebtors) in the process make the instrument independent of the oringators' own rating.

Dispersion of Product:

The basic purpose of securitization is to disperse the product as much as possible. The extent ofdistribution, which the originator would like to achieve, is based on a comparative analysis of the costsand the benefits achieved. Wider dispersion or distribution leads to a cost-benefit in the sense that theissuer is able to market the product with lower return, and hence, lower financial cost to him. However,wide investor base involves costs of distribution and servicing. In practice, securitization issues are still

difficult for retail investors to understand. Hence, most securitizations have been privately placed withprofessional investors.

Homogeneity:



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The instrument should be packaged as into homogenous lots for marketability of the product.Homogeneity, like the above features, is a function of retail marketing. Most securitized instruments arebroken into lots affordable to the small marginal investor, and hence, the minimum denominationbecomes relative to the needs of the smallest investor.

Shares in companies may be broken into slices as small as Rs. 10 each, but debentures and bonds aresliced into Rs. 100 each to Rs. 1000 each. Designed for larger investors, commercial paper may be indenominations as high as Rs. 5 Lac. Other securitization applications may also follow the same type ofmethodology.

Special purpose vehicle:

In case the securitization involves any asset or claim that needs to be integrated and differentiated, thatis, unless it is a direct and unsecured claim on the issuer, the issuer will need an intermediary agency. Itacts as a repository of the asset or claim, which is being securitized. In the case of a secured debenture, itis a secured loan from several investors. Here, security charge over the issuer's several assets needs to beintegrated and thereafter broken into marketable lots. For this purpose, the issuer will bring in an

intermediary agency whose function is to hold the security charge on behalf of the investors. In turn, itissues certificates to the investors of beneficial interest in the charge held by the intermediary. Thus, thecharge continues to be held by the intermediary, beneficial interest therein becomes a marketablesecurity.

The same process is involved in securitization of receivables. The special purpose intermediary holdsthe receivables with it, and issues beneficial interest certificates to the investors.

Securitization and financial disintermediation:

Securitization used to result into financial disintermediation. If we imagine a financial world withoutintermediaries, all financial transactions will be carried only as one-to-one relations. For example, if acompany needs a loan, if will have to seek such loan from the lenders, and the lenders will have toestablish a one-to-one relation with the company. Each lender has to understand the borrowingcompany, and to look after his loan. This is difficult process in modern world of business. There is afinancial intermediary, such as a bank, pools funds from many such investors. It uses these funds to lend

to the company. If the company securitizes the loan, and issue debentures to the investors eliminatingthe need for the intermediary bank. Since the investors may now lend to the company directly in smallamounts each, in form of a security, which is easy to appraise, and which is liquid.

Utilities added by financial intermediaries:



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A financial intermediary initially came in picture to avoid the difficulties in a direct lender-borrowerrelation between the company and the investors. Let us analyze what are the difficulties that will beaddressed by the financial intermediary.

(a) Difficulty of transactions: An average small investor would have a small amount of sum to lendwhereas the company's needs would be massive. The intermediary bank pools the funds from smallinvestors to meet the needs of the company. The intermediary may issue its own security, of smallervalue.(b) Non availability of information: An average small investor would either not be aware of theborrower company or would not know how to appraise or manage the loan. The intermediary fills thisgap.(c) Risk perception of Risk: The risk as investors perceive in investing in a bank may be much lesserthan that of investing directly in the company, though in reality, the financial risk of the company istransposed on the bank. However, the bank is a pool of several such individual risks, and hence, theinvestors' preference of a bank to the borrower company can be understood easily.Securitization of the loan into bonds or debentures addresses all the three difficulties in direct exchange

between borrower and lender. It avoids the transactional difficulty by breaking the lumpy loan intomarketable lots. It avoids informational difficulty because the securitized product is offered generally byway of a public offer, and its essential features are disclosed. It avoids the perceived risk difficulty, sincethe instrument is generally well secured and generally rated for the investors' satisfaction.

Securitization changes the function of intermediation:

It is true to say that securitization leads to better disintermediation for its advantage. Disintermediationis one of the important aims of present-day organizations, since by skipping the intermediary, thecompany intends to reduce the cost of its finances. Securitization has been employed to disintermediate.However, it is important to note that securitization does not eliminate the need for the intermediary. Itredefines the intermediary's role. In the above example, if the company in the above case is issuingdebentures to the public to replace a bank loan, is it eliminating the intermediary altogether? No. Wouldbe avoiding the bank as an intermediary in the financial flow, but would still need the services of an

investment banker to successfully conclude the issue of debentures. Therefore, securitization changesthe basic role of financial intermediaries.Financial intermediaries have emerged to make a transaction possible by performing a pooling function,and have contributed to reduce the investors' perceived risk by substituting their own security for that ofthe end user. Securitization puts these services of the intermediary in a background by making it



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possible for the end-user to offer these features in form of the security. In this case, the focus shifts tothe more essential function of a financial intermediary. That is distribution a financial product. Forexample, in the above case, where the bank being the earlier intermediary was eliminated and insteadthe services of an investment banker were sought to distribute a debenture issue. Thus, the focus shifted

from the pooling utility provided by the banker to the distribution utility provided by the investmentbanker.Securitization seeks to eliminate funds-based financial intermediaries by fee-based distributors. In theabove example, the bank was a fund-based intermediary, a reservoir of funds, whereas the investmentbanker was a fee-based intermediary, a catalyst, and a pipeline of funds. Hence, with increasing trendtowards securitization, the role of feebased financial services has been brought into the focus. In case ofa direct loan, the lending bank was performing several intermediation functions. It is a distributor in thesense that it raised its own finances from a large number of small investors. It is appraising andassessing the credit risks in extending the corporate loan, and having extended it, it manages the same.Securitization splits each of these intermediary functions apart, each to be performed by separatespecialized agencies. The investment bank, appraisal function, will perform the distribution function bya credit-rating agency and management function possibly by a mutual fund that manages the portfolio of

security investments by the investors. Hence, securitization replaces fund-based services by several fee-based services.

Securitization: changing role of banking systems

Banks are increasingly facing the threat of disintermediation. In a world of securitized assets, bankshave diminished roles. The distinction between traditional bank lending and securitized lending clarifiesthis situation. Traditional bank lending has four functions: originating, funding, servicing, andmonitoring.

Originating means making the loan, funding implies that the loan is held on the balance sheet. Servicingmeans collecting the payments of interest and principal, and monitoring refers to conducting periodicsurveillance to ensure that the borrower has maintained the financial ability to service the loan.Securitized lending introduces the possibility of selling assets on a bigger scale and eliminating the needfor funding and monitoring. The securitized lending function has only three steps: originate, sell, andservice. This change from a four-step process to a three-step function has been described as the

fragmentation or separation of traditional lending.

Capital markets role in securitization:



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The capital markets have provided the needed impetus to disintermediation market. Professional and publicly available rating of borrowers has eliminated the informational advantage of financialintermediaries. Let us imagine a market without rating agencies: any investor has to take an exposuresecurity has to appraise the entity. Therefore, only those who are able to employ analytical skills will be

able to survive. However, the availability of professionally conducted ratings has enabled smallinvestors to rely on the rating company's professional judgment and invest directly in the securityinstruments rather than to go through intermediaries. But this should not be construed as no role for banker. The development of capital markets has re-defined the role of bank regulators. A banksupervisory body is concerned about the risk concentrations taken by a bank. More the risk undertaken,more is the requirement of regulatory capital. On the other hand, if the same assets were to bedistributed through the capital market to investors, the risk is divided, and the only task of the regulatoris that the risk inherent in the product is properly disclosed. The market sets its own price for risks -higher the risk, higher the return required. Capital markets tend to align risks to risk takers. Free ofconstraints imposed by regulators and risk-averse depositors and bank shareholders, capital marketsefficiently align risk preferences and tolerances with issuers (borrowers) by giving providers of funds(capital market investors) only the necessary and preferred information. Other features of the capital

markets frequently offset any remaining informational advantage of banks: variety of offering methods,flexibility of timing and other structural options. For borrowers able to access capital markets directly,the cost of capital will be reduced according to the confidence that the investor has in the relevance andaccuracy of the provided information. As capital markets become more complete, financialintermediaries become less important as touch points between borrowers and Savers. They become moreimportant as specialists that

(1) Complete markets by providing new products and services,(2) Transfer and distribute various risks via structured deals, and(3) Use their reputational capital as delegated monitors to distinguish between high and low-qualityborrowers by providing third-party certifications of creditworthiness.

These changes represent a shift away from the administrative structures of traditional lending to market-oriented structures for allocating money and capital. In this sense, securitization is not really-speakingsynonymous to disintermediation, but distribution of intermediary functions amongst specialist agencies.

Securitization and structured finance:

In the definition of securitization, we called it "structured financial instrument". It is a financialinstrument structured or tailored to the risk-return and maturity needs of the investor, rather than a



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underlying financing involved, why can't the financing and the credit be stripped as two differentproducts?The development of credit derivatives has not reduced the role for securitization: it has only increasedthe potential for securitization. Credit derivatives are only a tool for risk management: securitization is

both a tool for risk management as also treasury management. Entities that want to go for securitizationcan easily use credit derivatives as a credit enhancement device, that is, secure total returns from theportfolio by buying a derivative, and then securitize the portfolio.

Economic impact of securitization:

Securitization is necessary to the economy similar to organized markets.

1. Creates of markets in financial claims:

By creating tradeable 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.

2. Spread of holding of financial assets:

The basic intent of securitization is to spread financial assets amidst as many savers as possible. Withthis end in view, the security is designed in minimum size marketable lots as necessary. Hence, it resultsinto dispersion of financial assets. One should not underrate the significance of this factor just becauseinstitutional investors have lapped up most of the recently developed securitizations. Lay investors needa certain cooling-off period before they understand a financial innovation. Recent securitizationapplications, viz., mortgages, receivables, etc. are, therefore, yet to become acceptable to smallinvestors.

3. Promotion of savings:

The availability of financial claims in a marketable form, with proper assurance as to quality in form ofcredit ratings etc., securitization makes it possible for the simple investors to invest in direct financialclaims at attractive rates. If the bank rate is lower than the rates offered by securities, investors will gofor these instruments.

4. Reduces costs:



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Securitization tends to eliminate fund-based intermediaries, and it leads to specialization inintermediation functions. This saves the End-user Company from intermediation costs, since thespecialized-intermediary costs are service-related, and comparatively lower.

5.Risk diversification:

Financial intermediation is a case of diffusion of risk because of accumulation by the intermediary of aportfolio of financial risks. Securitization spreads diversified risk to a wide base of investors, with theresult that the risk inherent in financial transactions is diffused.

6. Focuses on use of resources, and not their ownership:

Once an entity securitizes its financial claims, it ceases to be the owner of such resources and becomesmerely a trustee or custodian for the several investors who thereafter acquire such claim. Imagine theidea of securitization being carried further, and not only financial claims but claims in physical assetsbeing securitized, in which case the entity needing the use of physical assets acquires such use without

owning the property. The property is diffused over investors. In this sense, securitization processassumes the role of a trustee of resources and not the owner.

Social benefits of Securitization:

Securitization does is to break a company, a set of various assets, into various subsets of classifiedassets, and offer them to investors. Imagine a world without securitization: each investor would betaking a risk in the unclassified, composite company. How can we call this as serving economic benefitif the company is made into different parts and sold to different investors?To appreciate the underlying economics driving a securitization, consider an imaginary holdingcompany ABCLtd. It has on its balance sheet three wholly-owned subsidiaries, A, B, and C. The process

of securitization can be thought of as treating distinguishable pools of assets as if they were the wholly-owned subsidiaries, A, B and C. Let us make the following assumptions about the subsidiaries A, B andC.A is 100% debt financed (5-year debentures issued at 9%) with its only asset a single 5-year loan to anAAA-rated borrower paying 10%. B is a software company with no earnings or performance history, butwith projections for attractive, volatile, future earnings. C is a well-known manufacturing company withpredictable earnings.If ABC goes to the debt markets seeking additional unsecured funding, potential investors would facethe difficult task of evaluating its assets and assessing its debt repaying abilities. The assessed cost ofmarginal ABC borrowing might consist of an "average" of the calculated returns on the assets of thesegments that comprise ABC.



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This average would necessarily reflect known and unknown synergies, and costs and associative risksarising from the collective ownership parts (i.e., the group's imputed contribution for credit support,insolvency risk and liability recourse) and would likely include an "uncertainty" discount.Now consider the probable outcomes if ABC are to legally sell the ownership of one or more of its

"parts." In exchange for the exclusive rights to the cash flows from A, investors would return to ABCmaximum equivalent value in the form of cash. Such an offering appeals to a wide range of investors.This includes investors with a preference for, and having superior information regarding the riskrepresented by A's obligors. Those new investors who have had an aversion for the risk presented by theassociated costs and risks represented by B and C. This new arrangement returns to ABC is the fullvalue the market attaches to the certainty of the information concerning A, without uncertainty of theinformation regarding Band C. The value of the resulting ABC shares depends in part on the dispositionof the cash received from the spin-off. If ABC retains the cash, there may be a discount or revaluationresulting from the market's assessment of ABC's ability to achieve a return equal or better than it wouldhave earned from keeping the asset. There is always one clear collateral benefit to the resulting ABCthat derives from any divestment. The perceived value of the remaining components are relieved of anypreviously imposed discount for the disposed component's credit support and insolvency risk. Holding

aside separate considerations of corporate strategy and internal synergies, to the extent that theconsideration received from the divestment improves (in the perception of the market) the capitalstructure of the resulting ABC and/or reduces the marginal funding cost for the resulting organizationABC. The decision to divest or securitize is simplified. If the information held by ABC concerning anyof its segments is not or cannot be fully disclosed, or when disclosed will not be fully or accuratelyvalued, the correct decision is to retain the asset. Without securitization, ABC's bank faces significantand largely irreducible costs of evaluating the marginal impact on ABC's borrowing cost from ABC'spledging of assets (receivables) and of evaluating similar information for each other borrower that thelender or finances. If the imposed cost of borrowing is to be judged solely on the assets as we have seen,the most efficient way to assess the true cost of asset based borrowing). Evaluating each pool of assetsand assessing the likelihood that the cash flows from them will be uninterrupted must be repeated for

each borrowing.By developing a market for asset-specific expertise (not the least of which is represented by theexpertise of the rating agencies), and by relying on the capital markets to determine the best price for therated asset-backed securities (such rating representing the expression of the information provided by thedeveloped expertise), the cost of borrowings for issuers using properly organized securitisationstructures has steadily decreased and is well below the cost of borrowing from a lending institution.



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Capturing scale and volume efficiencies

By aggregating similarly originated assets into a sufficiently large pool, the consequences of anindividual receivable defaulting, and the levels of risk of default, are minimized. If we further collectand aggregate dissimilar pools of assets, and issue securities backed by the aggregated cash flowsderived from the underlying assets. Based on basic principles of diversification, the marginal risk to thepurchaser (investor) of such a security is significantly less than the risk of holding even a pool ofindividual receivables. In addition, it is less than the risk associated with a single receivable. If aborrower can identify, segregate and then satisfactorily describe for investors a pool of securitisableassets otherwise held on its balance sheet, the securitization process can give that borrower a lower costof funding and improve its balance sheet management. The borrower faced with such an opportunitythat chooses not to securitize runs the risk of handicapping its ability to compete.

Exception to the Securitization Act

But the application of this act is not absolute. It does not absolutely apply over all kinds of mortgagetransactions. This Act will not apply in some of the following cases: -

(i) A lien on any goods, money or security given by or under the Indian Contract Act or the Sale ofGoods Act or any other Law for the time being in force;(ii) A pledge of movables;(iii) Creation of any security in any aircraft and any vessel;(iv) Any conditional sale, hire purchase or lease or any other contract in which no security interest hasbeen created;(v) Any security interest for securing repayment of any financial asset, not exceeding Rs. 100000/-

(Rupees One lakh);(vi) Any security interest created in agricultural land;(vii) Any case in which the amount due is less than 20% of the principal amount and(viii) Any rights of an un-paid seller and any property not liable to attachment or sale as per the CivilProcedure Code.Impact on Banking Other than freeing up the blocked assets of banks, securitization can transformbanking in other ways as well. The growth in credit off take of banks has been the highest in the last 55years. But at the same time the incremental credit deposit ratio for the past one-year has been greaterthan one. What this means in simple terms is that for every Rs100 worth of deposit coming into the system more than Rs 100 is being disbursed as credit. The growthof credit off take though has not been matched with a growth in deposits. Banks essentially have beenselling their investments in government securities. By selling their investments and giving out that

money as loans, the banks have been able to cater to the credit boom. This form of funding credit growthcannot continue forever, primarily because banks have to maintain an investment to the tune of 25 percent of the net bank deposits in Statutory Liquidity Ratio (SLR) Instruments (government and semigovernment securities).The fact that they have been selling government paper to fund credit offtakemeans that their investment in government paper has been declining. Once the banks reach this level of



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25 per cent, they cannot sell any more government securities to generate liquidity. And given the pace ofcredit off take, some banks could reach this level very fast. So banks, in order to keep giving credit, needto ensure that more deposits keep coming in.

One way is obviously to increase interest rates. Another way is Securitization. Banks can securitize the

loans they have given out and use the money brought in by this to give out more credit. A.K. Purwar(AnEconomist), in a recent interview to a business daily remarked that bank might securitize some of itsloans to generate funds to keep supporting the high credit off take instead of raising interest rates. Notonly this, securitization also helps banks to sell off their bad loans (NPAs or non performing assets) toasset reconstruction companies (ARCs). ARCs, which are typically publicly/government owned, act asdebt aggregators and are engaged in acquiring bad loans from the banks at a discounted price, therebyhelping banks to focus on core activities. On acquiring bad loans ARCs restructure them and sell themto other investors as PTCs, thereby freeing the banking system to focus on normal banking activities.

A recent survey by the Economist magazine on International Banking, says that securitization is the wayto go for Indian banking. As per the survey, "What may be more important for the economy is toprovide access for the 92% of Indian businesses that do not use bank finance. That represents an

enormous potential market for both local and foreign banks, but the present structure of the bankingsystem is not suitable for reaching these businesses.

Future of securitization

Securitization is expected to become more popular in the near future in the banking sector. Banks areexpected to sell off a greater amount of NPAs by 2010, when they have fully shifted to Basel-II norms.Blocking too much capital in NPAs can reduce the capital adequacy of banks and can be a hindrance forbanks to meet the Basel-II norms. Moreover, even if the Securitization Bill doesnt substantially reducethe amount of NPAs recovered in the near future, it will serve the objective by showing borrowers thatlenders have teeth and if necessary will not hesitate to use them, thereby limiting the build-up of future.

Conclusion

Let us summarize the discussion with analysis of risks and benefits of securitization. Asset Transfersand Securitization by the Bank for International Settlements publication had the following comments onthe risks and benefits of securitization:The possible effects of securitization on financial systems may differ from country to country. Thereason is differences in the structure of financial systems or because of differences in the way in whichmonetary policy is executed .The effects will also vary depending upon the stage of development ofsecuritization in a particular country. The net effect may be potentially beneficial or harmful, but anumber of concerns are highlighted below that may in certain circumstances more than offset thebenefits. Several of these concerns are not principally supervisory in nature, but they are referred to herebecause they may influence monetary authorities' policy on the development of securitization markets.

While asset, transfers and securitization can improve the efficiency of the financial system and increasecredit availability by offering borrowers direct access to end-investors. The process may on the otherhand lead to some diminution in the importance of banks in the financial intermediation process. In thesense that securitization could reduce the proportion of financial assets and liabilities held by banks, thiscould render more difficult the execution of monetary policy in countries where central banks operatethrough variable minimum reserve requirements. A decline in the importance of banks could also



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weaken the relationship between lenders and borrowers, particularly in countries where banks arepredominant in the economy. One of the benefits of securitization, namely the transformation of illiquidloans into liquid securities, may lead to an increase in the volatility of asset values, although creditenhancements could lessen this effect. Moreover, the volatility could be enhanced by events extraneous

to variations in the credit standing of the borrower. A preponderance of assets with readily ascertainablemarket values could even, in certain circumstances, promote liquidation as opposed to going-concernconcept for valuing banks. The securitization process might lead to some pressure on the profitability ofbanks if non-bank financial institutions exempt from capital requirements were to gain a competitiveadvantage in investment in securitized assets.Although securitization can have the advantage of enabling lending to take place beyond the constraintsof the capital base of the banking system, the process could lead to a decline in the total capitalemployed in the banking system, thereby increasing the financial fragility of the financial system as awhole, both nationally and internationally.With a substantial capital base, credit losses can be absorbed by the banking system. Nevertheless, thesmaller that capital base is, the more the losses must be shared by others. This concern applies, notnecessarily in all countries, but especially in those countries where banks have traditionally been the

dominant financial intermediaries. For securitization to be great help, the institutional infrastructure in acountry will be of great advantage. If the institutions are fully developed and legal system is quick torespond to changing commercial norms, this process is likely to face difficulties.

References

1- www.economist.com2- www.vinodkothari.com3- www.valuemoney.com4- www.financialexpress.com


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