THE STRUCTURE OF FI MODEL AND THE SHIFT OF THIS MODEL IN RECENT YEARS AND CONSEQUENCES DUE TO THE SHIFT
For the longest time, banks have relied on their own deposits to fund loans. They kept these loans until they mature before giving them back to their respective clients. Banks heavily depended on the financial intermediation model which was also referred to as the originate to hold model. This model allowed banks to utilize money from external sources for investments and then return the money back to the owners after a stipulated maturity period elapsed. Traditionally,this method enabled banks to lend different types of loans including mortgages, credit card credits, and car and student loans. Nevertheless, the old mode of lending has changed significantly withtime and banks have now adopted the originate to distribute model of banking. In this model, the banks do not wait for the customers to make deposits before they can lend the money out in forms of loans. Instead, they create their own sources of funds, which they then lend out to other institutions and this has necessitated them to expand their funding to include bonds, insurance selling, repurchase agreement (repo) and commercial paper funding as well as corporate loans.
The Structure of FI Model and the Shift of this Model in Recent Years and Consequences Due to the Shift
Financial models are the methods used by financial institutions, like banks to source for funding and income for their activities as well as generate loans. Even though in the beginning banks would use the originate to hold model, they have since changed to the originate to distribute model (Akerlef 1970). This new model has created internal sourcing of funds for the banks and this facilitates lending to other institutions in order to maintain cash flow. Among the techniques that banks have decided to adopt include lending money to corporate institutions, selling loans over the counter, mortgages, and investing in real estate. Thus, banks have fully shifted gears from originate to hold, to originate to distribute financial model and this come with different consequences and implications for all parties involved. This paper therefore examines the changes that banks have implemented and their effects on the overall financial nature of the banks. In addition, the paper also looks at the consequences of these model shifts.
Distribution of loans by banks to corporate institutions began through syndicating and selling loans in the secondary markets. Banks have also come up with the CLO (collateralized loan obligations) which is a method of using collateral to distribute their originated loan and is common among investment management companies. In this case the companies are involved in putting together CLOs by acquiring loans, of which some are obtained at the time of syndication while others are gotten in the secondary loan market. Research by Santos (2012) shows that the move by banks to adopt the originate to distribute model, has led to an increase in syndicated loans.
This model has also enhanced the growth of the secondary loan market, and led to effective development of collateralized loan requirement, especially within the United States. The study further reveals that from a mere $339 billion in 1988 the loan market grew to $2.2 trillion in 2007, reaching its peak in the same year. On the other hand, the secondary loan market, became more active and dealer-driven and it sold and traded loans like other debt securities that trade over the counter as opposed to occasionally selling loans to other banks (Santos & Winton 2008).
The issue at hand that this paper seeks to address concerns the change in models adopted by financial institutions and their consequences. The effects of this shift are also another important concern. Thus, the paper seeks to find out more about the structure of financial intermediation (FI) model and the changes to different model in recent years as well as the consequences of suchshifts. The study is particularly important because it seeks to show the positive changes brought about by the shifts in models(Poza et al 2010). It also shows the means through which banks adopted the originate-to-distribute model in their corporate lending business and provides evidence of the consequence that this shift has had on the growth and progress of non-bank financial intermediation.
Scope and Structure of the Study
The scope of the study will entail an assessment of different financial institutions and how they have embraced the originate to distribute model. This model was largely adopted by leading banks and mortgage institutions and many scholars are of the opinion that the shift has negative effects. Other scholars on the other hand have come up with evidence showing that the shift has had positive effects. As such, the study will aim to clearly bring out the success of the model shift and also review the limitations that were accompanied with the shifts.
Critique of Literature
Research shows that banks might be prevented from lending up to the first best level by regulatory capital necessities and frictions in generating external capital. Such challenges can be resolved through the use of financial innovation , including the originate to distribute model. Purnanandam (2000) is of the opinion that this model entails 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 gives the originating financial institution better risk sharing opportunities with the rest of the economy. It also minimizes the regulatory capital, and helps to achieve better liquidity risk management.
Some of the financial professionals who have researched into the effectiveness of the model have shown that the changes in the models increased loans. For instance, Santos and Winton (2008) showed that changes in the model significantly increased the syndicated loan market, the secondary loan market, and collateralized loan obligations in the United States. Their study also indicates that the volume of loan trading also rose from $8 billion in 1991 to $176 billion in 2005 and that securitization of corporate loans also grew remarkably in the years that preceded the financial crisis. Prior to 2003, the volume per year of new CLOs issued in the United States rarely went beyong $20 billion (Santos, 2012).
However from 2007, loan securitization grew rapidly, and even peaked at $180 billion. This viewpoints show that the changes in the financial models positively impacted the US markets up until 2007 which was followed by a major financial crisis in the United States. Furthermore, it is believed that increased use of the originate to distribute model by banks as a lending term led to a transfer of important portions of credit risk out of the banking systems (Bord & Santos, 2012). Yet, in the process, this move contributes to the growth of financial intermediation in other financial institutions besides the banking sector. Such intermediation is inclusive of a larger role for unrestricted “shadow banking” institutions. With time, it is said that the new model will also allow for the credit kept by banks to balance out and also reduce the standards set by banks in lending process. Other authors, like Akerlef (1970) have shown that adopting the originate to distribute model allows the originating financial institution to enjoy risk sharing with the rest of the economy in addition to enabling the banks to economize on regulatory capital, and have better liquidity risk management. On the contrary, the author argues that as the lending practice changed from an originate-to-hold to an originate-to-distribute model, it did not have positive impacts but instead started interfering with the originating banks’ screening and monitoring incentives. Purnanandam (2000) states that this is possible because banks make decisions concerning lending based on specific characteristics of the borrowers.
Although some of these characteristics are easy to communicate to third parties, there are other details that cannot be verified easily by parties except the originating institution itself. Thus, lending loansgives banks an ability and incentive to collect such details and soft information but this decreases as the originating institution shares the credit risk, thereby increasing the distance between the originator and the eventual holder. Consequently, in cases where the final holders of credit risk do not completely understand the true credit risk of mortgage loans, then it becomes easy to dilute the screening incentives of the originator (Purnanandam 2000). Nevertheless, this condition is not necessary and automatically linked to the dilution in screening standards.
Changing of the financial intermediation models by banks from originate to hold to originate to distribute definitely affects the bank loans. For instance, Santos and Bord (2012) state that even though studies show that lead banks increasingly used this originate todistributemodel starting from the early 1990s, this increase was mostly limited to the terms of loans. These authors also indicate that when dealing with credit-line businesses with other corporations, banks continued to rely on the traditional originate-to-hold model.
The OTD models also gave the banks advantages, such as developing considerable proficiency in screening and monitoring borrowers leading to reduced costs that are related to adverse selection and ethical problems. Through this model, banks can easily select the right customers to lend loans (Parlou & Plantin, 2008). After advancing the loans to the selected right clients, banks could also easily monitor the repayment of these loans and this was done to reduce moral hazards that were implicated on the banks loaning system. Research has also shown that use of OTD enabled banks to have proper screening incentives which theyused to their advantage by making sure that they leverage most of the risk to the distributing institutions. This means that leading banks reduced the number of risks that they had to deal with based on their proper screening and monitoring incentives (Purnanandam 2000).
There are yet other authors who have stated that the screening and monitoring incentives only worked for the best for those banks that concentrated less on the newer OTD model of financial mediation. In fact banks that depended too much on the originates to distribute model of financial mediation were left with loans that they had to pay through their own generated cash and this was an indication that banks that heavily used the OTD model faced many risks and liquidity issues. The OTD model also enabled banks to push the risk of distributing loans to third party institutions including 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 originate-to-distribute model in the sector of corporate lending because of limited data. Most of the data available mainly concentrated on the use of OTD in mortgage and other institutions but not corporate lending. Secondly, the available data is also limited as it only included information available only at the time of loan origination hence making it difficult to use the database to investigate what happens to the loan after disbursement. Furthermore, Deal Scan database has very limited information with regard to the loan shares of investors 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 originate to hold to originate to distribute adopted by banks in the 1990s is not without its limitations.Some of these drawbacks that came with the shifting to originate to distribute model include the fact that there is a time lag for banks between generation of the loan and packaging them into fancy products. Banks spend more time in generating the loans as well as packaging them in the most attractive style so as to make customers want to take them out (Parlou &Plantin 2008). This time lag makes banks to incur almost all the risks that are accompanied with issuing loans. In addition, the credit risk still exists even if after banks package and sell their loans to other investors and this is mainly because banks normally retain a percentage of the packaged loans, which usually have a highest risk profile.
The OTD model also compels banks to Provide a guarantee for these products, or attach CDS to the advanced loans and this means that in case of defaults, banks can issue extended credit line to the specified SIV. Issues normally arise regarding maturity mismatch when generating loans to other companies and coming up with the SIV (Santos 2011). Maturity mismatch in the setting of SIV means high exposure of banks to liquidity risk as this is done off the banks’ balance sheet. Eventually, in case the SIV is unable to provide the required funding,these off-balance sheet items will be moved back to the balance sheet(Gary & Pennacchi 1990).
It is important to note that the OTD model allowed banks to distribute their loans to mortgage institutions and research shows that this had many negative effects on the mortgage industry, and actually preceded the 2007 financial crisis in the mortgage sector. For instance, when the secondary mortgage market succumbed to pressure in mid 2007, the banks with higher volumes of OTD loans were stuck with larger numbers of relatively inferior-quality mortgage loans. This can be attributed to the fact that the sale of their loans takesmore time to penetrate the secondary market from the originating bank. According to Pennacchi (1988), such loans can take about two to three quarters from the origination to the sale in the secondary market.
Effects of the Shift on Other Countries, and Why it is Important to Understand it
Despite having gone through so many financial crises, the 2007 financial meltdown that hit the USA, Europe, and many other countries of the world is considered the worst. Experts have strongly linked it to the shift from originate 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 institution took longer to be used hence the banks had to bear the consequences of inferior mortgage loans. Banks also had less screening and monitoring incentives in the generated loan and this was especially the case for leading banks that relied heavily on the OTD method. The effect of the adoption of OTD was felt in many, if not all parts of the world, because of the financial crisis of 2007. Understanding the effects of the financial intermediation shift is very important for banking institutions because they may need to take the necessary precaution to eliminate any possible repeat of the crisis. The crisis had major negative effects on human lives especially considering that many people lost their homes as well as their jobs.
Some studies have revealed that the bigger banks that heavily relied on the OTD method suffered greater losses during the financial crisis period. This is because such banks distributed most of their originated loans to mortgage institutions and the mortgage institutions, on the other hand, took time to use the loans as was expected by the banks (Bord &Santos 2012). Ultimately, the banks were left with pending loans, which they had to offset using their own funds and this led to the meltdown since most banks could not pay the loans easily.
Some authors believe that securitization is a viable solution for banks to cope with liquidity risks and mismatched maturity periods, as they cover their short-term liabilities. Asset securitization is the act of selling loans that banks consider as non marketable assets (Pennacchi 1988). This process places banks in the position of originators and distributors of the loan assets rather than originator and holders of the loans. It also allows banks to sell the loans less expensively as compared to the traditional deposits and equity issues as the funds received by banks through selling loans remove any costs related to reserves and required capital. Securitization also gives banks proper mechanisms for screening and monitoring of the loan assets.
Securitization makes banks liquid and this replaces deposits with bonds as a financial source for the banks. Research by Strahan and Loutskina (2009) has shown that securitization leads to the growth of structured products, like collateral debt obligation (CDO) credit card loans, collateralized loan obligations (CLOs) among others. This research has made many banks to resolve using CDOs despite the fact that the same CDO products are partially blamed for causing the financial crisis in 2007. Securitization has also taken a center stage in the mortgage institutions with most deciding to use securitization because it makes their finances more liquid than before. Research therefore shows that most banks and mortgage intuitions are opting for securitization because it helps them increase their liquidity (Sufi 2007).
Government-sponsored enterprises have contributed to the rapid growth of securitization in the mortgage market. This method enablesbanks to reduce the mismatch of maturity periods because loansare originated and distributed in the right quantities and after proper screening methods have been done. Securitization is also seen as a technique of reducing regulatory capital (Sufi 2007). Banks and mortgage institution have found securitization profitable because the normal average interest paid on securitized products is significantly lower compared to what is earned from underlying assets.The accrued profit is called the spread arbitrage and it was an original idea of the OTD model used by most banks. This method allowed banks to transfer credit risks to investors as opposed to keeping it in their balancesheet (Hull &White 2010). As a result, banks proceeded to securitize assets,including car loans, corporate debts, credit card receivables, and sub prime residential mortgages.
Many banks embraced the financial intermediation shift from originate to hold to originate to distribute method and as depicted in the discussion above, the method had both positive and negative effects. Following the 2007 financial crisis, which largely hit the mortgage sector, most banks chose to securitize their loans. Mortgage institutions too have not been left behind and have securitized their loans as well as they disburse them to secondary institutions. These institutions have since relied on securitization, because they believe that it will enhance their liquidity state. Researching in this areas was necessary, as it will pave way for future studies into the topic.
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