Debt securitisation and covered bonds Modalities - report 7

 4.2 Debt securitisation and covered bonds
214. Securitisation is an instrument for the refinancing of banks and for their portfolio risk
management, which has been widely used in the past, especially in the US, mainly for mortgages and, to a
certain extent for corporate loans. Through securitisation, various types of contractual debt are pooled and
sold to investors. These acquire rights to receive the cash collected from the financial instruments that
underlie the security.
215. In the case of SME loan securitisation, a bank (“the originator”) extends loans to its SME
customers (the “primary market”), bundles them in a pool (the “portfolio”) and sells the portfolio to capital
market investors through the issuance of notes, by a Special Purpose Vehicle (SPV) backed by the loan
portfolio (Asset-Backed Securities, ABS). These asset-backed notes, rated by agencies, are placed with
capital market investors, but can also be retained, at least in part, by the originator banks (Kraemer-Eis et
al., 2010).
216. Once the assets are transferred by the originator to the SPV, there is normally no recourse to the
originator itself. Through the securitisation process, assets are taken off the balance sheet of the originator.
Thus, with this “originator to distribute” model, the bank becomes a “conduit”, which derives its income
from originating and servicing loans ultimately funded by third parties. According to Martin-Oliver and
Saurina (2007), 

this model is changing the relationship of banks with customers, which is fading, in favour
of a transaction-based bank whose main proceeds come from the fees they earn originating and packaging
217. An alternative securitisation model, the “synthetic securitisation”, combines the above described
mechanism with credit derivatives, whereby the loans remain in the balance sheet of the originator,
whereas the credit risk of the loan portfolio is transferred to a SPV, which places credit-linked notes,
classified by risk categories, in the capital market (Kraemer-Eis et al., 2010).
218. Debt securitisation presents some advantages for banks, and, indirectly, for SME lending. First of
all, securitisation reduces the bank’s exposure to credit risk, which is transferred to the capital market. This
has important implications also in the light of the recent financial reforms (i.e. Basel III), as risky assets are
taken out of the banks’ balance sheets and the capital to risk-weighted asset ratios is improved. In other
terms, securitisation can represent an instrument for risk-reduction and “regulatory capital arbitrage”. 

Ultimately, by giving capital relief, securitisation reduces the bank’s total cost of financing.
219. Securitisation allows banks to transform SME loans in their balance sheets into liquidity assets,
which can be used to increase lending itself. In an empirical study of loan securitisation by Spanish banks,
Martin-Oliver and Saurina (2007) show that liquidity needs have been a key driver of securitisation, with
higher probability of using this mechanism for banks with rapid credit growth, less interbank funding and a
higher loan-deposit gap. Kraemer-Eis et al. (2010) note that securitisation can be especially important for
smaller banks, which face lending restrictions due to their size. Transferring risks to the capital market
increases their lending capacity. Furthermore, securitisation of SME loans can be an effective option for
them, as their closer customer relations and better monitoring capabilities give them a competitive edge in
lending to smaller companies.
220. Covered bonds work similarly to securitised debt, as they are debt securities (corporate bonds)
backed by the cash flows from mortgages or loans. In the European Union, the Capital Requirements
Directive (CRD) limits the range of accepted collateral to debts of (highly rated) public entities, residential,

commercial and ship mortgage loans with a maximum loan-to-value ratio of 80% (residential) or 60%
(commercial), and bank debt or mortgage-backed securities (Packer et al., 2007).
221. An important difference with respect to securitisation is that covered bond assets remain on the
issuer’s consolidated balance sheet, except under specific variants of the general model. Thus, they cannot
help to strengthen the issuer’s capital ratio. As the investor does not own the assets, the interest is paid to
them from the issuer's cash flow, as in the case of traditional corporate bonds. If the underlying assets
default, the issuer continues to pay interest to investors. 

However, in case of default by the issuer that is
unrelated to these underlying assets, the lender can take possession of them. As covered bonds are secured,
they are considered to be less risky than unsecured bank bonds, which implies low-cost funding for the
issuer. At the same time, asset encumbrance implies that they are seen as a complement, rather than as
substitute to securitisation.
222. On the demand side, securitised debt has some desirable risk characteristics for investors. Mainly,
as secured assets, these investment options may present lower risk than other market offers. In addition, as
they have limited correlation with the more traditional asset classes in the financial market, they can
improve the risk return profile of the investors’ portfolio. In itself, the bundling of different assets into the
securitised portfolio is an element for risk diversification. In the case of covered bonds, the fact that they
remain on the balance sheet of the originator may provide investors with more confidence with regard to
the assessment of risks and backup for their claims (Wehinger, 2012). In fact, in case of default, investors
have a double recourse, to the issuer and the cover pool. For this reason, covered bonds benefit from a
more favourable regulatory treatment than securitised debt, and greater liquidity in the market. It should be
noted, however, that in most cases, the market for SME covered bonds is relatively new. Indeed, the use of
SME loans as an asset class in covered bonds is not permitted in the legislation of most countries with an
active covered bond market. In some others, changes in regulation that allow this form are recent (OECD,

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