Shyamala Gopinath: Securitisation markets in India - a post-crisis
perspective
Inaugural address by Ms Shyamala Gopinath, Deputy Governor of the Bank of India, at the
India Securitisation Summit 2010 hosted by the National Institute of Securities Markets (NISM),
Mumbai, 10 August 2010.
* * *
1. It is my pleasure to be delivering the inaugural address at this Securitisation
Summit. I am thankful to the NSIM, particularly Mr. Sethu whose persistent efforts brought
me here today. The development of a robust securitisation market in India, along with a
broader corporate bond market, though universally acknowledged as a desired objective is
proving a challenge in reality. In my address today I wish to touch upon some of the issues
engaging the policy deliberations, particularly in the post-crisis context.
2. It has become customary these days for any speech on financial sector to start from
the vantage point of the crisis - it is such an inflexion point. Howsoever hard one tries, it
becomes well nigh impossible to disassociate from the immediacy of the crisis, particularly
when talking about a market so intricately linked to the crisis - securitisation.
3. Securitisation generically refers to the pooling of cash-flow-producing assets
(e.g., mortgages, loans, bonds) and subsequent issuance of securities in the capital markets
backed by these collateral pools. This broad definition encompasses simple non-tranched
structures, including covered bonds and pass through structures as well as tranched
waterfall structures. The latter is a recent phenomenon and it is this version which accentuated the
crisis.
4. Structural benefits from securitization arise from the flexibility they provide in
transforming cash flows and risks of the collateral pool into those of the securities issued on
the pool. The traditional vanilla securitisation models have played an important role in
strengthening the lending culture by providing the lenders with an avenue to free up the
balance sheets in a cost-effective manner. Securitization can also improve balance sheet
liquidity by converting long-term and illiquid receivables into funds that can be used for
additional value-generating investments. Furthermore, securitisation enables end investors to
obtain a more efficient market portfolio and thereby diversify their idiosyncratic risks.
5. However, the growing complexity over the years dissociated securitisation from its
key positive attributes. The role that market failures in securitisation, particularly
securitisations of US subprime mortgages, played in precipitating the financial crisis has
been widely acknowledged. The analysis has thrown up various factors but the fundamental
problem with the way securitisation markets developed in recent years was the inadequate
understanding and pricing of risks inherent in the process of transformation of risks - credit
risk transformation, liquidity transformation and maturity transformation. It was expected that
the process of securitisation was undertaking a socially value-enhancing inter-temporal and
inter-participant risk transfers through the capital markets. However, there were serious
deficiencies in this process, as became evident during the crisis, the most glaring of which
were that (i) task of risk management got disowned and (ii) risks ultimately remained on the
bank balance sheets.

The "originate and distribute" approach implied a clear incentive against prudent
credit appraisal standards as the traditional risk management of the loan portfolio
through sound monitoring and analysis was found to entail significant, avoidable
costs. The focus shifted decisively from "managing the risks" to "disowning the risks"
as soon as possible.

The growing complexity and lengthening of the chain involving multiple
intermediaries resulted in increased distance from the originator. The longer chain
gave rise to several principal/agent problems.

The maturity transformations, effected through the SIV model, placed predominant
reliance on indirect bank support to short term collateralised markets for funding
long term exposures. This militated against the very concept of de-risking the bank
balance sheets.

There were fundamental modelling issues which resulted in incorrect estimation of
riskiness and default correlations of the underlying assets. The problem of adverse
incentives induced by incorrect modelling issues was further exacerbated by the
legitimacy accorded to the same by rating agencies and the regulatory framework.
6. The repair work is underway and the efforts are directed at designing a framework
for "sustainable securitisation". These include BCBS measures adopted in July 2009 to
strengthen the capital treatment of securitisation and establish clear rules for banks'
management and Pillar 3 disclosure. These actions address the regulatory arbitrage
incentives that led to distortions in the market, and at the same time will drive changes in
transaction structures and incentives going forward. Accounting standards are being
strengthened to ensure disclosure of off balance sheet entities and tighten derecognition
requirements.
7. Other proposals being considered internationally include a requirements for the
originators to retain a portion of each securitization originated and a minimum period of
retention of loans prior to securitization to give comfort to ensure adequate due diligence by
the originator.
Indian securitisation market
8. The growth in the Indian securitisation market has been largely fuelled by the
repackaging of retail assets and residential mortgages and more recently by single loan
selloff of corporate loans of banks and other financial entities. This market which has been in
existence since the early 1990s, has matured only post-2000 with an established narrow
band of investor community and regular issuers. Asset backed securitisation (ABS) is the
largest securitisation class driven by the growing retail loan portfolio of banks, investors'
familiarity with the underlying assets and the short maturity of these loans.
9. Though securitisation of auto loans remained the mainstay throughout the 1990s,
over time, the market has spread into several asset classes - housing loans, corporate
loans, commercial mortgage receivables, project receivables, toll revenues, and more
recently, even microfinance loans have been securitised. Within the auto loan segment, the
car loan segment has been more successful than the commercial vehicle loan segment,
mainly because of factors such as perceived credit risk, higher volumes and homogenous
nature of receivables. Other types of receivables for which securitisation has been attempted
in the past include property rental receivables, power receivables, telecom receivables, lease
receivables and medical equipment loan receivables.
10. The mortgage backed securities (MBS) market has been relatively slow in taking off
despite a growing housing finance market due to the long maturity periods, lack of secondary
market liquidity and the risk arising from prepayment/re-pricing of the underlying loan. Unlike
many international jurisdictions, though, MBS in India has not depended on direct or indirect
government support/guarantee.
11. In the recent times, direct assignment of single loan or retail loan pools (as against
securitisation involving a special purpose vehicle, or SPV) has been gaining importance in
India. The broad structure of such transactions is similar to that of regular ABS or RMBS
transactions, except for the absence of the issuance of any instruments like PTCs. The pool
receivables in such cases are assigned directly to the "assignee" or "purchaser". Such deals
typically involve a bank or a mutual fund acquiring the portfolio from other banks or NBFCs.
12. The choice of the route, "direct assignment" or "securitisation" depends largely on
investor preference and such deals are customised to meet the requirements of investing
entities. For instance, while MFs can invest only in "instruments", banks often prefer to
acquire loan portfolios outright, as PTCs-by virtue of being investments- would need to be
marked to market, and loans and advances do not have such requirement. Further, for the
purchasing banks, the attraction is that many of such loans qualify for the Priority Sector
Lending (PSL) requirements.
13. From a regulatory perspective, the real issue is that of regulatory arbitrage. While
there is nothing wrong in direct sale of loans, banks should appreciate that if these
transactions are being done to avoid restrictions on profit booking and higher capital
requirements for credit enhancements, RBI would have concerns. As a prudent practice,
banks should apply regulatory instructions according to the substance of transaction rather
than form.
Recent trends
14. Though the securitisation market in India is marked by relatively simple structures
and stable ratings, concerns over asset quality have affected investor appetite for
securitisation in the post-crisis scenario. Much of the securitisation activity is driven on the
supply side by growth of retail loan portfolio in banks and NBFCs and the prevalent liquidity
conditions. On the demand side, the key factors have been the requirements of mutual
funds, particularly at the short end, ,insurance companies and r banks to meet priority sector
lending targets. Most of the securities are acquired with the intention to hold to maturity.
15. As per the data compiled by major rating agencies, the year 2009-10 has witnessed
an overall moderation in the volumes in securitisation market. Total issuance volume saw a
decline of 22% in 2009-10 over the previous fiscal. The dip in the overall securitisation
volumes owed mainly to the 60% reduction in loan sell-off (LSO) issuances, which were
mostly short-term in nature. In the case of retail loan-backed transactions, with the overall
growth in retail loan portfolios being subdued and the liquidity position of most financiers
being comfortable, the need to securitise - as a funding source - was limited. Nevertheless,
securitisation of retail loans, both ABS and RMBS reported a 61 per cent increase in volume
in 2009-10.
16. While the securitisation market has remained concentrated with a handful of
originators and limited investors, the asset classes have continued to diversify, the latest
additions being gold loans, microfinance loan receivables and loan against property.
Trends in structured finance volumes (Rs. billion)
Type 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10
ABS 12.9 36.4 80.9 222.9 178.5 234.2 313.2 135.8 209.7
MBS 0.8 14.8 29.6 33.4 50.1 16.1 5.9 32.9 62.5
CDO/LSO 19.1 24.3 28.3 25.8 21.0 119.0 318.2 364.4 145.8
/SLSD
OTHERS 4 2.3 0.5 26 - - 13 11.6 7.9
TOTAL 36.8 77.8 139.3 308.1 249.6 369.3 650.3 544.7 425.9
(CDO: Corporate Debt Obligations, LSO: Loan Sell off, SLSO: Single Loan Sell-down)
Source: Various Rating agencies like ICRA, CRISIL etc.
BIS Review 105/2010
RBI guidelines
17. RBI had issued comprehensive guidelines on securitization in February 2006 based
on international best practices. The main focus of the guidelines was to encourage
securitization in manner that ensures true sale-real risk transfer and banks do not retain risks
in the transferred assets beyond a point. To this end, limit was placed on banks' exposure to
PTCs and concentration of entire credit enhancement in the originating bank was
discouraged by making second loss facilities more costly through higher capital adequacy.
Banks are however permitted to invest outside the prescribed limit for non-listed investments
in ABS and MBS which are rated at or above the minimum investment grade.
18. Another feature of the 2006 guidelines was the requirement that the gain on
securitization of assets should not be recognized upfront and should be amortised over the
life of the securities issued. This requirement was put as a conservative measure to avoid
securitisation being used to inflate profits even while banks exposures in various capacities
to the SPV remain.
19. After market showed some maturity, the capital adequacy treatment was aligned
with that under Basel II in April 2007.
20. The recent draft guidelines issued in April 2010 stipulate a minimum holding period
(MHP) and a minimum retention requirement (MRR) by the originators. The guidelines
envisage MHP of 9 months and 12 months respectively for loans with maturity of less than
24 months and more than 24 months. Similarly, the MRR for loans with maturity of less than
24 months and more than 24 months has been proposed as 5% and 10% respectively.
Banks will not be permitted to hedge the credit risk in the retained exposures counting
towards the minimum retention requirements.
21. The guidelines further stipulate that the total exposure of banks to the SPV and/or
securitised assets in the form of investments in equity/subordinate/senior tranches of
securities issued by the SPV including through underwriting commitments; Credit
enhancements including cash and other forms of collaterals including over-collateralisation
and liquidity support should not exceed 20 percent. Complex securitisation structures viz.
resecuritisation, synthetic securitisations and securitisation with revolving structures are
specifically prohibited.
22. Similar guidelines have also been issued in respect of securitisation transactions
undertaken by NBFCs.
23. The feedback received mainly briefly relates to the following:
a. Level playing field between banks and NBFCs as regards MRR and MHP - On the
one hand, there is a view that given the intrinsic nature of loans given by the
NBFCs, particularly in the microfinance sector, stringent requirements may hamper
lending in these critical areas. On the other, there is the regulatory arbitrage issue
which necessitates ensuring that the incentive structures do not again result in a
shadow banking system.
b. Applicability of the guidelines to direct assignment transactions.
c. Category-specific relaxations for MHP
d. Relaxation of MRR requirement for retail loans
e. Treatment of "time-tranched" issuances as against "credit tranched" issuances
f. Relaxation in respect of the "total exposure" norm
24. RBI is examining the responses and the final guidelines for banks as well as NBFCs
will be issued after taking into account the feedback.
Conclusion
25. Globally, over the past two decades, banks have lost their traditional role as the
dominant suppliers of credit in some countries, and securitisation has become a core
component of the market-based supply of credit. While corporate bonds served as the main
dis-intermediated financing tool for non-financial corporations, securitisation acted as the
main capital market instrument for household finance, and to a lesser degree SMEs. Post
crisis, however, many of the pitfalls of the securitisation market have come to the fore.
Securitisation per se has not been discredited totally though the new normal for securitisation
markets is expected to be lower than its pre-crisis peak.
26. Covered bonds are considered an important part of this new normal particularly in
Europe where it is permitted subject to safeguards. In this case the bonds are issued
secured by high quality assets and both the liability and the assets remain on the balance
sheet of the bank. The concentration of risks in the banking system remains which puts great
strain on the health of the bank balance sheets. More importantly, it raises issues for the
resolution regime given that the backing for depositors gets constrained.
27. The downside of securitisation that has come to the fore is the absence of
alternative solutions available to borrowers to restructure their loans when there is a
downturn with the originator since the banker-customer relationship is snapped when the
loans are securitised. Any restructuring requires consent of the final investors and in the long
chain of intermediaries it becomes difficult to restructure debt.
28. One of the reasons for the complexities of structures is that other derivatives such
as currency and interest rate swaps are also embedded in some structures. This can be
dealt with if these transactions are undertaken by the SPV and not embedded in the original
structure.
29. In the Indian context, "sustainable securitisation" can indeed play a positive role in
financial intermediation provided there is genuine transfer of risk away from the banking
system. The existing and proposed guidelines are in line with international practices and may
appear stringent but in the long term, it is imperative that securitisation market develops for
the right reasons. It is also necessary to promote standardisation to facilitate risk assessment
and valuation and eventually enable the trading of these securities on the exchanges. There
are a few challenges which need to be addressed.

Bilateral assignments of a single loan or a portfolio that are in substance
securitisation should be subject to the guidelines on securitisation.

Though securitised paper issued by securitisation SPVs has been recognised as
"security" under SCRA, there are still some tax issues relating to recognition of
pass-through structure of the SPV.

Substitution of long term funding by banks by other market intermediaries through
securitisation, particularly mortgage related securitisation, may require active
participation by real money investors such as long term institutional investors such
as insurance companies and pension/provident funds and the investment guidelines
for these entities need to accommodate this aspect.

However it is also important to ensure that such investors have better access to
essential information and less reliance on rating agencies. This will require
dissemination of loan pool composition and ongoing performance detail.

The reliance on rating agencies may be the default option, in the absence of a viable
alternative. Some of the methodological issues, though, need to be addressed by
the regulators.

There are serious data issues and as regulators of banks and NBFCs, it may
become imperative for the RBI and the SEBI to put in place a robust reporting
mechanism for primary issuances as well as secondary market data.
30. I am sure the deliberations today will cover some of these issues and come up with
viable suggestions.