Introduction
Financial theorists have suggested that securitization is beneficial to financial institutions over the years. According to the suggested theories, securitization allows banks to improve their credit management capabilities as well as increase their profitability through cost reduction of funding. In practice, securitization has been found to have indirect adverse effects on banks performance. Further tests on the hypothesis indicate that securitization on average increase banks profitability, credit risks and cost of funding. Studies also reveal that securitization is not better than other sources of funding and supplementary methods of risk management. In addition, securitization does not outperform other techniques of improving profitability used by retail banks that has not been securitized (Sarkisyan et al, 2009, p.4). Therefore, the overall effects of securitization on retail banking performance remain to be ambiguous.
Reasons for securitization
Generally, securitization is an ordered procedure which banks use to change there illiquid assets into marketable securities. In the past, solid assets were those securities or assets held by those financial institutions for along period before they mature. Transaction in securitization process entails pooling together all the illiquid assets having fixed cash-flows into Special Purpose Vehicle (Uzun & Webb, 2007, p.12). SPV is the liquidation remote unit that is capable of funding the purchase of these securities by issuing the floating rate notes. These floating rate notes are baked or secured by the asset pool (Jones, 2000, p.37).
Danhoo and Shaffer (1991, p. 12) claim that banks opt for securitization in order to reduce their reserves and capital needs. Further argument is that other than the capital regulatory arbitrage, retail banks securitize to increase their economies of scale, reduce the cost of financing their debt amid diversifying their sources of funding. Minton et al. (2004, p. 5) found out that banks that are more risky and have high leverage are likely to be securitized. Similarly, poor performance and increased risks make the financial institutions to engage in securitization (Pais, 2009, p. 23). Banks that engage in securitization are lowly performing and have high credit risk with minimal liquidity. Banks are likely to securitize when they are prone to gaining greater benefits at a reduced cost both directly and indirectly. Essentially, banks engage in securitization process to increase their uncertain profit opportunities and also to adjust their asset portfolio
The economic effect of securitization
Entering into the security markets through the perspective of the original financial institution is of great benefit. The potential benefits these financial entities may derive from securitization are numerous. Basically, securitization will enable retail financial institutions to improve their risk management, profits as well as reduce the cost of funding (Bannier & Haensel, 2007, p. 9). However the realization of these potential benefits will depend on the underlying receivables which have a direct correlation with the practiced credit risk management (Sarkisyan et al, 2009, p. 15). Securitization has both positive and negative effects on the performance of these financial entities especially the retain banking.
The effect on the cost of funding
Retail banks that secure their illiquid assets have the opportunity to borrow money from the capital markets at a reduced cost. This is because the pooled assets issued through SPV are credited higher than that of the originating bank. The reason why these assets are rated highly is because the rating agencies base their ratings on the expected underlying asset pool performance as well as the provided credit improvements (Uzun & Webb, 2007, p.12). Besides, these credit rating institutions are independent of the prevailing financial conditions of the originator. In addition, securitization market offer diverse sources of funding that retail banks may choose from based on the cost comparisons.
Receivables that have poor performance are likely to prevent banks from entering the security markets thereby reducing their credit risk enhancement resulting into poor investment credit ratings. The general result is the significant increase in the cost of funding as well as reduced financing options. Uzun and Webb (2007, p. 12) argue that overreliance on securitization may also result in the banks ignoring other sources of finance thereby making these banks face liquidity in case funding sources through securitization becomes unavailable.
The effect on Risk reduction
There are a number of ways through which securitization reduce risks. Most importantly the transfer of the unanticipated risks such as risks resulting from defaults to the third party normally credit enhancers as well as the outside investors (Sarkisyan et al, 2009, p. 25). The banking management should be wary of the design of securitization that provides an implicit alternative to the outside investor after the transaction. In other words banks should avoid selecting receivables of higher quality for securitization as an incentive to the buyer. Securitization may result in negligence and lax monitoring processes leading to lower balance sheet quality and increased banks default rates in the future loans.
Effects on profitability
With increased sources of funding and improved risk, the management of securitization increases the banks profitability. Vermilyea et al. (2008, p.1199) assert that based on the operating choices securitization enables banks to outsource funding while at the same time upholding comparative advantage activities. These entails keep on servicing the transferred assets that will enhance the profitability of the originating bank. Boot and Thakor (1993, p.1354) claim that with asymmetric information, pooling these illiquid assets and putting various financial claims on these pooled assets of cash flows depend on the risk characteristics which considerably increase the issuing banks revenue. Banks can use additional capital gained from securitization to expand or settle the existing debt and this will result in reduced interest expenses hence increasing the earnings (Lockwood et al, 1996, p.152).
Empirical studies indicate that banks that securitize for the first time will have comparable profitability, credit risk as well as cost of funding. Additionally, findings show that securitization is source of funding which entails improving profitability as well as the way of enhancing risk management. It does not, however, outperform other techniques that are being used by non securitized financial entities.
Trading and dealing mechanisms of the principle markets
Principal markets are those placed where securities are traded. They are the main markets for common stocks and constitute most of the public corporations. In fact, a majority of the security markets are amalgam of activities such as clearings, two sided auctions and bilateral bargaining involving dealers, brokers, agents, vendors and other trade actors and intermediaries within the security markets. Whatever the mechanism involved in the security trade, implementation requires preliminary agreements or terms to be applied as in any other trade transaction (Ang, 1993, p.32). The agreement sets the terms of settlement which will ultimately set in motion the transfer of funds and securities. Though, the terms and processes are very important they seem automatic and routine. In most cases, traders within the security market seem to be less concerned with the details.
The market intermediaries
The new entries in the security market require some sort of pre-existing relationship and in particular one that is not direct or going through the intermediaries. The process begins with opening of brokerage account. In essence, establishing the brokerage account and clearing arrangement seem to be an expensive process that requires time. If the process is not properly undertaken, it may create a temporary barrier to entry for the new sellers and buyers in the market (Markham & Harty, 2008, p.870).
Trading in the stock market often involves a broker. Brokers are normally the market intermediaries though at times they may act as customer agents. As a conduit to the market, a broker’s main role is to manage the customer trading needs such as when and where to trade and the kind of securities to be purchased or orders to used (Naughton & Naughton, 2000, p.152). The relationship between the customer and the broker usually presents problems that relate to contracting, monitoring and enforcement that go beyond the principal-agent relationship.
Limit order markets
A limit order can be described as an order that spells out the acceptable security prices, quantity and direction. For instance, buy 2000 shares at $20.50 per share or sell 3000 shares at $25.80 per share. In the example direction, quantity and prices are clearly indicated. In most cases, at least one limit order book is present in any security market. In limit order markets, the prices of newly and randomly arrived orders are compared with the old orders that were already in the system. The comparison is done to establish a match in their prices (Iyer, 2001, p.19). If the results show that there is a match, then the shares will be traded at the set prices of the first order.
The set of executable prices is contained by the order book. The limit order book is highly dynamic because the limit orders are modified almost in every hour.
The changes in the limit order book can be very rapid especially in highly active markets that apply automated order management. Security markets with automated order management are characteristically transparent since the state of the book can easily be seen by all the potential market participants (Stevelman, 2007, p.779). In some cases, the security markets may contain multiple limit order books. In such a situation, each order book is managed by a different broker or other security market entities.
In the security markets, the sequences in which the orders are executed are governed by mechanism priority rules. Basically, price priority is the most important. For instance, an order that is priced at $50 will be given priority in execution before an order priced at $49. Though, there are other priorities such as time but they are secondary (Anonymous, 1993, p.13). It is true that at a particular price level, orders can be executed on the basis of first-in first-out. However, these time priority rules verify only the comparative status of orders in a certain limit book.
Limit order markets are characteristically known for the direct interaction of buyers and sellers where brokers are mainly used as the intermediary. The broker roles may include the provision of information, clearing services as well as the credit (Stringham & Boettke, 2004, p.62). The brokers may also perform roles that are more complicated and not related to the types of standard order. They generally do not operate as counter-parties to the clients.
Limit order market data are often accurate, detailed and easily understandable. Traders usually design their strategies based on the information got from the data. Nevertheless, there are various limitations associated with the data (Hasbrouck, 2009, p.1456). For instance, serious computation challenge as a result of huge volume of characteristically diverse data makes it difficult to match the orders. The difficulty in mapping the orders that may be cancelled or submitted by a similar trader is of a great importance.
Floor markets
In the floor markets, interest parties that may include potential and actual buyers and sellers are consolidated in the same floor of the exchange. In this process trading, physical aspect only takes place. The representative brokers of buyers and sellers meet to negotiate bilateral deals face-to-face. These brokers are habitually known as the members (Kroll, 2006, p76). They act as the agents or principals to the customers. The double roles of the broker often present a conflict of interest because the dual trading is highly regulated in the floor markets. Though, floor markets may seem chaotic, transparency is upheld as deceptive actions are greatly forbidden. Transparency is also enhanced by quickly and publicly announcing the transaction prices while errors and disputes that arise are quickly resolved.
Conclusive remarks
Principal markets have complex structures and the rapid changes that take place in the institution makes in difficult to determine which functional mechanism materialize to be of great importance. In theory, some mechanisms seem to be of more significant but practically the microstructure involved seems to deal with varying levels of complexity. The mechanisms in the limit order markets present the most current and commonly applied instrument in the principal market. Though, the floor markets may seem traditional, it is still being practiced especially when dealing with instruments that cannot be relayed electronically.
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