Securitization Capital Markets, Structured Financial and others

Change in the Function of Intermediation:

Securitization changes the basic role of financial intermediaries. Traditionally, 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 of the end user. Securitization puts these services of the intermediary in a background by making it possible for the end user to offer these features in the form of a security, in which case, the focus shifts to the more essential function of a financial intermediary, viz., distributing a financial product. For example, in the above case, the bank, being the earlier intermediary, was eliminated, and instead the services of an investment banker were sought to distribute a debenture issue. In this case the focus from the pooling utility provided by the banker to the distribution utility provided by the investment banker.

Securitization seeks to eliminate fund based financial intermediaries for fee based distributors. In the above example, the bank was a fund based intermediary, a reservoir of funds, whereas the investment banker was fee based intermediary, a catalyst, a pipeline of funds. Hence, with the increasing trend towards securitization, the role of fee based financial services has been brought into the focus.

In case of a direct loan, the lending bank was performing several intermediation functions as noted above. It was distributor, in the sense that it raised its own finances from a large number of small investors. It was appraising and assessing the credit risks in extending the corporate loan, and having extended it, it was managing the same. Securitization splits each of these intermediary functions apart, each to be performed by separate specialized agencies. The distribution function will be performed by the investment bank, appraisal function by a credit rating agency, and management function, possibly by a mutual fund which manages the portfolio of security investments by the investors. Hence, securitization replaces fund based services with several fee based services.

Capital Markets and Securitization:

A well developed capital market makes it possible for the emergence of securitization as a source of financial disintermediation in the following manner:

Rating Advantage

Professional and publicly available rating of borrowers has eliminated the informational advantage of financial intermediaries. Imagine a market without rating agencies. Anyone who has to take an exposure in any product or entity has to appraise the entity. Obviously enough, only those who are to employ high degree analytical skills will be able to survive. However, the availability of professionally and systematically conducted ratings has enabled lay investors to reply on the rating company’s professional judgment, and invest directly in the products or instruments of user entities, rather than to go through financial intermediaries.

Bank Regulators:

The development of capital markets has re-defined the role of bank regulators. A bank supervisory body is concerned about the risk concentration taken by a bank. More the risk under taken more is the requirement of regulatory capital. On the other hand, if the same assets were to be distributed through the capital market to investors, the risk is divided, and the only task of the regulator is to disclose properly the risk inherent in the product. The market sets its own price for risks, higher the risk; higher the return required.

Capital markets tend to align risks with risk takers. Free of constraints imposed by regulators and risk averse depositors and bank shareholders, capital markets efficiently align risk preferences and tolerances with issuers (borrowers) by giving fund providers (capital market investors) only the necessary and preferred information. Any remaining informational advantage of banks is frequently offset by other features of capital markets, such as variety of offering methods, flexibility of timing and other structural options. For borrowers who are able to access capital markets directly, the cost of capital will be reduced according to the confidence that the investor has in the relevance and accuracy of the provided information.

As capital markets become more complete, financial intermediaries become less important as contact points between borrowers and savers. They become more important, however, 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 reputation capital as delegated monitors to distinguish between high and low quality borrowers by providing third party certifications of creditworthiness. These changes represent a shift away from the administrative structure of traditional lending to market oriented structure for allocating money and capital.

From the foregoing analysis, it is clear that securitization is not exactly synonymous with disintermediation. But is the distribution of intermediary functions amongst specialist agencies.