Pre-GFC Bank Behaviour Change and Basel Accords

Pre-GFC Bank Behaviour Change and Basel Accords

DOI: 10.4018/978-1-4666-5950-6.ch003
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A most important consequence of de-regulation change has been the transit of banks’ behaviour from acting as financial intermediaries to taking the role as brokers in the structured finance market. The combined effects of financial deregulation, rapid technological change, the evolution of the banking function, and the increasing complexity and diversity of finance activities has left regulatory bodies grappling with the problem of designing appropriate prudential standards. This has been the rationale behind the evolution of capital regulation from the pre-Basel regulation to the 1988 Basel Accord (Basel I); the 1996 Basel I amendment; and then to the new Basel Accord (Basel II). The major thrust of this chapter is to discern the most appropriate and effective regulatory regime for the purposes of achieving financial stability of the system. Accordingly, the occurrence of the recent 2007-2008 financial crisis is raised to offer a preliminary appraisal of the effectiveness of Basel II.
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Structured Finance Products

In general, securitization is a form of financing in which the cash flows associated with the existing financial assets are used to pay for funds raised through the issue of asset-backed securities (ABSs). Securitization in other words consists of transferring illiquid assets (i.e. loans) to an independent company named the Special Purpose Vehicle (SPV) which is controlled by a trustee. The SPV buys the loans to from the bank and pays for them by selling securities that are backed by the loan receivables. To improve the marketability of the SPV's securities, banks usually provide some form of credit enhancement to the structure, by, for instance, granting a subordinated loan to the SPV. These SPV issued debts are structured in various degrees of seniority and the banks buy the lowest one. So the repayment of the SPV’s debt is made with the cash flows generated by the securitized loans1. The securities bought by investors have a better quality than the underlying loans because the first losses of the pool are absorbed by the equity tranche. This creates attractive investment opportunities for investors, but it implies that the main part of the risk is still in the bank’s balance sheet, because banks treat the sale of assets to SPVs as true sales even though they retain the underlying risk through credit enhancement to the ABS (Balthazar, 2006).

As a “market-oriented” financial practice, securitization activity is highly sensitive to changes in the market and depends heavily on liquidity (Wray, 2008, p. 3). By converting non-marketable credit instruments into publicly traded securities, securitization can allow the financial institutions to continue to initiate mortgages even when their funding capacities are low. Importantly, this implies the absence of limits to credit creation on the part of banks. Moreover, the active involvement of banks in the securitization market has partly been driven by the need to supplement fund income with fee income (Wray, 2008). It is argued that securitisation spreads risk across several financial sub-sectors, only a fraction of which - the banks themselves - remain under a prudential-oversight umbrella. Other NBFIs are comparably less oversighted and SPVs are generally not included in the balance sheet for regulatory purposes (Dymski, 2008).

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