Securitization and Bank Liquidity the Term Paper

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.." The Federal Reserve continues to keep a watch on both "current and potential exposures..." And are in the process of a review of the collateral valuation methods of the banking industry." (Kohn, 2008)

Kohn states that disruptions in liquidity in some financial markets have resulted in banking organizations facing challenges and specifically at present "significant liquidity demands can emanate from both the asset and liability of the bank's balance sheet." (Kohn, 2008) Kohn relates that when liquidity is reduced in the markets specifically for "certain structured credit products the creation of challenges and concerns relating to valuating spreads into other sectors and "illiquidity in some credit markets may make it difficult for some market participants, including banking organizations, to hedge positions effectively." (Kohn, 2008) Kohn states that the banking industry in the U.S. is up against some very serious challenges however, the Federal Reserve in cooperation with banking agencies in the United States has "acted -- and will continue to act - to ensure that the banking system continues to be safe and sound and able to meet the credit needs of a growing economy." (Kohn, 2008)

III. BANKING LESSONS recent report entitled: "Lessons from Northern Rock: Banking and Shadow Banking" states that two reports have been written on the "lessons...from the Northern Rock debacle" and states that is "...nothing substantially unilateral or coordinated international action to strengthen the financial system, just some pious platitudes about the need to strengthen risk management by banks and to improve the functioning of the securitization markets by 'beefing up valuation methods and the performance of credit rating agencies." (Buiter, 2008) Buiter additionally states: "This is a missed opportunity, as the current financial crisis has reminded us that when finance is global and regulation is national, accidents are much more likely to happen. Regulatory arbitrage and competitive deregulation to gain or retain footloose financial businesses within national jurisdictions have been important contributors to the excesses committed by financial institutions and to the mis-pricing and misallocation of risk by credit markets and other financial markets." (2008)

IV. CREATION of BANKING LIQUIDITY

The work of Allen N. Berger and Christ H.S. Bouwman entitled: "Bank Liquidity Creation" published in January 2007 states: "Although the modern theory of financial intermediation portrays liquidity creation as an essential service provided by banks, comprehensive measures of bank liquidity creation do not exist. We have therefore little understanding of how banks create, how this liquidity creation changes over time and the key factors that affect it." Berger and Bouwman relates that when conducting analyses of the role banks play in the creation of liquidity resulting in economic growth being spurred date traditionally back to 1776 and Adam Smith. Modern reincarnations of the idea that liquidity create is central to banking appear most prominently in the formal analyses in Bryant (1980) and Diamond and Dybvig (1983)."(2007) the argument of these theorists is that liquidity is created on the balance sheet by banks through finance of "less liquid assets with more liquid liabilities, an insight that is also closely related to the literature on financial intermediary existence." (Berger and Bouwman, 2007)

It has been suggested in the work of Kashyap, Rajan and Stein (2002) that liquidity is created off the balance sheets by banks "through loan commitments and similar claims to liquid funds." (in Berger and Bouwman, 2007) While the creation of liquidity by the banks is a generally well accepted fact of the economy, "the striking absence of empirical measures of bank liquidity creation makes it difficult to assess the size or pervasiveness of this effect. That is, we do not know the magnitude of the bank liquidity creation, the intertemporal behavior of bank liquidity creation, and the factors that affect bank liquidity creation." (Berger and Bouwman, 2007) the construction of liquidity creation measures is accomplished in the work of Berger and Bouwman through a three step process involving first the classification of assets, liabilities, equity and off-balance sheet activities of the bank as being:

1) Liquid;

2) Semi-liquid; and 3) Illiquid. (Berger and Bouwman, 2007)

The second step involves assigning weights to the activities in the first step of the process. The weights assigned as "consistent with the theory - maximum (i.e. dollar-for-dollar) liquidity is created when illiquid assets are transformed into liquid liabilities and maximum liquidity is destroyed when liquid assets are transformed into illiquid liabilities or equity." (Berger and Bouwman, 2007) Step three of the process involves construction of "four liquidity creation measure by combining the activities according to classification in the first step of the process and as weighted in step two of the process in a different manner. Berger and Bouwman state that calculations indicate that banks created in excess of $1.5 trillion in liquid assets ion 2003 which is "approximately equal to 22% of bank gross total assets or GTA and about two and half times the overall level of bank equity capital." (Berger and Bouwman, 2007) the total then is approximately $2.5 of liquidity per $1 of capital." (Berger and Bowman, 2007) the creation of liquidity is stated by Berger and Bouwman to have grown "dramatically over time." (2007) Furthermore, creation of liquidity "differs dramatically between large banks (GTA exceeding $1 billion) and small banks (GTA up to $1 billion)." (Berger and Bouwman, 2007) These writers relate incidentally that these calculations are "...in real 2003 dollars." Calculations stated by Berger and Bouwman for large banks responsibility towards the creation of industry liquidity is at a rate of 85% and further calculations shown that these banks are also responsible for creation of 80% of the industry assets as well, yet comprise merely 5% of the sample observations according to Berger and Bouwman (2007). A capital structure that is fragile is one that "encourages the bank to commit to monitoring its borrowers, and hence allows it to extend loans. Additional equity capital makes it harder for the less-fragile bank to commit to monitoring, which in turn hampers the bank's ability to create liquidity." (Berger and Bouwman, 2007) Liquidity creation may also be reduced due to crowding out of deposits."

This is referred to as the "first set of theories jointly" in the work of Berger and Bouwman as "financial fragility-crowing out' hypothesis of capital." (2007; p.3) Stated as a different manner in which to view this is to attain the perspective that the bank's capacity for absorption of risk is improved by capital and therefore liquidity is created. The bank's exposure to risk is increased by liquidity and the more the creation of liquidity occurs the "greater the likelihood and severity of losses associated with having to dispose of illiquid assets to meet customers' liquidity demands." (2007; p.3) the role of capital is one which has a well-known feature of risk absorption and expansion of the capacity of banks to bear risk. (Bhattacharya and Thankor, Von Thadden, 2004) Thus, capital rations that are higher enable the creation of more liquidity by the banks which is referred to in the work of Berger and Bouwman and 'risk absorption' hypothesis. It is these two theories, the risk absorption theory and the financial fragility-crowing out theory together which "produce this prediction."(2007)

V. SECURITIZATION and the IMPACT to BANK LENDING

The work of Elena Loutskina (2004) entitled: "Does Securitization Affect Bank Lending? Evidence from Bank Responses to Funding Shocks" reports a study conducted on banking lending and the effect of securitization and states that the market for securitized loans since the 1970s in the U.S. "has grown to dominate the mortgage market and has become an increasingly important factor in lending to both consumers and businesses." (Loutskina, 2004) Loutskina relates that $5.5 trillion in loans were securitized in 2003, which is approximately forty percent of outstanding loans. The securitization market presently "exceeds the size of the corporate bond market...and despite its importance, there is little research on how securitization has changed the behavior of banks." (2004) the work of Loutskina "...illustrates three ways that advancements in financial services have changed the nature of banking..." And includes the following:

Securitization has become an integral part of bank liquidity-risk management;

Securitization increases banks credit supply across sectors; and Banks' ability to securitize liquid mortgages increases their willingness to supply illiquid business loans. (Loutskina, 2004)

Loutskina states: "The major contributors to the development of bank loan securitization have been the so-called Government-Sponsored Enterprises (GSEs) that were created by the U.S. Congress to provide stability and ongoing assistance to the secondary market for residential mortgages and to promote access to mortgage credit and home ownership in the U.S.11 GSEs foster securitization by being the largest buyers of mortgages in the U.S. Fannie Mae and Freddie Mac, combined, purchase almost one-half of all conventional single-family mortgage loans originated each year. More importantly, GSEs facilitate small bank access to the securitization market by standing by to purchase individual mortgages as well as mortgage…[continue]

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