The Structure of FI Model and the Shift of this Model in Recent Years

The Structure of FI Model and the Shift of this Model in Recent Years and Consequences Due to the Shift

Introduction

Financial models are the methods used by financial institutions, such as banks to generate loans, funding, and income for their activities. Initially, banks used the originate to hold model, but they have changed over time to the originate to distribute model (Akerlef 1970). This new model has seen the banks generate their funds internally and lend them to other institutions in order to maintain cash flow. Banks have decided to lend money to corporate institutions, selling loans over the counter, mortgages, and to real estate. Thus, banks have shifted gears from originating to hold, to originate to distribute financial models. This shift has also come with different consequences. This paper, therefore, looks into the change that banks have gone through and their effects on the overall financial nature of the banks. The paper also looks at the consequences of such model shifts.

The banks started distributing these loans to corporate institutions by syndicating and selling loans in the secondary markets. Banks have also come up with a method of using collateral to distribute their originated loan. This method is known as the CLO (collateralized loan obligations) and is distributed through investment management companies. These companies take part in putting together CLOs by acquiring loans. Some of the loans are obtained at the time of syndication and others are in the secondary loan market. Research by Santos (2012) shows that since banks adopted the use of originating to distribute model, there has been an increase in syndicated loans.

This model has also led to the growth of the secondary loan market, and the development of collateralized loan requirements, especially in the United States. The study also shows that the syndicated loan market rose from a mere $339 billion in 1988 to $2.2 trillion in 2007, which is the year the market reached its peak. The secondary loan market, on the other hand, grew from a market in which banks participated occasionally, most often by selling loans to other banks, through individually negotiated deals, to an active, dealer-driven market where loans are sold and traded much like other debt securities that trade over the counter (Santos & Winton  2008).

The issue at hand that this paper needs to address is the change of model that financial institutions have adopted. Another clear issue is that the shift from one model to another has consequences that come with it. As such, the paper seeks to find out the effects of this shift. Thus, the paper seeks to find the structure of the financial intermediation (FI) model and the shift of this model in recent years, and the consequences due to the change. This study is important because it seeks to show the fact that the change of model brought about some positive changes (Poza et al 2010). It also shows how banks adopted the originate-to-distribute model in their corporate lending business and provide evidence of the effect that this shift has had on the growth of non-bank financial intermediation.

Scope and Structure of the Study

The scope of the study involves an analysis of various financial institutions and how they have adopted the originate to distribute model. This model was largely adopted by leading banks and mortgage institutions. Some scholars have said that this shift has negative effects. Other scholars on the other hand have shown that the shift has come with positive effects. As such, the study will aim to prove the success of the model shift as well as the limitations that came with the shifts.

Critique of Literature

Research has shown that regulatory capital necessities and frictions in generating external capital might prevent a bank from lending up to the first-best level. These challenges can be resolved using financial innovation, such as the originate to distribute model. Purnanandam (2000) views this model as a model of lending in which the originator of loans sells them to third parties. This model came as a solution to some of these challenges. This model allows the

originating financial institutions to achieve better risk-sharing with the rest of the economy, economize on regulatory capital, and achieve better liquidity risk management.

Some of the financial professionals who have carried out studies into the effectiveness of the model have shown that the shift brought about an increase in loans. For example, Santos and Winton (2008) showed that there was a significant increase in the syndicated loan market, the secondary loan market, and collateralized loan obligations in the United States. The syndicated loan market increased from a measly $339 billion in 1988 to $2.2 trillion in 2007, the year the market reached its peak. The study also indicates that the volume of loan trading went up from $8 billion in 1991 to $176 billion in 2005. The securitization of corporate loans also experienced remarkable growth in the years that preceded the financial crisis. Before 2003, the annual volume of new CLOs issued in the United States rarely surpassed $20 billion (Santos, 2012).

The loan securitization grew rapidly, reaching $180 billion in 2007. From this point of view, it can be stated that the shift in the financial model was positively significant until the year 2007, which was followed by a major financial crisis in the United States. It is also believed that as banks increase the use of the originate to distribute model in their business as a lending term; it will lead to a transfer of important portions of credit risk out of the banking system (Bord & Santos, 2012). However, in the process, it will contribute to the growth of financial intermediation outside the banking system. This intermediation includes a larger role for unregulated “shadow banking” institutions. The method will also make the credit kept by banks on their balance sheets less representative of the still essential role they perform in financial intermediation as time goes by. In addition, banks’ increasing use of the originate to distribute model could lead to some weakening of lending standards in the leading banks.

Other authors, such as Akerlef (1970) have shown that the originate to distribute model allows the originating financial institution to achieve better risk-sharing with the rest of the economy. This model also enables the banks to economize on regulatory capital, and achieve better liquidity risk management. On the contrary, the author argues that as the lending practice

shifted from an originate-to-hold to an originate-to-distribute model, it began to interfere with the originating banks’ screening and monitoring incentives. Purnanandam (2000) states that this is possible since banks make lending decisions based on a number of borrower characteristics.

Even though some of these characteristics are easy to credibly communicate to third parties, there are soft pieces of information that cannot be verified easily by parties other than the originating institution itself. Thus, the loans give the banks the ability and incentives to collect soft information decreases as the originating institution sheds the credit risk, and as the distance between the originator and the eventual holder of risk increases. Consequently, if the final holders of credit risk do not completely appreciate the true credit risk of mortgage loans, then it is easy to see the resulting dilution in the originator’s screening incentives (Purnanandam 2000). However, it is not a necessary condition for dilution in screening standards to occur.

A shift in the financial intermediation models by banks from originating to hold to originate to distribute have implications on the bank loans. For example, Santos and Bord (2012) state that even though studies show that lead banks increasingly utilized the originate to distribute model from the early 1990s onwards; the increase was mostly restricted to term loans. These authors also indicate that banks continued to rely on the traditional originate-to-hold model in their credit-line business with corporations.

The OTD models also gave the banks advantages, for example, they developed considerable proficiency in screening and monitoring their borrowers to reduce the costs of adverse selection and ethical problems. Thus, banks easily select the right customers to lend loans (Parlou & Plantin, 2008). After advancing the loans to the selected right clients, they had the ability to monitor how they repaid the loans. They did this to ensure that no moral hazards were implicated in the bank’s loaning system. Research has also shown that banks had proper screening incentives based on the OTD. Banks used this to their advantage by ensuring that they leverage most of the risk to the distributing institutions. This means that leading banks had few risks to deal with based on their proper screening and monitoring incentives (Purnanandam 2000).

Some authors have also stated that the screening and monitoring incentives only worked for those banks that concentrated less on the OTD model of financial mediation. Those banks that overly relied on originates to distribute models of financial mediation were left with loans that they had to pay using their own generated cash. This meant that leading banks that heavily used the OTD model faced many risks and liquidity issues. The OTD model also enabled banks to be able to escape the risk of distributing loans by pushing such risks to third-party institutions, such as mortgages (Strahan and Loutskina 2009).

Limitations of Existing Literature on OTD

It has been difficult to investigate the degree to which the U.S. banks have adopted the use of the originate-to-distribute model in corporate lending because of data limitations. Most available data only talk about the use of OTD in mortgages and other institutions but not corporate lending. Secondly, most available data includes information available only at the time of loan origination. This makes it difficult to use the database to investigate what happens to the loan after it has been distributed. Furthermore, the Deal Scan database has very limited information on investors’ loan shares at the time of origination

Consequences of the shift in Financial Model

The limitations of the model

The discussion above shows that the move from the origin to hold to originate to distribute adopted by banks in the 1990s came with many limitations. Some of these drawbacks that came with the banks’ ability to originate to distribute models include the fact that there is a time lag between generating the loan and packaging them into fancy products. Banks spend more time in generating the loans as well as packaging the loans in the most attractive style in order to attract customers (Parlou & Plantin 2008). This time lag makes banks incur almost all the risks that come with loans. The other drawback is that the credit risk still exists even if banks package and sell the loans to other investors. This is because banks usually retain a part of the packaged loans, which usually have the highest risk profile.

The OTD model also requires banks to provide a guarantee for these products, or attach CDS to the advanced loans. This means that in case of defaults, banks should issue extended credit lines to their SIV. There is an issue with maturity mismatch while generating loans to other companies and coming up with the SIV (Santos 2011). Maturity mismatch in the setting of SIV means banks are highly exposed to liquidity risk as they are done off the banks’ balance sheet. Eventually, these off-balance sheet items will be moved back to the balance sheet if the SIV is not able to provide the required funding (Gary & Pennacchi 1990).

It is important to note that the OTD model allowed banks to distribute their loans to mortgage institutions. Research has shown that this had many negative effects on mortgages, which preceded the 2007 financial crisis in the mortgage sector. For example, When the secondary mortgage market came under pressure in mid-2007, banks with a higher volume of OTD loans were stuck with large numbers of relatively inferior-quality mortgage loans. This is because the sale of their loans takes much time to get to the secondary market from the originating bank. For example, according to Pennacchi (1988), the loans can take about two to three quarters from the origination to the sale of these loans in the secondary market.

Effects of the Shift on Other Countries, and Why it is Important to Understand it

The world had gone through many financial crises in the past, but the worst crisis was the 2007 financial meltdown that hit the USA, Europe, and many other countries of the world. This meltdown was closely related to the shift from originating to hold to originate to distribute method of financial mediation (Gary & Pennacchi 1990). The problem arose because the originated loans released by banks to mortgage institutions took longer to be utilized. This means the banks had to bear the consequences of inferior mortgage loans. Banks also had fewer screening and monitoring incentives in the generated loans. This was especially so for leading banks that relied highly on the OTD method. The effect of the shift was felt in many, if not all parts of the world, due to the financial crisis of 2007. It is important to understand the effects of the financial intermediation shift so that banking institutions can take the necessary precaution to eliminate any possible repeat of the crisis. The crisis had major effects on human lives; most people lost their homes as well as their jobs.

Some studies revealed that major (lead banks) relied heavily on the OTD method and are the ones that suffered greatly during to the financial crisis period. This is because the banks distributed most of their originated loans to mortgage institutions (Bord & Santos 2012). The mortgage institution on the other hand took time to utilize the loans as was expected by the banks. The banks eventually had pending loans, which they had to offset using their own funds. This leads to the meltdown since most banks could not pay the loans easily.

Securitization

Some authors believe that securitization is able to help banks cope with liquidity risks and mismatched maturity periods, by covering their short-term liabilities. Asset securitization refers to the selling of loans that the banks considered as nonmarketable assets (Pennacchi 1988). This process allows banks to see themselves as originators and distributor of the loan assets rather than originators and holders of the loans. This loan sale also allows banks to sell the loans less expensively as compared to the traditional deposits and equity issues. This is because funds received by banks through selling loans eliminate costs related to reserves and required capital. Securitization also enables banks to have proper screening and monitoring of the loan assets.

Securitization makes banks liquid and thus replaces deposits with bonds as a financial source. Research by Strahan and Loutskina (2009) states that securitization has led to the growth of structured products, such as collateral debt obligation (CDO) credit card loans, collateralized loan obligations (CLOs) among others. From this research, most banks have decided to use CDOs even though these CDO products are partially blamed for causing the financial crisis in 2007. Securitization has also taken a center stage in mortgage institutions. These institutions have decided to use securitization because it makes their finances more liquid than before. The research, therefore, shows that most banks and mortgage intuition have turned to securitization since it helps them increase their liquidity (Sufi 2007).

The rapid growth of securitization in the mortgage market is due to government-sponsored enterprises. This method also enables banks to reduce mismatch of maturity periods since loans are originated and distributed in appropriate quantities after screening. Securitization is also viewed as a method of reducing regulatory capital (Sufi 2007). Banks and mortgage institutions have found securitization profitable since the normal average interest paid on securitized products is significantly lower than that earned on underlying assets. The accrued profit is referred to as spread arbitrage and was an original idea of the OTD model used by most banks. It allowed banks to transfer credit risks to investors instead of keeping them in their balance sheets (Hull & White 2010). Banks went ahead and securitized assets, such as car loans, corporate debts, credit card receivables, and sub-prime residential mortgages.

Conclusion

Many banks embraced the financial intermediation shift from originating to hold to originate to distribute method. This method had its positive and negative effects as shown in the above discussion. After the 2007 financial crisis, which largely hit the mortgage sector, most banks have decided to securitize their loans. Mortgage institutions too have decided to securitize their loans as they disburse them to secondary institutions. These institutions have since relied on securitization, as they believe that it will improve their liquidity state. This research is important, as it will pave way for future studies into the topic.

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