Securitization is a process in which a corporation pools its various financial assets and debts to create a consolidated financial instrument sold to investors. In exchange, investors in these securities receive interest.

The purpose of this procedure is to increase market liquidity. This is a helpful instrument, particularly for financial firms, as it allows them to raise capital. If a corporation has previously provided many loans to its clients and wishes to increase the amount, securitization can help.

In this situation, the corporation can pool its assets and debts to create financial instruments to sell to investors. This allows the company to expand its capital base and offer more loans to its consumers. On the other hand, investors can diversify their portfolios and earn high returns.

Aggregating multiple types of debt instruments (assets), such as mortgages and other consumer loans, and selling them as bonds to investors is known as securitization. Asset-backed security (ABS) or collateralized debt obligation is the name given to a bond created in this manner (CDO). The bond is referred to as mortgage-backed security if the debt instrument pool comprises mostly mortgages (MBS). The holders of these securities are entitled to receive principal and interest payments on the obligations they are backed by.

Lenders benefit from securitization because it offers liquidity and allows them to diversify their holdings to reduce risk. The securitized pool of debt instruments is separated and sold into smaller portions known as tranches. Each tranch reflects a claim to a portion of the underlying debt instruments’ receipts. Tranching allows smaller investors to purchase these products while allowing lenders to generate more money by selling them to a larger market.

ABSs are frequently made up of various debt instruments, such as mortgages, credit card debt, vehicle loans, and so on. The complexity of the mixture can make assessing the security’s riskiness difficult for an investor who buys a piece of it.

The securitization of mortgages into MBSs financed most of the surge in subprime lending in the United States in the 1990s. Subprime mortgages, which were issued to households with weak credit records, made up a large share of the mortgages securitized at this time.

The securitization of mortgages into MBSs financed most of the surge in subprime lending in the United States in the 1990s. Subprime mortgages, which were issued to households with weak credit records, made up a large share of the mortgages securitized at this time.

The mortgage-securitization market was severely harmed by the financial crisis of 2007–08 and the subsequent Great Recession. As the number of defaults on subprime mortgages increased, MBSs backed by subprime mortgages became worthless. The Federal Reserve, the US central bank, began buying MBSs from investors through quantitative easing (QE) operations to provide essential liquidity to the financial markets.

As the financial markets gradually recovered, banks and other financial institutions began to reintroduce securitization to profit from their growing portfolios of new mortgages and refinances. Nonetheless, to maintain adequate liquidity, the Federal Reserve continued to buy MBSs from the market for several years following the recovery.

Securitization’s Importance in Bank Liquidity and Funding Management

The importance of securitization in bank management is investigated in this research. I propose a new “bank loan portfolio liquidity” index, a weighted average of the capacity to securitize loans of a specific type, with the weights reflecting the composition of a bank loan portfolio. I utilize this new index to demonstrate how securitization diminishes banks’ liquid securities holdings while increasing their lending capabilities by allowing them to transform illiquid loans into liquid cash. Securitization also gives banks a new funding source and makes bank lending less susceptible to cost-of-funds fluctuations. As a result, securitization reduces the monetary authority’s power to influence bank lending activity while making banks more vulnerable to liquidity and funding crises if the securitization market is shut down.

First, I examine whether securitization has lowered banks’ need for liquid assets to fulfill unanticipated depositor and borrower needs. I show that securitization substitutes traditional liquid money on bank balance sheets using the new loan liquidity index (Sit). Because banks decide on liquidity levels and lending together, I utilize two methods to account for endogeneity. First, I use a synthetic instrument similar to the loan liquidity index to implement the instrumental variable regressions (Sit). I employ fixed bank portfolio choices as of the beginning-of-period values while designing the instrument. This constant-over-time loan portfolio structure eliminates the effect of managers’ discretion, ensuring that the instrument only varies when the securitization market deepens. Second, I conducted a difference-in-differences analysis on two sets of regulatory interventions and market shocks that significantly altered the ability or willingness of the securitization market to absorb new loans.

The findings show that as banks’ ability to securitize loans has grown, they can maintain liquid assets on their balance sheets. This reduction is statistically and economically significant in magnitude. Due to the rising secondary lending market, the share of total assets held as liquid securities declined by 7.33 percentage points from 1976 to 2007. This drop equates to around 69 percent of bank capital and cannot be explained by patterns such as increased average bank size or changes in banking regulation. Because liquid funds and loans are two of the most critical components of a bank’s assets, a reduction in liquid funds suggests an increase in lending. As a result of securitization, the availability of bank loans per dollar of capital grew.

I believe that securitization has reduced the sensitivity of loan growth (particularly in business loans) to cost of funds shocks. Under monetary tightening, a bank with a more liquid loan portfolio (e.g., one that holds a considerable quantity of mortgages) experiences a more minor on-balance sheet reduction in lending than a bank with a less liquid loan portfolio (e.g., a bank focused on business lending).

Discussion and conclusion

The impact of securitization on the nature of banking is examined in this research. I propose a new bank-level liquidity index for bank loan portfolios, which I use to assess the impact of securitization on bank liquidity and lending management. First, I believe that securitization functions as a substitute for a bank’s on-balance sheet liquidity. It offers deposit institutions a convenient way to transform illiquid loans into liquid securities.