SECURITISATION: PATH FORWARDS FOR EMERGING MARKETS
Securitisation can provide a platform through which entities looking to raise funding can overtime, lower their cost of funding whilst providing a framework to raise large amounts of funds.
In emerging markets, financial institutions predominantly employ a bi-lateral approach to raising funds. In essence, a bank seeking to raise funding will typically obtain the funding directly from another financial institution. In so doing, the lender will inevitably have to price in risks associated with the borrowing institution such as insolvency risk, risk of underlying debtors defaulting and balance sheet risk.
Despite the initial upfront costs to set up the appropriate structure, through a securitisation, financial institutions in emerging markets can systematically reduce their cost of funding. The funding is procured through an off balance sheet structure utilising a special purpose vehicle (SPV). This SPV is a separate company or trust, independent of the borrowing institution.
The borrowing institution in a securitisation transaction is referred to as the ‘Originator’. As a consequence of the Originator being independent from the SPV, the risks inherent in the Originator, is compartmentalised. The Originator then subsequently assigns receivables to the SPV. Some examples of receivables include payments due on loans made out by the Originator to debtors, payments due to the Originator from mortgages it has granted companies or individuals, payments due to the Originator on government notes it has purchased such as treasury bills or payments on corporate bonds held by the Originator. The objective of the assignment is to provide the SPV with sufficient collateral.
The collateralised SPV then issues notes to investors. As the SPV has sufficient collateral to secure the note issuance, the risk for investors is subsequently reduced and this reduction in risk enables the SPV to issue the notes at a reduced cost of funding. A fundamental characteristic of the receivables is that they should have sufficient historical performance in order to be able to determine how they will perform in the future. For example, rates of default, growth in volume year on year and rates of delayed payment, enable investors and rating agencies to build a picture of their performance. Rating agencies are then able to ascribe a rating to the receivables and the note issuance.
Upon the note issuance by the SPV to investors, the proceeds collected by the SPV from the issuance is then utilised to purchase the receivables from the Originator. This achieves the effect of what in securitisation is labelled a ‘True Sale’. This should place the SPV out of the reach of liquidators in the event of insolvency proceedings against the Originator. This is known as ‘Insolvency Remoteness’. The Insolvency Remoteness of the SPV from the Originator reduces the risk inherent in the note issue and also enables the SPV to issue the notes at a reduced cost of funding.
The benefits of this reduced cost of funding is passed onto the Originator by the SPV at the point the SPV utilises the proceeds of the notes issue to purchase the receivables from the Originator. When the receivables are purchased, from the Originators point of view, it will get upfront payment on receivables which it has sold to the SPV. The benefit to investors is that they invest in a debt instrument issued by an SPV that has sufficient collateral to cover the note issuance and the SPV is a separate entity from the Originator and consequently is not ordinarily affected in the event the Originator is rendered insolvent.
The net effect of the transaction for the Originator is that it is able to benefit from the better credit profile which the SPV has inherited from the assignment of the receivables. This is known as a credit arbitrage. The SPV can be structured with the appropriate collateral so as to enhance its credit rating. This flexibility to engineer a credit profile of the SPV to suit a specific fundraise presents an attractive proposition for all parties involved.
The securitisation structure enables institutions to raise larger sums, in a more efficient and less costly manner in spite of the initial set up costs which are necessary to cover legal and advisory fees. In emerging markets, financial institutions tend to focus most of their fundraising on bi-lateral unsecured facilities. Due to market fluctuations and the fact that the fundraising is unsecured, the pricing ends up being more costly. However, if these financial institutions planned more medium to long term, they could implement a securitisation set up which would enable them to benefit from a credit arbitrage and consequently reduce the cost of funding.
Furthermore, as the whole premise of a securitisation is an off-balance sheet transaction, this enables the financial institution to continue its activities and obligations regardless of the securitisation, whilst simultaneously yielding a positive impact on its balance sheet ratios as funding raised through the sale of receivables can be utilised to clear liabilities on the balance sheet, improve the return on capital and deliver a positive impact on the debt to asset ratio.
Inevitably, the economic downturn of 2008 negatively impacted the levels of securitisation in developed markets. However, the importance of these transactions to the economy has compelled regulatory bodies such as the Bank of England and the European Central Bank to shift their focus towards reviving the securitisation market. Emerging markets are gradually realising the importance of this means of raising funds as there is a growing consensus that it will be critical for the growth and development of financial institutions operating within those markets due to its ability to simultaneously bolster their balance sheet whilst enabling them to raise larger sums of cash at a cheaper cost.