CU-MBA-SEM-IV-International Banking and Forex

to the Tokyo Interbank Offer Rate. Since non-Japanese banks are dominating the LIBOR panel and the Tokyo city banks are dominating the TIBOR panel, the changing TIBOR- LIBOR spread indicates the credit risk related to Japan premium or Japanese banks. The determinants of Japan premium are investigated in this paper. Based on the results, it is discovered that interest rate, as well as, stock price effects combined with public information of good and bad news concerning Japanese banking can explain the systematic variation of the spread. This examines how LIBOR rates are affected by underreporting. On the 29th of May, 2008, it was reported by the Wall Street Journal that a number of big international banks were reporting inexcusable LIBOR rates that were low. Since the report, two large banks known as UBS and Barclays have paid huge fines for altering their LIBOR rates and other banks are meant to be fined as well. This analyses the underreporting of LIBOR rates by certain banks and if it had a major effect on the reported LIBOR rates. This was tested by if there was a major change in the relations holding between the LIBOR rate and a different rate which shows banks default risk. 3.3.1 Introduction The most widely used financial benchmark, the LIBOR, was found to have been manipulated by individuals at various financial institutions. The event created shock waves in the financial system – the credibility of a financial reference used to price and determine payoffs for trillions of dollars of loans/bonds/derivatives came under a cloud. The crux of the problem lay in the fact that LIBOR prices a market – the market for unsecured wholesale term lending for banks – in which dwindling volumes rendered efficient pricing difficult. Structural changes in the financial markets, especially since the global financial crisis, meant that transaction-based submissions leading to LIBOR formation tapered off and what is left are estimates. In affirmative action, in 2017, the Financial Conduct Authority (FCA), UK, announced that it would not use its legal power to mandate banks to poll LIBOR beyond end-2021. The search for alternative reference rates has begun by shifting away from a benchmark that has been almost universally used in financial contracts globally for nearly five decades is a formidable challenge worldwide and in India even as the end date is fast approaching. Against this backdrop, this looks at the evolution of LIBOR, the events leading to the decision to replace it, the search for alternative benchmarks and the issues involved in transition. Section II of the traces the origin of LIBOR and the efforts at reforming it over the years. Section III delves into the search for alternate benchmarks and the issues around the transition to alternate benchmarks. Section IV examines how the transition affects the Indian jurisdiction. Section V concludes with policy perspectives. 3.3.2 The Origin The use of LIBOR interest rates can be traced to the rise of the Eurodollar market (US dollar to the rise of the Eurodollar market in branches of banks outside the US in the 1960s. The 51 CU IDOL SELF LEARNING MATERIAL (SLM)

origin of the term ‘LIBOR’ has been credited to a Greek banker called Minos Zombanakis, who was running the London branch of Manufacturers Hanover, now part of JPMorgan.2 In 1969, he organised an $80 million syndicated loan for the Shah of Iran, referenced to what he called a London interbank offered rate. These rates were initially computed for three currencies – the US dollar, the British pound and the Japanese yen. Over time, more currencies / maturities got added and, at its peak, LIBOR rates were announced for ten currencies in 15 maturity terms ranging from overnight to one year. At present, 35 LIBOR rates are posted each day for seven maturities each for five major currencies, viz., the Swiss franc, the Euro, the Pound sterling, the Japanese yen, and the US dollar. LIBOR rates are computed as a ‘trimmed mean’ of polled rates elicited from major banks based on responses to the question: ‘At what rate could you borrow funds were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 a.m.? The subjective nature of size just prior to 11 a.m.?’ The subjective nature of the question, especially related to timing and size – ‘reasonable market size’ and ‘just before 11 a.m.’ – leave LIBOR vulnerable to manipulation. Concerns about LIBOR and its governance process are, however, not new. As the use of LIBOR grew during the 1970s and 1980s, polling banks started accepting Euro dollar deposits at interest rates linked to LIBOR, leading to adverse incentives to report lower rates. In view of these concerns, the British Bankers’ Association took over the governance process of LIBOR in 1986. Over time, the evolution of the repo market led to a decline in the volumes of unsecured interbank transactions. As these transactions dwindled, LIBOR rates became increasingly un-verifiable and increasingly reliant on expert judgement of banks. Conflicts of interest were inherent – the polling banks have ‘significant’ presence in related markets, but they also hold large derivative and loan contracts that are priced by using LIBOR rates. Discrepancies were first observed during 2007-08 when the polled rates were found to be not reflecting the actual rates at which banks lent to each other. The possibility that banks were reporting LIBOR quotes significantly lower than those implied by prevailing credit default swap (CDS) spreads was highlighted in a Wall Street Journal and in various research papers in 2008. This brought attention to the fact that there were incentives for banks to manipulate LIBOR rates as instruments through which banks signal their perceived credit-worthiness, especially in periods of stress or through which trading positions could be influenced. Post this publication, there was an immediate spike in the 3-month USD LIBOR rate. This triggered off investigations into the LIBOR fixation process. By 2012, manipulations in LIBOR fixations were established and banks were levied with fines totalling about $ 9 billion for misconduct. In response to these developments, the UK commissioned a review of the structure and governance of LIBOR. The Wheatley Review concluded that LIBOR should be retained as a benchmark but that it should be comprehensively reformed. It made wide-ranging recommendations about improvements in the benchmark governance process for LIBOR. It also recommended that publication of LIBOR in certain currencies and maturities in which the volumes of trades were particularly low should be discontinued. Several reforms to the governance process 52 CU IDOL SELF LEARNING MATERIAL (SLM)

were undertaken in the wake of the recommendations. In particular, the responsibility of benchmark administration was moved to the Intercontinental Exchange (ICE), an oversight committee to independently challenge the benchmark processes was put in place and governance reforms were carried out in the submitting banks. 3.3.3 In Search of an Alternative Benchmark LIBOR serves as a reference rate at which financial instruments can contract upon to establish the terms instruments can contract upon to establish the terms of agreement and also as a benchmark rate that reflects a relative performance measure for investment returns. LIBOR is used almost ubiquitously in global financial markets for a wide array of financial instruments in different kinds of loan and derivative products, thereby enabling non-rival consumption properties akin to a public good in terms of reducing complexity, increased standardization, enhanced liquidity and lower transaction costs. Beyond the pricing of financial instruments, LIBOR is also extensively used for valuation and accounting purposes. An Alternative Reference Rate (ARR) – one which retains the desirable features of LIBOR while ensuring that it is based on transactions in liquid markets – has to satisfy several key attributes; it should provide to satisfy several key attributes; it should provide a robust and accurate representation of interest rates in core money markets that is not susceptible to manipulation; it should offer reference rates for financial contracts that extend beyond the money market; and serve as a benchmark for term lending and funding Jurisdictions where LIBOR is the domestic interbank interest rate benchmark have identified alternative benchmarks linked to actual transactions in liquid markets. In practice, this has resulted in ARRs based on shorter-tenor contracts – essentially overnight repo markets, which are the most liquid and secured rather than unsecured transactions. Additionally, the ARRs have moved beyond pure interbank markets to include non-bank wholesale participants such as money market and investment funds and insurance companies in a bid to garner a wider participant base. In addition, several jurisdictions where LIBOR forms one component of the local interest rate benchmarks have also identified or are identifying new benchmarks. For example, in Singapore, the existing benchmark – the Singapore Dollar Swap Offer Rate (SOR) – uses LIBOR as one of its components. The jurisdiction has identified the Singapore Dollar Overnight Rate Average (SORA) - a transaction-based benchmark with no term component – as its ARR and a few SORA based transactions have already been contracted. In Thailand, the Thai Baht Interest Rate contracted. In Thailand, the Thai Baht Interest Rate Fixing (THBFIX) relies on LIBOR. The Thai Overnight Repurchase Rate (THOR) has been identified as the ARR for the jurisdiction. The LIBOR is a combination of interbank rates comprising credit risk premia, term premia and liquidity premia. As against this, ARRs are overnight benchmark rates, which lack a term structure and a credit risk component. For the transition from LIBOR to ARR to succeed, term rates will need to emerge to enable ARRs to serve as reference rates for new financial contracts. Also, the development of liquid financial markets linked to the new rates will be critical. Both these aspects present significant 53 CU IDOL SELF LEARNING MATERIAL (SLM)

challenges. Development of term benchmarks should ideally be based on actual transactions in line with the overall thrust of benchmark reforms. The simplest construct of term structures will be to compound overnight interest rates, i.e., ‘compounding in arrears. These term structures will, however, be backward looking in contrast to the LIBOR, which is forward- looking. By design, therefore, the ARRs will not reflect market expectations about future interest rates or financial conditions. Policy makers across the world, including the Financial Stability Board (FSB), have been emphasizing that overnight ARRs compounded in arrears will and should become the norm and that transition efforts should not await the emergence of forward-looking term versions of risk-free rates (FSB, 2019). Nevertheless, there will be some parts of the market, which will need forward-looking term reference rates. Development of liquidity in contracts that reference ARRs remains a challenge, and is, in many ways, a chicken-and-egg problem. Deep markets are likely to develop only when new contracts start referencing the ARRs. At present, bond issuances linked to Secured Overnight Financing Rate (SOFR) and Sterling Overnight Interbank Average Rate (SONIA), in particular, have begun and now constitute a significant share of total floating rate bond issuances. Trading in derivatives has also begun. Trading volume in SOFR and SONIA futures has been increasing over the months. 3.3.4 The Indian Context The use of benchmarks in the Indian financial system is not new. A range of foreign exchange and interest rate benchmarks have been in use, primarily by the banking sector, to price contracts and value assets and liabilities. The Reserve Bank has been taking steps to preserve the integrity of such benchmarks. In the context of manipulation of LIBOR, it constituted a Committee on Financial Benchmarks in June 2013, to review the systems governing financial benchmarks in India. 7 Pursuant to the recommendations of the Committee, an independent entity i.e. Financial Benchmark India Pvt. Ltd (FBIL), was set up to act as an administrator for benchmarks in debt, interest rates and foreign exchange markets. The FBIL now administers various benchmarks - Overnight Mumbai Interbank Outright Rate (MIBOR); Mumbai Interbank Forward Outright Rate (MIFOR); Market Repo Overnight Rate (MROR); Forward Premia Curve; Foreign Currency Rupee Options Volatility Matrix; and Rupee reference rates. In June 2019, the Reserve Bank put in place a regulatory framework for financial benchmark administrators, aimed at ensuring acceptable standards of governance and accountability as well as the quality of benchmarks and of the computation methodology in the benchmark administration process. Six financial benchmarks, viz, MIBOR, MIFOR, USD/INR Reference Rate, Treasury Bill rates, valuation of Government Securities and valuation of State Development Loans (SDL) were notified as significant benchmarks in January 2020. In India, exposures to LIBOR arise from loan contracts linked to LIBOR; FCNR deposits with floating rates of interest linked to LIBOR; and derivatives linked to LIBOR or to the MIFOR - a domestic benchmark based on LIBOR. Preliminary estimates suggest that about $50 54 CU IDOL SELF LEARNING MATERIAL (SLM)

billion of debt contracts in the form of ECB/FCCBs and $281 billion of derivative contracts will expire beyond 2021. These figures are, however, not static as new contracts referencing LIBOR continue to be signed. In addition, there are Government exposures linked to LIBOR. These include LIBOR-referenced loans availed by the Government from multilateral / bilateral agencies and Lines of Credit offered to other countries. A large number of trade contracts also reference LIBOR but most of these are short term and existing contracts may not continue after the cessation of LIBOR. The challenges for India and milestones for preparing for the cessation of LIBOR at the end of December 2021 are similar to those faced by other jurisdictions, especially those which are, in some sense, ‘LIBOR-takers’, i.e., they rely on LIBOR interest rates of major jurisdictions. In India, MIFOR – which has LIBOR as one of its components – is a key benchmark used in the interest rate swap (IRS) markets. An alternate benchmark based on global ARRs will need to be developed in place of the MIFOR. At present, the Clearing Corporation of India Limited provides guaranteed settlement for IRS contracts that reference the MIFOR. The clearing and settlement arrangements will also need to be modified to provide for the alternate benchmark. 3.4 EURIBOR The Euro Interbank Offered Rate (Euribor) and the Euro Overnight Index Average (Eonia) are critically important interest rate benchmarks for the eurozone. Yet they are about to be either replaced or transformed, because neither complies with the recently introduced EU Benchmarks Regulation (BMR). The race is on to reform Euribor so that it complies before the BMR authorization deadline of 1 January 2020. No attempt will be made to reform Eonia, however, and transition to a new overnight reference rate will be required. European authorities have established an industry working group tasked with recommending alternative euro risk free rates and a plan for adopting them. The European Central Bank (ECB) is simultaneously developing Euro Short-Term Rate (ESTER), a new euro unsecured overnight interest rate, a possible alternative to Eonia and, potentially, to Euribor. While regulators are supportive of the Euribor reform process, its success is not guaranteed. There are scenarios where the volume of transactions in the market which Euribor is meant to reflect prove insufficient even for a hybrid methodology. This could leave the industry needing to adopt (as yet, undefined) new reference rates for new business from as early as January 2020. The disruption could be yet greater if banks need to transition the >$175 trillion stock of outstanding contracts referencing Euribor and Eonia to alternative rates. Preparations are already underway for a transition away from the London Interbank Offered Rate (LIBOR), an equivalent to Euribor for US Dollars and four other major currencies (including EUR- LIBOR), triggered by the FCA’s announcement that it will stop supporting LIBOR after 2021. As of today, the industry has less than four years to make the transition, which is claimed by many to be too little time given the ubiquity of LIBOR and the potential systemic risks created by the transition. There has so far been much less attention on Euribor and Eonia but, in the worst case, the transition time may be less than two years. With a similar 55 CU IDOL SELF LEARNING MATERIAL (SLM)

order of magnitude of business referencing Euribor and Eonia as LIBOR, this represents a major risk. In the best case, Euribor can be reformed to allow a seamless transition, as with the recent reform of the Sterling Overnight Interbank Average (SONIA) rate in the UK. But whether this best case will eventuate will not be known until very close to the deadline, and this still leaves the issue of Eonia. Given the volume of business involved, it would be a brave institution that relied on this happening without developing a Plan B. Transition from the rates presents a unique set of challenges for market participants due to their ubiquitous nature; the range of clients impacted, with varying levels of sophistication; the economic impact due to potential material differences between Euribor/Eonia and an alternative rate but also potentially between Euribor today and a successfully reformed Euribor; and the very present conduct and litigation risk which is building with every contract that is currently being entered into with a maturity beyond the transition dates. Euro rate transition has more expedited timelines than even LIBOR transition. Firms with exposure to Eonia must now shift gear to prepare for transition to an alternative rate. Firms need to also take action now to develop a credible Plan B for Euribor transition in the event that reform is unsuccessful or if the reformed rate is materially different. Delaying action will only increase the final transition costs and will amplify the financial, operational, and reputational risks. Indeed for some firm’s transition costs in excess of $100 million have been estimated. European banks that mobilize now for Euro rate transition will reap the benefits in LIBOR transition. Euribor and Eonia are critically important for the eurozone. Together, they are used as reference rates for >$175 trillion of wholesale and retail financial products, including long- term residential mortgages in Finland, Spain, and Italy. And they have several other applications across both financial and non-financial sectors. However, EMMI, the administrator for both Euribor and Eonia, has determined that neither currently complies with the BMR that came into effect on 1 January 2018. In particular, changes must be made to comply with the regulatory requirement that benchmarks should be “anchored in transactions, to the extent possible”. To be used within the EU, EU benchmark administrators must be authorised by regulators, with a deadline of 1 January 2020 to apply for authorization. Euribor will need to be reformed to meet BMR requirements by this date if it is to be used afterwards. EMMI has already announced that it will not seek to reform Eonia to meet BMR requirements, and new contracts will not, therefore, be able to reference it from 1 January 2020. Under BMR, benchmark users are required to have written plans setting out the actions they would take in the event a benchmark materially changes or ceases to be provided. BMR also restricts the period during which authorities can compel submission or the administration of “critical” benchmarks to two years. If Euribor panel banks were to request withdrawal, the number of submitters could fall to a level which makes calculation of Euribor impossible after the two-year compulsion period. Indeed, the number of panel banks submitting data to calculate Euribor has already decreased from 43 in 2008 to 20 today. By way of comparison, before the principal provisions of BMR came into force, the UK’s FCA gained voluntary support from LIBOR submitters for four and a half years to support the transition. 56 CU IDOL SELF LEARNING MATERIAL (SLM)

3.5 ECDS CMR is based on the detection of signals from hydrogen nuclei which are in very high concentration within the body (approximately 100 M). Upon a patient entering a scanner, hydrogen nuclei align with and “presses” about the axis of the magnetic field. This precession can be perturbed by application of additional small magnetic field pulses. By applying these pulses in a controlled manner in the form of “pulse sequences,” signals can be received and processed to produce an image of the spatial distribution of the spins or protons within the body. A unique feature of CMR is the availability of multiple types of pulse sequences for imaging that can define cardiac structure, characterize tissue, or measure cardiovascular function. The strength of the magnetic field within the scanner is measured in Tesla (T). Typical commercially available CMR field strengths for use in patients with cardiovascular disease are 1.0-, 1.5-, and 3.0-T. In general, images acquired at higher field strengths exhibit proportionally greater signals, and thus can produce images with higher spatial resolution and more precise delineation of cardiac or vascular structures. On occasion, however, artifacts become more prominent at higher field strengths, which may sometimes negate the advantage provided by the higher spatial resolution. Third, CMR is a flexible imaging modality that allows assessment of multiple different parameters of cardiovascular anatomy and function. As mentioned, CMR can define cardiovascular anatomy and structure, characterize tissue composition, measure function in terms of heart wall motion or blood flow, assess metabolism with spectroscopic techniques, visualize and quantify myocardial perfusion, and define the course and orientation of epicardial coronary arteries. Importantly, recent advances allow for the acquisition of this type of information throughout the body; thus, the ability exists to precisely define cardiovascular phenotype in patients with disease processes such as atherosclerosis, cardiomyopathies, diabetes, and hypertension that commonly affect individuals with cardiovascular disease.3 A fourth advantage of CMR imaging is the ability to quantify with relatively high spatial and temporal resolution meaningful measures of cardiovascular structure or performance that discriminate normal from abnormal pathologic conditions or denote adverse cardiovascular prognoses.3 At 1.5-T, voxel sizes of 113 cm can be acquired with most pulse sequence strategies. When cine sequences are required, frame rates of 20 to 40 ms are routinely available allowing for the characterization of time-dependent processes such as left ventricular (LV) diastolic function. Measurements of myocardial mass; blood flow through vessels or across valves; LV or right ventricular (RV) myocardial thickening, strain, or tissue perfusion; infarct size; or plaque burden can be quantified in absolute terms. Studies have confirmed high reproducibility and low variance of these measures in repeated samples indicating marked precision of CMR for use in clinical or research examinations 57 CU IDOL SELF LEARNING MATERIAL (SLM)

Dark blood imaging sequences, for example, those acquired with spin echo or inversion recovery techniques, are used to acquire morphologic images of the heart.5–8 In these techniques, protons in non-moving or slowly moving structures such as the myocardium provide high signal in the images, while rapidly flowing blood within the heart and great vessels moves out of the imaging slice, resulting in a signal void. Dark blood imaging strategies are used throughout the spectrum of cardiovascular diseases, including the assessment of cardiac and great vessel morphology in congenital heart disease and thoracic aortic disease, the assessment of myocardial masses, and the evaluation of the pericardium. CMR is an accurate and highly reproducible technique for measuring ejection fraction and ventricular volumes in 3 dimensions.16 Unlike 2-dimensional (2D) projection techniques, cine CMR imaging does not rely on geometric assumptions or calculations based on incomplete sampling of the cardiac volumes.17–19 Newer SSFP techniques have largely replaced conventional GRE for cine CMR assessment of myocardial volumes, mass, and systolic function.20,21 An offset exists between the older conventional GRE techniques and SSFP ingenerated CMR measures. The offset between volumes and mass between the 2 CMR methods is linear over the range of interest, so that normal databases for myocardial function may be adapted for the newer SSFP cine CMR method. For CMR measurement of myocardial volume and mass, consecutive breath-hold short axis 6- to 10-mm tomographic cine short-axis cross-sections of the heart are obtained; the summation of discs method is then applied to determine the total myocardial mass and volume.3 A series of long-axis views rotated around the anatomical axis of the left ventricle can also be used to assess LV function with comparable accuracy.23–25 In a typical application, the temporal resolution of cine CMR for myocardial function determination is 50 ms or less. Breath-hold time for each cross-sectional slice is approximately 5 to 10 seconds; the lower imaging times are achieved with newer CMR scanners that use parallel imaging techniques. For myocardial mass, the total volume of the myocardial wall at end-diastole is multiplied by the specific gravity of the myocardium (1.05 g/mm3). Myocardial mass and ventricular volumes are commonly adjusted for body size by dividing raw measures by body surface area to derive indexed values. Single acquisition, 3-dimensional (3D) CMR acquisition methods for the heart are available. The temporal resolution in thin, relatively new acquisition is typically lower than the slice-by-slice acquisition methods; spatial resolution is lower as well. The primary advantage is a single breath-hold of 20 to 30 seconds to cover the entire myocardium in this cine 3D mode. A significant advantage of CMR for evaluation of myocardial mass and volume is its reproducibility and accuracy compared with 2D planar or projection techniques that depend on geometric assumptions in order to define mass and volume determinations. As a result, small changes in myocardial mass and/or volume can be detected over time or as a result of therapy. This is particularly useful for determining the impact of therapy or for research purposes in clinical trials where sample size can be reduced by an order of magnitude compared with planar or projection techniques using LV geometric assumptions.26,27 CMR LV size and systolic function are precisely determined with 58 CU IDOL SELF LEARNING MATERIAL (SLM)

standard errors of about 5%.16,19,28–30 Using CMR, normal LV volumes and mass have been determined to be smaller for women than men even after adjustment for body size.16 In normal individuals, LV mass is relatively constant with increasing age in adults, although LV volumes decrease by about 3% per decade from age 45 years. Asian-American men tend to have slightly smaller body size– adjusted LV mass and volumes (5%) compared with Whites, African-Americans, and Hispanics. Regional myocardial function may be assessed using CMR tagging In this method, specialized radiofrequency pulses are applied prior to the beginning of the cine CMR pulses sequence. These additional pulses result in alteration of the magnetic properties of the heart, typically in a grid stripe pattern. The grids or stripes are dark relative to the remaining myocardium, and the grids are displaced as a result of myocardial motion/contraction. For research purposes, specialized software is available for dynamic analysis of the spacing between the magnetic stripes, allowing regional myocardial strain to be calculated. CMR tagging has allowed precise quantification of regional heterogeneity in myocardial contraction in the setting of coronary artery disease (CAD) and nonischaemic cardiomyopathy. In clinical practice, CMR tagging is most commonly interpreted qualitatively rather than quantitatively. New methods DENSE [displacement encoding with stimulated echoes in CMR] and HARP [harmonic phase] may offer more automated methods for myocardial strain analysis. 3.6 INTERNATIONAL COMMERCIAL BANK’S ASSETS Having established the pivotal role performed by the banking system in the Indian financial sector and by implication, in the system in the Indian financial sector and by implication, in the overall financial intermediation process, thus supporting the real sector of the economy. The strong points of the financial system are its ability to mobilize savings, its vast geographical and functional reach and institutional diversity. Between 1965 and 1990, the household sector’s gross savings in the form of financial assets rose from 5.5 per cent to 12.2 per cent of net domestic product. Since 1969 when major banks were nationalized, the number of commercial bank branches increased from about 8,300 to well over 65,000 by 2005. The commercial banking structure in India consists of: Scheduled Commercial Banks and Unscheduled Banks. Scheduled Commercial Banks and Unscheduled Banks. Scheduled commercial banks constitute those banks, which have been included in the Second Schedule of Reserve Bank of India (RBI) Act, 1934. RBI includes only those banks in this schedule, which satisfy the criteria laid down vide section 42 (6) (a) of the Act. Indian banks can be broadly classified into nationalized banks/ public sector banks, private banks and foreign banks. The Indian banks include 27 public sector banks excluding 196 Regional Rural Banks (RRBs). Prof. Syers, defined banks as “institutions whose debt—usually referred to as ‘bank deposits’—are commonly accepted in final referred to as ‘bank deposits’—are commonly 59 CU IDOL SELF LEARNING MATERIAL (SLM)

accepted in final settlement of other people’s debts”. According to Banking Regulation Act of 1949, “Banking means the accepting for the purpose of lending or investment of deposits of money from the public, repayable on demand or otherwise, and withdrawal by cheque, draft, order or otherwise”. From the above definitions we can analyse that the primary functions of banks are accepting of deposits, lending of these deposits, allowing deposits to withdraw through cheque whenever they demand. The business of commercial banks is primarily to keep deposits and make loan and advances for short period up to one or two years made to industry and trade either by the system of overdrafts of an agreed amount or by discounting bills of exchange to make profit to the shareholders. From the above discussion, we can say that the following are the functions of commercial banks. Asset’s structure will reflect the deployment of sources of funds of commercial banks. The main source of funds of commercial of commercial banks. The main source of funds of commercial banks is deposits. The other sources of funds are borrowings from other banks, capital, reserves and surplus. The deposits of commercial banks are from savings deposits, current account deposits and term deposits. These deposits constitute 80 per cent of the total sources of funds. Out of the total deposits, term deposits constitute 50 per cent. Borrowings are around 5 per cent of the total liabilities of the commercial banks. These sources are deployed by the commercial banks mainly on its financial assets i.e., loans and advances which constitute 48.6 per cent of the total assets of the banks. The investments is another important component of the assets of commercial banks which is around 40 per cent of the total assets of the banks during the year 2005. This is because of pre-emptions like SLR and CRR requirements in the banking sector. The investments in commercial banks have increased also because of surplus liquidity in Indian banks during this period due to reduction of SLR and CRR to 25 and 4.5 respectively during that period and less demand for loans and advances from credit-worthy customers. This scenario is changing in India due to increasing demand in credit from industrial, agriculture sector and also the growth of FMCG market. The assets structure of the banks is governed by certain principles, like liquidity, profitability, shift ability and recklessness. The other factors which influence the assets structure of Commercial Banks 39 commercial banks are nature of money market, economic growth of the country, policies and vision of the governments. In the countries like India, China, Russia, North Korea and Brazil there is a boom in the growth of the economy hence naturally there will be heavy demand for the credit. 3.7 FORMS OF INTERNATIONAL LENDING The relationship between commercial banks and developing countries has been transformed in the developing countries has been transformed in the past fifteen years. Before 1970 banks lent developing countries relatively small amounts to finance trade and to meet the requirements of subsidiaries of multinational companies located there. After 1970, banks went on to become the fastest-growing and most flexible source of foreign finance for 60 CU IDOL SELF LEARNING MATERIAL (SLM)

developing countries primarily to cover balance of payments deficits only to run into the debt problems of the early 1980s. The past three years have been traumatic for many banks and their borrowers in the developing world. There has been a retrenchment of bank lending that has emphasized the instability of the relationship with developing countries. All parties have learned some valuable lessons, which will help to redefine their relationship for the years ahead. The securities markets, in contrast, have not had such strong ties with developing countries. Given that the markets for bonds and a number of innovative securities have grown recently while traditional bank lending has fallen, there is a question as to whether the securities markets could play a bigger role in financing developing countries. The banking relationship- The commercial links between banks and developing countries are complex and extensive. They run from simple deposit taking to short-term lending, trade financing (both with and without official guarantees), and medium-term lending (often in syndicated form). All of these types of business appear on banks' balance sheets. But off-balance sheet operations have also been important; they include advice on managing debt and reserves, and business such as letters of credit for financing trade. These ties often started when developing countries placed their liquid reserves with the banks., the low-income countries have consistently been net depositors with the 110 banks, while the middle-income groups have become net borrowers. This contrast reflects the fact that low-income countries are seldom creditworthy enough to borrow from the banks. Developing countries have dealt both with the head offices of international banks and with offices operating in the Eurocurrency markets. However, many banks have set up offices in developing countries, both to channel external finance and to undertake domestic banking business. Altogether the various banks located within developing countries have received about 36 percent of the funds channelled by outside banks to these countries over the past four years. Developing countries' own banks are playing an increasing role in raising external funds for domestic users as well as in performing a broad range of business services. Lending has been the main form of international banks' business with developing countries, and it grew very rapidly between 1973 and 1981. Bank claims on developing countries increased at an average annual rate of 28 percent over this period. In 1973 total new international lending amounted to $33 billion, of which 29 percent went to developing countries. By 1981 new lending was $165 billion, of which developing countries composed 32 percent. Much of the lending was syndicated Eurocurrency loans carrying five- to ten-year maturities and floating interest rates. Lending to developing countries in this form increased from $7 billion in 1973 to $45 billion in 1981. Most syndicated loans were arranged by a core of twenty-five to fifty large commercial banks based in the industrial countries. Up to 3,000 others (second tier banks) joined in from time to time. They included regional banks from industrial countries, banks from developing and centrally planned economies, and consortium banks. On one theory, changes in the distribution of current surpluses and deficits around the world surpluses and deficits around the world should not change the role of banks; they would still act as intermediaries between lenders and borrowers. But that theory holds good only if the 61 CU IDOL SELF LEARNING MATERIAL (SLM)

portfolio preferences of all lenders are the same;banks have the same perception of creditworthiness for all potential borrowers; and the interbank market operates without friction to redistribute liquidity. Without these conditions, the pattern of surpluses and deficits does indeed have a powerful effect on the banks. During the 1970s both the volume and geographical structure of current account balances changed dramatically. The members of OPEC ran large surpluses for much of the 1970s and initially had a strong preference for bank deposits. They favoured the Eurocurrency market rather than domestic banking systems, in part because of the higher returns available in the former. Over the decade, sizable amounts of funds were transferred by oil importers from domestic banks in industrial countries to OPEC members and ultimately to the Eurocurrency markets. Such a switch of funds increased the lending capacity of the Eurocurrency markets. The expansion of liquidity in the banking markets coincided with a positive shift in the attitude of the banks toward international lending. After the first major increase in oil prices, when there was a need to recycle large amounts of funds, banks were lauded for the success with which they performed this function. Confidence in the banking system was maintained by central banks and deposit insurance agencies, which gradually increased their protection for depositors at the major banks. The behavior of regulators or, more precisely, expectations of their behavior-gave comfort to depositors and helped attract money to comfort to depositors and helped attract money to banks. This may have led banks, in turn, to take larger lending risks than would otherwise have been the case. The preferences of developing countries also encouraged the growth of bank lending in the 1970s. Developing countries were attracted by the general purpose nature of bank finance and by the large volumes and flexibility of instruments available at a time when alternative sources of finance were growing very slowly. Developing countries naturally favoured the low or negative real interest rates charged by banks in preference to the conditionality attached to some official finance and the strict creditworthiness standards of bond markets. 3.8 SUMMARY  Banks have had to temper their desire to contain the growth of exposure to some developing countries the growth of exposure to some developing countries with their need to safeguard existing loans. Accordingly they have adopted a flexible approach to dealing with countries with debt-servicing difficulties. Banks quickly realized that rescheduling only principal payments due or in arrears was not adequate. Debtors needed more relief, and banks rescheduled debt and provided new loans in the context of IMF programs. Each bank's share of the new loan was based on its share of all the bank debt owed by the rescheduling country.  While not without difficulties, this burden-sharing approach has been generally successful. In some of the early rescheduling’s, short-term bank debt was included along with one or two years of maturities of long-term bank debt. However, all the 62 CU IDOL SELF LEARNING MATERIAL (SLM)

participants soon recognized the special nature of short-term debt and its importance for maintaining the debtor's foreign trade. More for maintaining the debtor's foreign trade. More recently, banks have been handling short-term credits separately or creating short-term credit facilities.  Bankers have also realized that high spreads and large fees may be self-defeating. In 1983, when they signed major rescheduling agreements with Brazil, Chile, Ecuador, Mexico, Uruguay, and Yugoslavia, their interest spreads on rescheduled loans ranged from one and seven-eighths to two and a half percentage points. However, during the second half of 1984 spreads on rescheduled loans under agreements in principle with Argentina, Mexico, and Venezuela were reduced to a range of seven-eighths to one and one-quarter percentage points. Bankers have reduced or eliminated their fees and sometimes dropped the expensive pricing option of using the U.S. prime rate.  Lenders are also being given the option of shifting the denomination of some of their dollar loans to their home currencies, which could reduce some interest costs for debtor countries. Perhaps the most significant development in debt rescheduling’s is the movement toward multiyear agreements for some countries that have made significant progress in adjusting their economies. A bunching of loan maturities poses an obstacle to the restoration of a normal market relationship between a rescheduling country and its creditors. 3.9 KEYWORDS  Authority to Purchase – Similar to an authority to pay, except that drafts under an authority to purchase are drawn directly on the buyer. The correspondent bank purchases them with or without recourse against the drawer and, as in the case of the authority to pay, they are usually not confirmed by a U.S. bank. This type of transaction is unique to Far Eastern trade  Baker Plan – Proposed in 1985, this initiative encouraged banks, the International Monetary Fund, and the World Bank to jointly increase lending to less developed countries that were having difficulty servicing their debt, provided the countries undertook prudent measures to increase productive growth.  Balance of Payments – The relationship between money flowing into and out of a country for a given period of time. Directly affected by the country’s foreign trade position, capital inflows and outflows, remittances into and out of the country, grants and aid, and tourism. A deficit balance occurs when outflows exceed inflows with the converse situation reflecting a balance of payments surplus.  Balance of Trade – The difference between a country’s total imports and total exports for a given period of time. A favourable balance of trade exists when exports 63 CU IDOL SELF LEARNING MATERIAL (SLM)

exceed imports. An unfavourable trade balance is reflected when imports exceed exports.  Band – The maximum range that a currency may fluctuate from its parity with another currency or group of currencies by official agreement. 3.10 LEARNING ACTIVITY 1. Create a survey on Forms of International Lending. ___________________________________________________________________________ ___________________________________________________________________________ 2. Create a session on International Commercial Bank’s Assets. ___________________________________________________________________________ ___________________________________________________________________________ 3.11UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What are REPOs? 2. What is Banking? 3. Define Commercial Bank’s? 4. Define Benchmark? 5. Write the full form of Euribor? Long Questions 1. Explain the concept of REPOs. 2. Explain the concept of International Commercial Banking. 3. Illustrate the International Commercial Bank’s Assets. 4. Illustrate the Forms of International Lending. 5. Examine the Search of an Alternative Benchmark. B. Multiple Choice Questions 1. Which of the following cannot be utilised for the Premium received on issue of shares? a. For the issue of bonus shares b. For writing of preliminary expenses 64 CU IDOL SELF LEARNING MATERIAL (SLM)

c. For providing premium payable on redemption d. For distribution of dividend 2. Under which Section of companies act 1956 deals with the scheme of stock invest? a. 69 to 70 b. 69 to 71 c. 69 to 72 d. 69 to 73 3. What happens when the shares issued at premium and the following account is credited? a. Share premium account b. Share first call account c. Share allotment account d. Share forfeited account 4. What should be the Minimum number of members in case of public company? a. 4 b. 5 c. 6 d. 7 5. What is the maximum number of members in public limited company? a. 10 b. 20 c. 30 d. Unlimited Answers 65 1-d, 2-d, 3-a, 4-d, 5-d 3.12 REFERENCES References book  Allen, F. and D. Gale, 2000. Financial Contagion. Journal of Political Economy. CU IDOL SELF LEARNING MATERIAL (SLM)

 Allen, F., A. Babus and E. Carletti, 2010. Financial Connections and Systemic Risk. National Bureau of Economic Research, working paper.  Babura, M., and G. Rustler, 2011. A look into the factor model black box: publication lags and the role of hard and soft data in forecasting GDP. International Journal of Forecasting . Textbook references  Barigozzi,, M. and C. T. Brownlee’s, NETS: Network Estimation for Time Series (May 18, 2014).  Billio, M., M. Getmansky, A. Lo and A. Pelizzon, 2012. Econometric measures of connectedness and systemic risk in the finance and insurance sectors. Journal of Financial Economics.  Bloom, N., 2009. The impact of uncertainty shocks. Econometrics. Website  https://www.emmi-benchmarks.eu/assets/files/Euribor_code_conduct.pdf  https://www.oliverwyman.com/content/dam/oliver- wyman/v2/publications/2018/june/Eonia-Euribor-rate-transition.pdf  https://thebusinessprofessor.com/en_US/banking-lending-credit-industry/london- interbank-offer-rate-libor-definition 66 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 4 – RISK MANAGEMENT FOR INTERNATIONAL BANKS STRUCTURE 4.0 Learning Objectives 4.1 Introduction 4.2 Securitization 4.2.1 Assets Backed Securities (ABS) 4.2.2 Collateralized Debt Obligation (CDO) 4.2.3 Credit Default Swaps (CDS)) 4.3 Summary 4.4 Keywords 4.5 Learning Activity 4.6 Unit End Questions 4.7 References 4.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Examine the concept of Securitization  Illustrate the concept of Assets Backed Securities (ABS)  Explain the concept of Collateralized Debt Obligation (CDO) 4.1 INTRODUCTION Risk can be defined as the chance of loss or an unfavourable outcome associated with an action. Uncertainty is not knowing what will happen in the future. The greater the uncertainty, the greater the risk. For an individual farm manager, risk management involves optimizing expected returns subject to the risks involved and risk tolerance. Agricultural producers make decisions in a risky environment every day. The consequences of their decisions are generally not known when the decisions are made. Furthermore, the outcome may be better or worse than expected. The two situations that most concern agriculture producers are: 1) is there a high probability of adverse consequences, and 2) would those adverse consequences significantly disrupt the business? 67 CU IDOL SELF LEARNING MATERIAL (SLM)

Risk is what makes it possible to make a profit. If there was no risk, there would be no return to the ability to successfully manage it. For each decision there is a risk-return trade-off. Anytime there is a possibility of loss (risk), there should also be an opportunity for profit. Growers must decide between different alternatives with various levels of risk. Those alternatives with minimum risk may generate little profit. Those alternatives with high risk may generate the greatest possible return but may carry more risk than the producer will wish to bear. The preferred and optimal choice must balance potential for profit and the risk of loss. It all comes down to management, and there are no easy answers. This handbook is designed to improve the risk management skills of American farmers and ranchers. There is a broad array of established risk management tools ready to be used and new tools are always being developed. By learning about and using these tools, crop and livestock producers can build the confidence needed to deal with risk and exciting opportunities of the future. Marketing is that part of a farm business that transforms production activities into financial success. Agriculture operates in a global market. Unanticipated forces anywhere in the world, such as weather or government action, can lead to dramatic changes in output and input prices. When these forces are understood, they can become important considerations for the skilled marketer. Marketing risk is any market related activity or event that leads to the variability of prices farmers receive for their products or pay for production inputs. Access to markets is also a marketing risk. Many of the day-to-day activities of all farmers involve commitments that have legal implications. Understanding these issues can lead to better risk management decisions. Legal issues intersect with other risk areas. For example, acquiring an operating loan has legal implications if not repaid in the specified manner. Production activities involving the use of pesticides have legal implications if appropriate safety precautions are not taken. Marketing of agricultural products can involve contract law. Human issues associated with agriculture also have legal implications, ranging from employer/employee rules and regulations, to inheritance laws. Risk management strategies are also affected by an individual’s capacity or ability to bear (or to take) risk. Financially, risk bearing capacity is directly related to the solvency and liquidity of one’s financial position. Risk bearing ability is also affected by cash flow requirements. This includes the obligations for cash costs, taxes, loan repayment, and family living expenses that must be met each year. The higher these obligations are as a percentage of total cash flow, the less able the business is to assume risk. The best source of historical production and marketing information is the records maintained for the business. The records may be supplemented and complemented by information from outside sources. But there is no substitute for actual historical data. Risk neutral producers understand they must take some chances to get ahead, but recognize that there are degrees of risk in every situation. Before making a decision or taking action they gather information and analyse the odds and seek to maximize income Risk preferring 68 CU IDOL SELF LEARNING MATERIAL (SLM)

individuals enjoy risk as challenging and exciting and look for the chance to take risks. Some producers may be in this category with respect to their marketing plans, even though they may not consciously plan to take on market risk . Risk management is the identification, evaluation, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability or impact of unfortunate events or to maximize the realization of opportunities. Risks can come from various sources including uncertainty in international markets, threats from project failures, legal liabilities, credit risk, accidents, natural causes and disasters, deliberate attack from an adversary, or events of uncertain or unpredictable root-cause. There are two types of events i.e. negative events can be classified as risks while positive events are classified as opportunities. Risk management standards have been developed by various institutions, including the Project Management Institute, the National Institute of Standards and Technology, actuarial societies, and ISO standards. Methods, definitions and goals vary widely according to whether the risk management method is in the context of project management, security, engineering, Industrial processes, financial portfolios, actuarial assessments, or public health and safety. Strategies to manage threats typically include avoiding the threat, reducing the negative effect or probability of the threat, transferring all or part of the threat to another party, and even retaining some or all of the potential or actual consequences of a particular threat. The opposite of these strategies can be used to respond to opportunities. Certain risk management standards have been criticized for having no measurable improvement on risk, whereas the confidence in estimates and decisions seems to increase In ideal risk management, a prioritization process is followed whereby the risks with the greatest loss (or impact) and the greatest probability of occurring are handled first. Risks with lower probability of occurrence and lower loss are handled in descending order. In practice the process of assessing overall risk can be difficult, and balancing resources used to mitigate between risks with a high probability of occurrence but lower loss, versus a risk with high loss but lower probability of occurrence can often be mishandled. Intangible risk management identifies a new type of a risk that has a 100% probability of occurring but is ignored by the organization due to a lack of identification ability. For example, when deficient knowledge is applied to a situation, a knowledge risk materializes. Relationship risk appears when ineffective collaboration occurs. Process-engagement risk may be an issue when ineffective operational procedures are applied. These risks directly reduce the productivity of knowledge workers, decrease cost-effectiveness, profitability, service, quality, reputation, brand value, and earnings quality. Intangible risk management allows risk management to create immediate value from the identification and reduction of risks that reduce productivity. 69 CU IDOL SELF LEARNING MATERIAL (SLM)

Opportunity cost represents a unique challenge for risk managers. It can be difficult to determine when to put resources toward risk management and when to use those resources elsewhere. Again, ideal risk management minimizes spending (or manpower or other resources) and also minimizes the negative effects of risks. Risk is defined as the possibility that an event will occur that adversely affects the achievement of an objective. Uncertainty, therefore, is a key aspect of risk. Systems like the Committee of Sponsoring Organizations of the Treadway Commission Enterprise Risk Management (COSO ERM), can assist managers in mitigating risk factors. Each company may have different internal control components, which leads to different outcomes. For example, the framework for ERM components includes Internal Environment, Objective Setting, Event Identification, Risk Assessment, Risk Response, Control Activities, Information and Communication, and Monitoring. 4.2 SECURITIZATION This chapter gives a brief introduction to the field of securitization, thus providing a basis for the description of best practices for securitization risk management a basis for the description of best practices for securitization risk management in the later chapters. Section 1.1 discusses the motives behind securitization, as well as defining this type of capital market instrument and delineating it from other instruments from a risk management perspective. Based on the general structure of a securitization transaction, section 1.2 presents the essential functions assumed and instruments deployed by banks to take on risk in securitization transactions. Furthermore, it gives an overview of the most common securitization structures. Section 1.3 concludes the chapter with a description of recent innovations in securitization structures as well as current developments on the Austrian securitization market. In a securitization transaction, the credit risks associated with a defined pool of receivables (i.e. assets) are isolated from the originator of the receivables, then receivables (i.e. assets) are isolated from the originator of the receivables, then structured and passed on to one or more investors in the form of at least two different risk positions. In addition to transferring risk, financed structures can also create an inflow of liquid funds corresponding to the value of the pool of receivables for the originator. Banks have five essential motives for securitizing assets: Risk diversification: By transferring risk in a securitization transaction, a bank can restructure its credit portfolio thus improving its risk/return profile and deliberately pass on risks or take on new ones. This might be useful, for example, in cases where a bank’s credit portfolio accumulates considerable concentration risks due to its regional sales strength. Securitization deals are thus not only a source of risk, they can also be used in risk management with the specific aim of controlling risk. Access to liquidity: Funded structures provide the securitizing bank with additional funds by means of refinancing on the capital market. By isolating the pool of receivables and refinancing it separately, the bank might also 70 CU IDOL SELF LEARNING MATERIAL (SLM)

be able to obtain more favourable terms than in the case of on-balance-sheet refinancing. This is especially attractive to banks whose ratings would only allow less favourable refinancing terms on the capital or interbank market. Reduction of capital requirements: By transferring credit risks to third parties, banks can reduce their regulatory and economic capital requirements. Therefore, securitization provides a means of reducing tied-up capital, thus making it available for new business opportunities. Product range enhancement: In addition to bank claims, other receivables such as corporate accounts can also be securitized. This gives companies an alternative source of capital market financing instead of financing by means of conventional bank loans. Banks frequently offer securitization products to their corporate clients in addition to such loans. Investment opportunities: Banks also invest in the bonds issued in securitization transactions, as these bonds frequently offer attractive yields. These motives are likely to gain importance in the eyes of the banks due to the harmonization and internationalization of markets, which might in turn lead to the increased use of securitization. The need to pay increased attention to securitization in risk management also stems from its unique structural characteristics compared to other capital market instruments. For all of the parties involved, securitization risk management presents a number of special challenges resulting from the characteristics of securitization. In this guideline, securitization transactions are delineated on the basis of three central structural features: Best Practices in Risk Management for Securitized Products. The basis of a securitization transaction is a defined pool of receivables. Therefore, risk management not only has to take into account the risk involved in risk management not only has to take into account the risk involved in individual claims, it also has to consider pooling effects (e.g. volume and diversification effects). The pool can contain a wide variety of receivables, and the risks involved can differ significantly from those of conventional loans, thus requiring particular caution in assessment (e.g. trade receivables, receivables from licensing). In a securitization transaction, the defined pool of receivables is isolated from the credit originators credit rating, and the risks in the pool are transferred to third parties and in some cases refinanced separately. Therefore, the complete isolation of the pool of receivables as well as the wide variety of instruments used for risk transfer and refinancing deserve special attention in securitization risk management. The risk transfer and any refinancing in a securitization transaction are structured, that is, at least two positions (tranches) which are assigned different levels of priority are created in the distribution of risks and cash flows. Identifying the risks contained in the individual tranches requires a careful analysis of this (usually complex) structuring mechanism. On the basis of these three structural characteristics, securitization transactions can be differentiated clearly from other capital market instruments as follows: The direct sale or derivative-based hedging of individual loans involves refinancing and/or a transfer of risk, but not a defined pool of receivables. No structuring is performed in the direct sale or derivative-based hedging of a pool of receivables. Furthermore, the reference portfolio used in derivative based hedging does not necessarily have to match the defined pool of receivables; it can contain defined positions not 71 CU IDOL SELF LEARNING MATERIAL (SLM)

held by the originator (e.g. in the case of a basket credit default swap). In the case of Pfandbrief mortgage bonds, the pool of receivables is not completely isolated from the credit rating of the credit originator, nor is the pool structured. The subordinated status of a conventional bond only causes a payment disruption if the issuer goes bankrupt; this does not constitute structuring as defined above. In contrast to a subordinated bond, a junior securitization tranche will already be endangered by defaults in the pool of receivables well before an issuer becomes bankrupt. Securitization products are thus innovative and clearly differentiated capital market instruments which have to be treated separately in risk management. The main parties involved in a securitization transaction are the originator, the investor, and the servicer. These parties are related by means of a special-purpose the investor, and the servicer. These parties are related by means of a special-purpose vehicle or SPV. In the course of its business activities, the originator generates assets in the form of receivables (such as those arising from credit agreements) from debtors (obligors). A defined pool of receivables is then transferred to the special-purpose vehicle established specifically for this purpose. In turn, the special-purpose vehicle structures the risks and payments involved in the transaction, after which it passes them on to the investors. The servicer is commissioned by the special-purpose vehicle to handle the ongoing management and collection of those receivables. In addition, a large number of other parties also cooperate in securitization transactions. The securitization deal is structured by the arranger, who usually also evaluates the pool of receivables. In the structuring process, some of the risks are transferred to credit enhancers (i.e. providers of credit risk mitigation). The special-purpose vehicle is founded by the sponsor, which may be the same organization as the originator or trustee. The trustee monitors the proper execution of the transaction as well as the business activities of the special-purpose vehicle and servicer on behalf of the investors. The trustee might also act as the paying agency between the servicer and the investors. If the special-purpose vehicle transfers risk by way of the capital market, the credit quality of tranches has to be assessed by rating agencies, and tranches are placed on the market by an Best Practices in Risk Management for Securitized Products 11 underwriting syndicate. In general, banks can assume all of the functions except for those of the rating agency. Depending on the duties they assume, banks take on risks by means of various instruments. Among the instruments used to assume risk, it is first necessary to differentiate between credit derivatives and traditional securitization instruments. Credit derivatives can be subdivided into credit default swaps (CDSs) and credit-linked notes (CLNs). In contrast to CDSs, CLNs provide funding for the issuer. Credit derivatives can be used to transfer risk both from the originator to the special-purpose vehicle and from the special-purpose vehicle to the investors. In traditional securitization, ownership as well as the risks are transferred from the originator to the special- purpose vehicle through the sale of receivables. In a traditional securitization environment, the special-purpose vehicle will pass the risks on to the investors by issuing bonds which are collateralized by the receivables and called asset-backed securities (ABS). Both of these steps 72 CU IDOL SELF LEARNING MATERIAL (SLM)

provide funding for the respective seller. To a limited extent, risk is also transferred using other risk mitigation instruments or credit enhancements, which include credit insurance, guarantees, letters of credit, or liquidity facilities to bridge short-term payment disruptions. Credit enhancements are distinguished from credit derivatives and asset-backed securities by the nature of the instruments used as well as the fact that they are granted by credit enhancers and not sold to investors. The most subordinated risk position is usually referred to as the first-loss piece (FLP), as it has to absorb the first losses incurred in the pool of receivables. The general structure presented here can be found in almost all forms of securitization transactions; however, specific structural characteristics may well be arranged differently in individual cases. In order to ensure comprehensive risk management, practitioners will require a more detailed understanding of common securitization structures. These structures are presented in the next section. 4.2.1 Assets Backed Securities (ABS) Credit performs the essential function of moving funds from the savers who want to lend to the investors and from the savers who want to lend to the investors and consumers who wish to borrow. Under ideal conditions, this process ensures that funds are invested by the most skilled and productive individuals, thus improving efficiency and stimulating growth, and that consumers can get funds when they need them the most to satisfy their consumption needs. Many different instruments of borrowing and lending have emerged to better address the needs of borrowers and lenders. Examples are trade credit, banks, stocks and commodities markets, and an enormous variety of financial institutions. For many years, banks and financial institutions were collecting and lending funds while keeping the resulting loans on their books until they were repaid. Regulations and the need to follow sound and prudent lending practices were generating a need for collateral, thus tightly linking the amount of funds collected to the amount of loans created, even in the presence of more profitable and productive lending activities. For example, a bank generating lots of mortgage loans, which are typically financed by short-term deposits, had to keep a significant share of collateral to ensure that they could repay their depositors in case they wanted their money back at short notice. To alleviate firms’ need to hold large amounts of collateral and allow investors and institutions to share risk, asset-backed securities products were introduced in 1970. Asset- backed securities (ABS) are bonds backed by the cash flow of a variety of pooled receivables or loans. ABS can be securities backed by any type of asset with an associated cash flow, but are generally securities collateralized by certain types of consumer and business loans as opposed to mortgage-backed securities, which are backed by mortgages. Firms issue ABS to diversify The asset-backed securities markets, the crisis, and TALF Summit Agarwal, Jacqueline Barrett, Crystal Cun and Mariacristina De NardiSumit Agarwal is a senior financial economist, Jacqueline Barrett is an associate economist, Crystal Cun is a former associate economist, and Mariacristina De Nardi is a senior economist and economic advisor at the Federal Reserve Bank of Chicago. sources of capital, borrow more cheaply, reduce the 73 CU IDOL SELF LEARNING MATERIAL (SLM)

size of their balance sheets, and free up capital. For example, a bank holding consumer loans on its books could pool a large number of loans together and issue bonds with specific income streams generated by this pool of loans. In addition, the bank would transfer the loans to a separate entity. Selling the loans would generate cash flows that could be used to issue additional loans on the market. ABS issuance grew steadily, increasing liquidity and reducing the cost of financing. From an annual issuance of $10 billion in 1986, the ABS market grew to an annual issuance of $893 billion in 2006, its peak in the U.S.1 This growth was accompanied by expansion in the ABS market investor base from banks and institutional investors to hedge funds and structured investment vehicles (SIV). The growth in ABS came to a sudden end with the financial crisis that started in 2007, which was characterized by a global credit crunch. The crisis began with a decline in house prices and an increase in mortgage defaults, particularly on subprime mortgages (high-risk loans to borrowers with poor credit). Uncertainty quickly spread to other consumer loan markets, such as those based on car loans, credit cards, and student loans. In July 2007, ABS issues backed by residential mortgages dried up. The failure of Lehman Brothers in October 2008 was a big shock to the financial markets and to investor confidence, and yields on ABS skyrocketed.2 In this new high-yield environment, there was no economic incentive for lenders to issue new ABS. Consumer ABS (auto, credit card, and student loan segments) and commercial mortgage- backed securities markets3 issuances vanished. The intermediation markets3 issuances vanished. The intermediation of household and business credit between investors and borrowers stopped. This credit crisis was in many ways also a credit rating crisis. Given the difficulty for investors to evaluate these structured financial products, most relied on ratings of ABS bonds by the major rating agencies. Prior to the crisis, more than half of the structured finance securities rated by Moody’s carried a rating of AAA, the highest possible rating and typically reserved for securities that are perceived to be extremely low risk. In 2007 and 2008, the creditworthiness of structured finance securities deteriorated dramatically. Almost 40,000 Moody’s-rated tranches (specific portions within a class of bonds) were downgraded, and almost one-third of the downgraded tranches had been rated AAA. The ensuing confusion about the true value and risk of these complicated financial products and the extent of financial institutions’ exposure to them fuelled additional market uncertainty and further reduced the availability of credit. The Board of Governors of the Federal Reserve System recognized the importance of keeping a healthy supply of credit alive and acknowledged the important role of ABS markets in this process. To get these markets working again, the Board introduced the Term Asset-Backed Securities Loan Facility (TALF) on November 25, 2008. The official document announcing the facility stated: “The ABS markets historically have funded a substantial share of consumer credit and SBAguaranteed small business loans. Continued disruption of these markets could significantly limit the availability of credit to households and small businesses and thereby contribute to further weakening of U.S. economic activity.” The same document also explained that the TALF was “intended to assist the credit markets in accommodating the credit needs of consumers and 74 CU IDOL SELF LEARNING MATERIAL (SLM)

small businesses by facilitating the issuance of asset backed securities (ABS) and improving the market conditions for ABS more generally.” TALF facilitated issuance of new ABS and, even more importantly, provided a safety net by allowing people holding ABS products to borrow by putting up these products as collateral at a given price. This not only allowed these investors to satisfy their liquidity needs, but also provided an important guarantee of a maximum price of liquidity for qualified borrowers. This guarantee generated a crucial backstop against irrational fears, lowering the value of these assets below what one could expect based on reasonable fundamentals. In this , we analyse the role of ABS markets in generating credit and liquidity. We study how this role was disrupted during the crisis, and we argue that TALF successfully helped re-establish the ABS markets and the credit supply. First, we describe how ABS products work, the growth of the market for these products, and its collapse. Then we show that TALF helped calm the markets and helped restart ABS issuance and reduce credit spreads, thus helping to re-establish a healthy credit supply to the markets. Overview of the ABS market How does securitization work? The essence of securitization is pooling and trenching. After pooling a set of assets, the originator creates different classes of securities, known as tranches, which have prioritized claims against the collateral pool. In a trenched deal, some investors hold more senior claims than others. In the event of default, the losses are absorbed by the lowest priority class of investors before the higher priority class of investors are affected. Thus, the pooling and trenching create some securities that is safer than the average asset in the collateral pool and some that are much riskier entity (SPE). The SPE then transfers the receivables to a securitization vehicle, receivables to a securitization vehicle, typically a qualified SPE trust, or QSPE.The trust then packages the receivables and issues investor certificates (sold to investors) and trust certificates (retained by the transferor or affiliate). Proceeds from the sale of the investor certificates go to the trust. The trust in turn pays the financial institution (seller) for the purchase of the underlying receivables. The investor certificates are usually issued with a senior/ subordinated structure. The seller/originator often retains the bottom or most subordinated pieces, which get paid out last, in order to obtain high ratings from rating agencies. The trust certificates are also referred to as the transferor’s interest, seller’s certificate, or seller’s interest. The seller’s interest is traditionally retained by the originator, but as the ABS market expanded, an active market in subordinated sellers’ tranches developed. Credit derivatives could also be used to hedge away exposure risk. This meant that it was relatively easy for originators to sell their interest in securitizations, or at least hedge away some of the risk. The monthly payment rate (MPR) is the principal collected during the month divided by the ending or collected during the month divided by the ending or average principal balance of receivables for the same period. The MPR measures the portion of outstanding receivables paid down each month; an MPR of 50 percent indicates full loan repayment in two months. The underlying receivables may have different maturities from the outstanding certificates. For example, credit card securitizations have a relatively short life, typically eight to ten 75 CU IDOL SELF LEARNING MATERIAL (SLM)

months, while supporting outstanding certificates that may have three, five, or ten year maturities. As a result of this maturity mismatch, each series issued out of the master trust is structured to have a revolving period, typically followed by a controlled accumulation period. During the revolving period, payments are made to the servicer for cash flows from the receivables. The servicer deposits the payments into two collection accounts, one reserved for principal and the other for trust expenses and interest payments on the investors’ certificates. New receivables generated by the designated accounts are purchased from the originating institution/ seller with funds from the principal account. During a controlled accumulation period, the principal payments are reinvested in short-term investments and become the collateral for the outstanding investor certificates. As principal payments are received, the short-term investments grow until they equal the amount of the outstanding investor certificates in the maturing series. At this point, the trustee makes a bullet payment to all investment certificate holders. During a controlled amortization period, principal collections are paid out to investors monthly throughout the period. If funds in the principal and interest payment reserve accounts are insufficient to repay investors on the expected maturity date, the accumulation or controlled amortization period will continue until the legal final maturity date. At this time, the trust will sell the remaining receivables to pay investors, if necessary. ABS products are backed by a pool of receivables, have a complicated seniority structure, and rely on specific have a complicated seniority structure, and rely on specific legal guarantees in case of default. In addition, there is asymmetric information between the issuers of the securities and the investors. To help inform investors and the market at large, rating agencies analyse ABS bonds and attach credit ratings to their various tranches. The credit analysis of securitizations is a complex process that includes an evaluation of the originator and servicer; an assessment of the collateral and historical asset performance; an understanding of the securitization and legal structure; and modelling of cash flows under various stress scenarios. The interaction between credit ratings and financial regulation was an important contributor to the growth in securitization markets. The use of credit ratings in the regulation of financial institutions created a large demand for highly rated securities. Minimum capital requirements for banks, insurance companies, and broker-dealers depend on the credit ratings of the assets on their balance sheet. Pension funds also face rating-based investment restrictions. Securitization allowed investors to participate in asset classes to which they would otherwise not have had access. For example, an investor that was not permitted to buy B-rated corporate bonds could invest in Aerated ABS securities that were issued on a pool of B-rated corporate bonds, which would typically yield more than bonds rated A or higher. In order to receive higher debt ratings and thus improve marketability and financing costs, ABS products require credit enhancements. Enhancements can be internal, external, or a combination of both. Common external credit enhancement facilities include cash collateral accounts, collateral invested amounts (CIA). 76 CU IDOL SELF LEARNING MATERIAL (SLM)

The ABS market that had such a prominent role in the recent financial crisis evolved over the course in the recent financial crisis evolved over the course of several decades. Before the 1970s, banks usually held loans on their balance sheet until they matured or were paid off. The loans were primarily funded by bank deposits and depository institutions and mainly provided credit to the areas where they accepted these deposits. As a result, geographical imbalances in the flow of credit to borrowers emerged. Although investors traded whole loans, the market was relatively illiquid; mortgage lenders faced the risk that they would not find investors to purchase the whole loans, as well as the risk that interest rates could change. The introduction of securitization addressed several of the shortfalls in the housing market, in particular. In 1970, the first form of securitization was brought to the marketplace. At this time, the Government National Mortgage Association (GNMA) introduced government- insured pass-through securities, in which the principal and interest payments were passed from borrowers to investors who purchased bonds that were backed by Federal Housing Administration and Veterans Administration 30-year single-family mortgages. Soon after, the Federal Home Loan Mortgage Corporation (FHLMC) and the Federal National Mortgage Association (FNMA) began issuing pass-through securities of their own. The pass-throughs were structured so that interest payments on the mortgages were used to pay interest to investors of the bonds, and principal payments were used to pay down the principal of the bonds. The launch of pass-through securities provided several advantages. Investors could buy a liquid instrument that was free of credit risk. Lenders could move any interest rate risk associated with mortgages off their balance sheet and make additional loans with the new capital that they received from securitizing older loans. Businesses and consumers faced lower borrowing costs and were given increased access to credit as the geographical inefficiencies that were previously present were eliminated. One of the drawbacks to these new securities is that they were unable to accommodate different risk preferences and time horizons of investors. The mortgage market continued to evolve with the issuance of the first private-label mortgage passthrough security by Bank of America in 1977 and the first collateralized mortgage obligation (CMO) by FHLMC in 1983. CMOs addressed an important risk of owning pass-through securities prepayment risk. Prepayment risk is the unexpected early return of principal as a result of refinancing. Borrowers are most likely to refinance when interest rates fall and investors are forced to reinvest the returned principal at a lower return than they previously expected. CMOs lowered prepayment risk for certain investors by providing different classes (tranches) of securities that offered principal repayment at varying speeds. The introduction of tranches in CMOs set the stage for more sophisticated debt vehicles that were tailored to the preferences of different types of investors. The senior tranches are highly rated and have the lowest risk. In the event that defaults occur in the underlying bonds, the losses are distributed among the junior tranches first. The senior tranches do not experience losses until all of the junior tranches have been exhausted. The junior tranches are high-risk instruments that come with the potential for high yields. In the mid-1980s, securitization techniques that were developed for the mortgage 77 CU IDOL SELF LEARNING MATERIAL (SLM)

market were applied to nonmortgage assets. Other types of receivables such as auto loans and equipment leases involved predictable cash flows, which made them attractive for securitization. Banks also soon developed structures to normalize the cash flows of credit card receivables, facilitating the creation of credit card ABS. In order to provide additional protection to investors on these securities, which were not government-insured, the pools of assets were over-collateralized, so that the value of the underlying loan portfolio was larger than the value of the security. Additional credit enhancements, such as the excess spread, the creation of reserve accounts, and letters of credit, were also implemented. The purpose of these credit enhancements was to limit losses for investors in the event of defaults. The market grew to include the securitization of additional asset types, including home equity loans, manufactured housing loans, and student loans. The ABS market increased dramatically from 1996, when the value of outstanding securities was $404.8 billion, to 2008, when the value of outstanding securities reached $2,671.8 billion. Although each type of security exhibited growth during this period, the largest expansions were seen in home equity ABS, student loan ABS, and collateralized debt obligations (CDOs), which are securities that can be backed by several different types of debt. Securities backed by credit card receivables made up the largest portion of ABS in 1996; by 2009, home equity ABS and CDOs made up the bulk of the market. The formation and bursting of the housing bubble played an important role housing bubble played an important role in starting and subsequently deepening the financial crisis. Among the factors contributing to the housing bubble were programs aiming at increasing home ownership, low interest rates, and reduced credit standards. For decades, increasing homeownership has been a government policy objective, implemented through subsidies, tax breaks, and dedicated agencies. These policy interventions, coupled with historically low interest rates, encouraged unprecedented borrowing. As home prices surged, many households borrowed against the value of their homes by refinancing mortgages or taking out home equity lines of credit. At the same time, the banks that originated the loans were selling them rather than keeping them on their balance sheets. By securitizing mortgages, banks were able to originate more mortgages, but the quality of these mortgages deteriorated as the quantity increased. Lenders allowed borrowers with poor credit to purchase homes with low or no down payments. The credit rating companies compounded the problems by rating the ABS securities under the assumption that house prices would keep appreciating. This critical assumption turned out to be false. In 2007, the housing market started to decline: Home sales and construction starts slowed, home prices dropped, and interest rates began to rise. Defaults on subprime loans, especially those that had not required a down payment or income verification, started to surge. As interest rates started rising, adjustable mortgages started to reset at higher levels and fears spread that foreclosures would increase. Lenders and mortgage buyers responded to the defaults by tightening credit standards. Several subprime lenders suffered losses and eventually were forced to file for bankruptcy. As it became clear that many of the mortgages in default had been securitized, the previously highly rated securities 78 CU IDOL SELF LEARNING MATERIAL (SLM)

were downgraded, causing demand for outstanding asset-backed securities to collapse. At the same time, a banking panic in the sale and repurchase agreement (repo) market forced banks to sell their assets at unfavourable prices. There was also a sharp decline in the issuance of new housing-related securities. Although securities backed by housing-related collateral made up the majority of new ABS issuances in 2005 and 2006, starting in 2007, issuances for housing-related securities dried up. By 2008, securities that were backed by student loans, credit card receivables, and automobile loans made up the majority of new ABS issuance because there were so few securities backed by real estate loans. Benmelech and Dlugosz show that the deterioration in the credit ratings of structured financial products began in 2007, when there were more than 8,000 downgrades, an eightfold increase over the previous year. In the first three quarters of 2008, there were almost 40,000 downgrades, which overshadowed the cumulative number of downgrades since 1990. In 2007, downgrades were not only more common, but also more severe. The average downgrade was 4.7 notches in 2007 and 5.8 notches in 2008, compared with an average 2.5 notches in both 2005 and 2006. 4.2.2 Collateralized Debt Obligation (CDO) This addresses the risk analysis and market valuation of collateralized debt obligations (CDOs). We illustrate the effects of correlation and prioritization for the market obligations (CDOs). We illustrate the effects of correlation and prioritization for the market valuation, diversity score, and risk of CDOs, in a simple jump-diffusion setting for correlated default intensities. A CDO is an asset-backed security whose underlying collateral is typically a portfolio of bonds (corporate or sovereign) or bank loans. A CDO cash-flow structure allocates interest income and principal repayments from a collateral pool of different debt instruments to a prioritized collection of CDO securities, which we shall call tranches. While there are many variations, a standard prioritization scheme is simple subordination: Senior CDO notes are paid before mezzanine and lower-subordinated notes are paid, with any residual cash flow paid to an equity piece. Some illustrative examples of prioritization are provided in Section 4. A cash-flow CDO is one for which the collateral portfolio is not subjected to active trading by the CDO manager, implying that the uncertainty regarding interest and principal payments to the CDO tranches is determined mainly by the number and timing of defaults of the collateral securities. A market-value CDO is one in which the CDO tranches receive payments based essentially on the mark-to-market returns of the collateral pool, as determined in large part by the trading performance of the CDO manager. In this , we concentrate on cash-flow CDOs, avoiding an analysis of the trading behavior of CDO managers. A generic example of the contractual relationships involved in a CDO is, taken from Schorin and Weinrich. The collateral manager is charged with the selection and purchase of collateral assets for the SPV. The trustee of the CDO is responsible for monitoring the contractual provisions of the CDO. Our analysis assumes perfect adherence to these contractual provisions. The main issue that we address is the impact of the joint distribution of default risk of the underlying collateral securities on the risk and valuation of 79 CU IDOL SELF LEARNING MATERIAL (SLM)

the CDO tranches. We are also interested in the efficacy of alternative computational methods, and the role of “diversity scores,” a measure of the risk of the CDO collateral pool that has been used for CDO risk analysis by rating agencies. Our findings are as follows. We show that default time correlation has a significant impact on the market values of individual tranches. The priority of the senior tranche, by which it is effectively “short a call option” on the performance of the underlying collateral pool, causes its market value to decrease with the risk-neutral default-time correlation, fixing the (risk-neutral) distribution of individual default times. The value of the equity piece, which resembles a call option, increases with correlation. There is no clear Jensen effect, however, for intermediate tranches. With sufficient over-collateralization, the option “written” (to the lower tranches) dominates, but it is the other way around for sufficiently low levels of over-collateralization. Spreads, at least for mezzanine and senior tranches, are not especially sensitive to the “lumpiness” of information arrival regarding tranches, are not especially sensitive to the “lumpiness” of information arrival regarding credit quality, in that replacing the contribution of diffusion with jump risks (of various types), holding constant the degree of mean reversion and the term structure of credit spreads, plays a relatively small role. Regarding alternative computational methods, we show that if (risk-neutral) diversity scores can be evaluated accurately, which is computationally simple in the framework we propose, these scores can be used to obtain good approximate market valuations for reasonably well collateralized tranches. Currently the weakest link in the chain of CDO analysis is the availability of empirical data that would bear on the correlation, actual or risk-neutral, of default. In perfect capital markets, CDOs would serve no purpose; the costs of constructing and marketing a CDO would inhibit its creation. In practice, CDOs address some important marketing a CDO would inhibit its creation. In practice, CDOs address some important market imperfections. First, banks and certain other financial institutions have regulatory capital requirements that make it valuable for them to securitize and sell some portion of their assets, reducing the amount of (expensive) regulatory capital that they must hold. Second, individual bonds or loans may be illiquid, leading to a reduction in their market values. Securitization may improve liquidity, and thereby raise the total valuation to the issuer of the CDO structure. valuation to the issuer of the CDO structure. In light of these market imperfections, at least two classes of CDOs are popular. The balance-sheet CDO, typically in the form of a collateralized loan obligation (CLO), is designed to remove loans from the balance sheets of banks, achieving capital relief, and perhaps also increasing the valuation of the assets through an increase in liquidity.1 An arbitrage CDO, often underwritten by an investment bank, is designed to capture some fraction of the likely difference between the total cost of acquiring collateral assets in the secondary market and the value received from management fees and the sale of the associated CDO structure. Balance-sheet CDOs are normally of the cash-flow type. Arbitrage CDOs may be collateralized bond obligations (CBOs), and have either cash-flow or market-value structures. Among the sources of illiquidity that promote, or limit, the use of CDOs are adverse selection, trading costs, and 80 CU IDOL SELF LEARNING MATERIAL (SLM)

moral hazard. With regard to adverse selection, there may be a significant amount of private in- formation regarding the credit quality of a junk bond or a bank loan. An investor may be concerned about being “picked off” when trading such instruments. For instance, a potentially better-informed seller has an option to trade or not at the given price. The value of this option is related to the quality of the seller’s private information. Given the risk of being picked off, the buyer offers a price that, on average, is below the price at which the asset would be sold in a setting of symmetric information. This reduction in price due to adverse selection is sometimes called a “lemon’s premium”. In general, adverse selection cannot be eliminated by securitization of assets in a CDO, but it can be mitigated. The seller achieves a higher total valuation (for what is sold and what is retained) by designing the CDO structure so as to concentrate into small subordinate tranches the majority of the risk about which there may be fear of adverse selection. A large senior tranche, relatively immune to the effects of adverse selection, can be sold at a small lemon’s premium. The issuer can retain, on average, significant fractions of smaller subordinate tranches that are more subject to adverse selection. For models supporting this design and retention behavior, For a relatively small junk bond or a single bank loan to a relatively obscure borrower, there can be a small market of potential buyers and sellers. This is not unrelated to the effects of adverse selection, but also depends on the total size of an issue. In order to sell such an illiquid asset quickly, one may be forced to sell at the highest bid among the relatively few buyers with whom one can negotiate on short notice. Searching for the relatively few buyers with whom one can negotiate on short notice. Searching for such buyers can be expensive. One’s negotiating position may also be poorer than it would be in an active market. The valuation of the asset is correspondingly reduced. Potential buyers recognize that they are placing themselves at the risk of facing the same situation in the future, resulting in yet lower valuations. The net cost of bearing these costs may be reduced through securitization into relatively large homogeneous senior CDO tranches, perhaps with significant retention of smaller and less easily traded junior tranches. Moral hazard, in the context of CDOs, bears on the issuer’s or CDO manager’s incentives to select high-quality assets for the CDO, to engage in costly enforcement of covenants and other restrictions on the behavior of obligors. By securitizing and selling a significant portion of the cash flows of the underlying assets, these incentives are diluted. Reductions in value through lack of effort are borne to some extent by investors. There may also be an opportunity for “cherry picking,” that is, for sorting assets into the issuer’s own portfolio or into the SPV portfolio based on the issuer’s private information. There could also be “front-running” opportunities, under which a CDO manager could trade on its own account in advance of trades on behalf of the CDO. These moral hazards act against the creation of CDOs, for the incentives to select and monitor assets promote greater efficiency, and higher valuation, if the issuer retains a full 100-percent equity interest in the asset cash flows. The opportunity to reduce other market imperfections through a CDO may, however, be sufficiently large to offset the effects of moral hazard, and result in securitization, especially in light of the advantage of building and maintaining a reputation 81 CU IDOL SELF LEARNING MATERIAL (SLM)

for not exploiting CDO investors. The issuer has an incentive to design the CDO in such a manner that the issuer retains a significant portion of one or more subordinate tranches that would be among the first to suffer losses stemming from poor monitoring or asset selection, demonstrating a degree of commitment to perform at high effort levels by the issuer. Likewise, for arbitrage CDOs, a significant portion of the management fees may be subordinated to the issued tranches. In light of this commitment, investors may be willing to pay more for the tranches in which they invest, and the total valuation to the issuer is higher than would be the case for an un-prioritized structure, such as a straight-equity pass-through security. Innes has a model supporting this motive for security design. One of a pair of CLO cash-flow structures issued by NationsBank in 1997. A senior tranche of $2 billion in face value is followed by successively lower- subordination tranches. The ratings assigned by Fitch are also illustrated. The bulk of the underlying assets are floating-rate NationsBank loans rated BBB or BB. Any fixed- rate loans were hedged, in terms of interest rate risk, by fixed-to-floating interest-rate swaps. As predicted by theory, the majority of the (unrated) lowest tranche was retained. 4.2.3 Credit Default Swaps (CDS) The objective of introducing Credit Default Swaps (CDS) on corporate bonds is to provide market participants a tool to transfer and manage credit risk in an effective manner through redistribution of risk. CDS as a risk management product offers the participants the opportunity to hive off credit risk and also to assume credit risk which otherwise may not be possible. Since CDS have benefits like enhancing investment and borrowing opportunities and reducing transaction costs while allowing risk-transfers, such products would increase investors’ interest in corporate bonds and would be beneficial to the development of the corporate bond market in India CDS will be allowed only on listed corporate bonds as reference obligations. However, CDS can also be written on unlisted but rated bonds of infrastructure companies. Besides, unlisted/unrated bonds issued by the SPVs set up by infrastructure companies are also eligible as reference obligation. Such SPVs need to make disclosures on the structure, usage, purpose and performance of SPVs in their financial statements. In the case of banks, the net credit exposure on account of such CDS should be within the limit of 10% of investment portfolio prescribed for unlisted/unrated bonds as per extant guidelines issued by RBI. NBFCs and PDs shall adhere to the extant regulatory guidelines prescribed in respect of credit exposure limits for investment in unlisted/unrated bonds.The reference obligations are required to be in dematerialized form only. The reference obligation of a specific obligor covered by the CDS contract should be specified a priori in the contract and reviewed periodically for better risk management. Protection sellers should ensure not to sell protection on reference entities/obligations on which there are regulatory restrictions on assuming exposures in the cash market such as, the restriction against banks holding unrated bonds, single/group exposure limits and any other restriction imposed by the regulators from time to 82 CU IDOL SELF LEARNING MATERIAL (SLM)

time. The users cannot buy CDS for amounts higher than the face value of corporate bonds held by them and for periods longer than the tenor of corporate bonds held by them. Holding CDS Protection by users without having an underlying: Since the users are envisaged to use the CDS only for hedging their credit risks, assumed due to their investment in corporate bonds, they shall not, at any point of time, maintain naked CDS protection i.e. CDS purchase position without having an eligible underlying. Proper caveat may be included in the agreement that the market-maker, while entering into and unwinding the CDS contract, needs to ensure that the user has exposure in the underlying. Further, the users are required to submit an auditor’s certificate or custodian’s certificate to the protection sellers or novating users, of having the underlying bond while entering into/unwinding the CDS contract. Users cannot exit their bought positions by entering into an offsetting sale contract. They can exit their bought position by either unwinding the contract with the original counterparty or, in the event of sale of the underlying bond, by assigning (novating) the CDS protection, to the purchaser of the underlying bond (the “transferee”) subject to consent of the original protection seller (the “remaining party”). After assigning the contract, the original buyer of protection (the “transferor”) will end his involvement in the transaction and credit risk will continue to lie with the original protection seller. every effort should be made to unwind the CDS position immediately on sale of the underlying. The users would be given a maximum grace period of ten business days from the date of sale of the underlying bond to unwind the CDS position. 2.6.3 In the case of unwinding of the CDS contract, the original counterparty (protection seller) is required to ensure that the protection buyer has the underlying at the time of unwinding. The protection seller may also ensure that the transaction is done at a transparent market price and this must be subject to rigorous audit discipline. CDS transactions are not permitted to be entered into either between related parties or where the reference entity is a related party to either of the contracting parties. Related parties for the purpose of these guidelines will be as defined in ‘Accounting Standard 18 – Related Party Disclosures’. In the case of foreign banks operating in India, the term ‘related parties’ shall include an entity which is a related party of the foreign bank, its parent, or group entity. 2.8 Other Requirements The single-name CDS on corporate bonds should also satisfy the following requirements: the user (except FIIs) and market-maker shall be resident entities; the identity of the parties responsible for determining whether a credit event has occurred must be clearly defined a priori in the documentation; the reference asset/obligation and the deliverable asset/obligation shall be to a resident and denominated in Indian Rupees; the CDS contract shall be denominated and settled in Indian Rupees; Obligations such as asset-backed securities/mortgage-backed securities, convertible bonds and bonds with call/put options shall not be permitted as reference and deliverable obligations; CDS cannot be written on interest receivables; CDS shall not be written on securities with original maturity up to one year e.g., Commercial Papers (CPs), Certificate of Deposits (CDs) and Non-Convertible Debentures (NCDs) with original maturity up to one year; the CDS contract must represent a direct claim on the protection seller; the CDS contract must be irrevocable; there must be no clause in the 83 CU IDOL SELF LEARNING MATERIAL (SLM)

contract that would allow the protection seller to unilaterally cancel the contract. However, if protection buyer defaults under the terms of contract, protection seller can cancel/revoke the contract the CDS contract should not have any clause that may prevent the protection seller from making the credit event payment in a timely manner, after occurrence of the credit event and completion of necessary formalities in terms of the contract; the protection seller shall have no recourse to the protection buyer for credit-event losses; dealing in any structured financial product with CDS as one of the components shall not be permitted; and dealing in any derivative product where the CDS itself is an underlying shall not be permissible. Documentation Fixed Income Money Market and Derivatives Association of India (FIMMDA) shall devise a Master Agreement for Indian CDS. There would be two sets of documentation: one set covering transactions between user and market-maker and the other set covering transactions between two market-makers. While drafting documents, it would be absolutely necessary for the participating institutions to ensure that transactions are intra vires and legal risks are reduced to the maximum possible extent. 4.3 SUMMARY  Receivables in MBSs are secured by land or real estate. In CDOs, loans and similar products (e.g. bonds) are securitized, and the debtors are mainly corporate similar products (e.g. bonds) are securitized, and the debtors are mainly corporate clients. The narrow definition of ABSs includes all securitization transactions not categorized as MBSs or CDOs. The most frequently used types of receivables are credit card debt, leasing receivables, trade receivables and consumer loans. In addition, the underlying receivables can be categorized by their origins (primary or secondary market) and debtors (banks, corporate clients, public-sector entities).  It is necessary to differentiate types of receivables in risk management because valuating a pool of receivables backed by real assets, for example, will require different parameters from those used to assess a pool of credit card receivables. ABSs are also often based on revolving receivables.  Receivables are referred to as revolving when debtors are allowed to vary the amounts borrowed and repaid within agreed limits (e.g. in the case of credit card debt and corporate lines of credit). This poses an additional challenge in securitization: The precise amounts of the debt as well as the associated interest and principal payments can fluctuate heavily and can only be forecast to a limited extent. This has to be taken into consideration accordingly in risk management.  When it comes to the means of transferring risk, a fundamental distinction is made between synthetic securitization and true-sale structures. The latter type of transaction is also referred to as a traditional securitization transaction in Basel II terminology. In the case of synthetic securitization, the originator retains ownership of the receivables, 84 CU IDOL SELF LEARNING MATERIAL (SLM)

and only the credit risks arising from them are transferred to the special-purpose vehicle. In a true-sale structure, ownership of the receivables — including the credit risk — passes to the special-purpose vehicle and the originator receives the corresponding amount of financial funds.  Synthetic securitization transactions only provide funding for the originator under certain circumstances. In general, a distinction is to be made between under certain circumstances. In general, a distinction is to be made between flows of funds to the special-purpose vehicle and the financing effects for the originator in synthetic securitization deals. In order to achieve these financing effects, the special-purpose vehicle can issue CLNs or ABSs. For its part, the originator can issue CLNs to the special-purpose vehicle in order to receive financial funds in return.  Otherwise, the special-purpose vehicle should invest the funds in top-rated instruments. Under the latter arrangement, it follows that funds would only be transferred to the originator if it issued such highly rated instruments that the special purpose vehicle could reinvest in them. In the case of synthetic securitization, it is possible to avoid setting up a special-purpose vehicle altogether if the originator has such a high rating that it can also issue CLNs on its own balance sheet. 4.4 KEYWORDS  Buyer’s Option Contract – When the buyer has the right to settle a forward contract at their option any time within a specified period.  Buying Rates – Rates at which foreign exchange dealers will buy a foreign currency from other dealers in the market and at which potential sellers are able to sell foreign exchange to those dealers.  Capital Controls – Governmental restrictions on the acquisition of foreign assets or foreign liabilities by domestic citizens or restrictions on the acquisitions of domestic assets or domestic liabilities by foreign citizens.  Capital Flight – A transfer of investors’ funds from one country to another because of political or economic concerns about the safety of their capital.  Central Bank Intervention – Direct action by a central bank to increase or decrease the supply of its currency to stabilize prices in the spot or forward market or move them in a desired direction to achieve broader economic objectives (e.g., weaken currency to a given point in order to boost export activity). 4.5 LEARNING ACTIVITY 1. Create a survey on Securitization. 85 CU IDOL SELF LEARNING MATERIAL (SLM)

___________________________________________________________________________ ___________________________________________________________________________ 2. Create a session on Assets Backed Securities. ___________________________________________________________________________ ___________________________________________________________________________ 4.6UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Define the term Asset? 2. Define Debt? 3. What isSwaps? 4. What do you mean by credit? 5. Define the term Securities? Long Questions 1. Explain the concept of Securitization. 2. Explain the concept of Risk management. 3. Illustrate the Assets Backed Securities (ABS). 4. Illustrate the Collateralized Debt Obligation (CDO). 5. Illustrate the Credit Default Swaps (CDS). B. Multiple Choice Questions 1. What does the payoffs for financial derivatives are linked to? a. Securities that will be issued in the future. b. The volatility of interest rates c. Previously issued securities. d. Government regulations specifying allowable rates of return. 2. What does financial derivatives include? 86 a. Stocks b. Futures c. Bonds d. None of these CU IDOL SELF LEARNING MATERIAL (SLM)

3. Identify the right option for the statement, risk management is one of the most important jobs for a. a. Client b. Investor c. Production team d. Project manager 4. Which of the following risk is the failure of a purchased component to perform as expected? a. Product risk b. Project risk c. Business risk d. Programming risk 5. What happen by hedging a portfolio to a bank manager? a. Reduces interest rate risk b. Increases reinvestment risk. c. Increases exchange rate risk d. Increases the probability of gains. Answers 1-c, 2-d, 3-a, 4-a, 5-a 4.7 REFERENCES References book  Gorton, G., and N. Souleles, 2006, “Special purpose vehicles and securitization,” in The Risks of Financial Institutions, R. Stulz and M. Carey (eds.), Chicago: University of Chicago Press.  Ip, G., J. Hagerty, and J. Karp, 2008, “Housing bust fuels blame game,” Wall Street Journal, February 27.  Johnson, K., K. Pence, and D. Vine, 2010, “New vehicle sales and credit supply shocks: What happened in 2008?,” Federal Reserve Board of Governors, working paper. 87 CU IDOL SELF LEARNING MATERIAL (SLM)

Textbook references  Robinson, K., 2009, “TALF: Jump-starting the securitization markets,” Economic Letter, Federal Reserve Bank of Dallas, Vol. 4, No. 6, August.  Rosen, R., 2007, “The role of securitization in mortgage lending,” Chicago Fed Letter, Federal Reserve Bank of Chicago, No. 244, November.  Sabry, F., and C. Okongwu, 2009, “How did we get here? The story of the credit crisis,” Journal of Structured Finance, Vol. 15. Website  https://en.wikipedia.org/wiki/Risk_management  https://www.cimaglobal.com/Documents/ImportedDocuments/cid_tg_intro_to_manag ing_rist.apr07.pdf  https://r.search.yahoo.com/_ylt=Awr9JnNh9A1hbP4ASh5XNyoA;_ylu=Y29sbwNnc 88 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 5 – INTERNATIONAL LOANS SYNDICATION STRUCTURE 5.0 Learning Objectives 5.1 Introduction 5.2 The Syndication Process and Main Actors 5.3 Types of Loan 5.3.1 Personal Loans 5.3.2 Credit Card Loans 5.3.3 Home Loans 5.3.4 Car Loans 5.3.5 Two-Wheeler Loans 5.3.6 Small Business Loans 5.3.7 Payday Loans 5.3.8 Cash Advances 5.3.9 Home Renovation Loan 5.3.10 Agriculture Loan 5.4 Loan and Secondary Market 5.5 Summary 5.6 Keywords 5.7 Learning Activity 5.8 Unit End Questions 5.9 References 5.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Illustrate the concept of Syndication Process and Main Actors  Explain the concept of Types of Loan  Illustrate the concept of Loan and Secondary Market 89 CU IDOL SELF LEARNING MATERIAL (SLM)

5.1 INTRODUCTION This analyses the market for syndicated loans, a hybrid of private and public debt, which has grown at well over a 20 percent rate annually over the last public debt, which has grown at well over a 20 percent rate annually over the last decade and totalled over $1 trillion in 1997. While loan sales have been heavily researched, there has been little work on syndications, which differ in character from sales. We present empirical evidence that the extent to which a loan can be syndicated increases as information about the borrower becomes more transparent, as the syndicate’s managing agent becomes more “reputable,” as the loan’s maturity increases, and as the loan lacks collateral. The lead manager holds larger proportions of information-problematic loans in its own portfolio. Loan syndications, like loan sales, appear to be motivated, in part, by capital regulations, but the liquidity position of the agent bank does not influence its syndication behavior. Activity in the syndication market is broadly consistent with Diamond’s “life-cycle” model of borrower choice, but our results also support the view that contract characteristics and reputation can serve as “substitutes” for information in the debt market. A significant literature has emerged in recent years on the topic of borrower choice between private and public debt. A consensus view suggests borrower choice between private and public debt. A consensus view suggests that a critical factor driving the choice is the character and quality of the information available about the borrower. Diamond develops a formal model which involves borrowers shifting from private sources to the public markets as the quality of the information about the firm improves and the borrower develops a “reputation” in the form of a history of successful debt repayments. Carey, Prowse, Rea and Udell propose an extended continuum, with firms gravitating from insider finance, through venture capital, bank loan finance, private placements, and the public debt markets as information and collateral become increasingly available and the borrower’s repayment “track record” improves. As borrowers become less “information problematic,” the characteristics of the lenders and the underlying debt contracts vary systematically. Bank loans tend to be relatively short term, involve extensive covenants, and are frequently re- negotiated. The majority of public-debt contracts are longer term, involve relatively loose covenants, and are almost never restructured. These contractual characteristics have been extensively examined and rationalized in the literature in papers such as Berlin and Loeys, Berlin and Master, and Rajan and Winton. As CPRU note, some borrowing techniques and their associated contracts involve overlap between the public and private markets. They focus primarily on private placements, which involve lenders who are intermediaries (typically insurance companies) and contracts that have relatively strict covenants and insurance companies) and contracts that have relatively strict covenants and reasonably frequent restructuring, which are all characteristics of private debt. Like public debt, however, private placements are issued in large amounts by sizable firms at fixed interest rates, and sales of these debt claims to investors normally are facilitated by investment banks or commercial bank holding company affiliates. In addition, James finds that announcing private placement 90 CU IDOL SELF LEARNING MATERIAL (SLM)

financing has no effect on the equity returns to the borrowing firm, whereas loan announcements have a significantly positive impact. Still another type of financing that involves characteristics of both public and private debt is syndicated loans. Syndication involves the sale of a relatively large commercial loan in “parcels” to a group of institutional buyers, whereas a private placement typically is the sale of a “whole” debt contract to a single lender. In principle, any loan could be syndicated by any financial institution that acts as a loan originator. In practice, only certain kinds of loans and certain types of institutions engage in syndications. This identifies the factors that influence a loan’s syndication potential. Our maintained hypothesis is that the characteristics of the borrower, of the lender, and the loan contract itself can play some role. By sorting out these influences empirically, we hope to: provide further evidence on the significance of information problems and mechanisms for resolving them in financial contracting and specify where syndicated loans “fit” on the private/public debt continuum. An analysis of syndicated loans also may provide indirect evidence concerning the role of relationships in financial arrangements. Recent papers by concerning the role of relationships in financial arrangements. Recent papers by Berger and Udell, Petersen and Rajan, and Cole provide evidence that an ongoing relationship between a borrower and financing agent can serve as a mechanism for attenuating agency and information problems. When borrowers seek multiple loans from the same bank over time, a repayment history accumulates and the lender forms a more extensive and dynamic information set based on multiple assessments of financial statements, discussions with managements, and possible renegotiations. When lending is complemented with the provision of deposit, cash-management and operations based (e.g., payroll) services, the information set becomes still broader and deeper. Berger and Udell find that interest rates and collateral requirements on lines of credit decline with the length of a bank-borrower relationship, while Petersen and Rajan provide evidence that dependence on trade credit decreases with the length of a relationship. Cole finds that the probability a small business will receive credit increases in the presence of a relationship, especially if the borrower obtained multiple services in that context. When lenders provide funds to borrowers in the context of a syndicated loan, the elements that facilitate establishing and deepening a relationship are less likely to be present. While the lead bank may have some form of relationship with the borrower, this is less likely to be the case for participating members. Since the buyer of the syndicated loan cannot rely on relationships with the borrower as a substitute for other mechanisms that resolve agency 4 problems, evidence that certain loan contract characteristics play a different role in a syndication context relative to a relationship setting would confirm the relevance of relationships as a factor for resolving information problems. Syndicating loans is a centuries old process that has shown significant growth in the 1990’s. Gold Sheets Annual, a publication of Loan Pricing growth in the 1990’s. Gold Sheets Annual, a publication of Loan Pricing Corporation, reports that loan syndication volume hit a 91 CU IDOL SELF LEARNING MATERIAL (SLM)

record high $888 billion in 1996 compared to $137 billion in 1987, a compound annual growth rate of roughly 23 percent.2 In 1997, loan syndications exceeded $1 trillion for the year as a whole, compared to roughly $300 million of private placements. Syndicated financings in 1996 were employed largely for general corporate purposes (49.5 percent) and for debt repayment (33.5 percent), which represents a considerable shift from the late 1980’s when syndicated loans were used primarily to finance mergers and acquisitions and leveraged buyout activities. The rapid growth in volume has been accompanied by declining spreads and fees. In 1996, the average rate spread over LIBOR on BB credits averaged 71 basis points, compared to 130 basis points in 1992. Average fees were lower by about 10 basis points over the same period. Buyers of syndicated credits included basis points over the same period. Buyers of syndicated credits included commercial and investment banks, insurance companies, mutual funds, and other institutional funds managers. The American Banker reports that over $14 billion of loans were syndicated in 1997 through the Internet, including a $4 billion loan to Compaq Computer, Inc., using a secure private communications system called Intralinks. The syndication market has grown significantly more than the private placement market in recent years and, according to some practitioners, has begun to converge with the junk bond component of the public debt market in terms of borrowers, investors, and underwriters. The convergence has been facilitated by innovation in contractual structures in the syndication market, including the establishment of loan “packages” containing tranches with longer than- average maturities (10-12 years), bullet repayments of principal, and call protection. These various innovations, in turn, are fuelled by competition between commercial and investment banks for syndication share and the increasing availability of information about such deals. The American Banker reports that three information services Loan Pricing Corporation, Securities Data Company and Portfolio Management Data LLC compete aggressively in this market, updating their databases on-line on a daily basis. 5.2 THE SYNDICATION PROCESS AND MAIN ACTORS In a syndicated loan, two or more banks agree jointly to make a loan to a borrower. As emphasized by Gorton and Pennachi, loan syndications borrower. As emphasized by Gorton and Pennachi, loan syndications differ from loan sales. A loan sale typically involves a “participation contract” which grants the buyer a claim on all or part of a loan’s cash flows. The buyer of a participation is an “indirect lender” with no relationship to the borrower. From a relationship viewpoint, the purchaser of a participation is in a position similar to the buyer of a public debt contract. In a syndication setting, each bank is a direct lender to the borrower, with every member’s claim evidenced by a separate note, although there is only a single loan agreement contract. One lender will typically act as managing agent for the group, negotiating the loan agreement, then coordinating the documentation process, the loan closing, the funding of loan advances, and the administration of repayments. The agent 92 CU IDOL SELF LEARNING MATERIAL (SLM)

collects a fee for these services. The syndicate members typically will have less interaction with the borrower than the lead bank over the life of the loan. Consequently, the benefits of an on-going relationship as a means of resolving agency problems are less operative for the participating members, save for relationships based on prior transactions with the borrower in question. Agent banks have several potential motivations for syndicating loans. Regulators limit the maximum size of any single loan to a portion of the bank’s equity capital, so syndication can be a method to avoid “overlining.” Syndication also may reflect a voluntary diversification motive, a mechanism for managing interest rate risk, or a strategy for enhancing fee income. Participating banks interest rate risk, or a strategy for enhancing fee income. Participating banks may be motivated by a lack of origination capabilities in certain geographic regions or in certain types of transactions or a desire to economize on origination costs. Pennachi suggests that loan purchasing banks may have funding advantages relative to originators. The agent bank commonly issues a commitment letter to a borrower in which it may commit to fund an entire loan facility, or alternatively some portion thereof, with a promise to use “good faith efforts” to arrange commitments from other lenders for the remainder. If the agent commits for the entire amount, the loan can be syndicated after it is closed, to the advantage of the borrower in the sense that the funds are received more promptly.3 Otherwise, the loan must be syndicated prior to closing. The agent bank prepares an “information memorandum” that contains descriptive and financial information concerning the borrower. Recipients of the memorandum sign a confidentiality agreement. The agent typically will meet with prospective members to explain the terms of the credit, describe the borrower’s business and prospects, and answer questions. The agent bank negotiates and drafts all the loan documents, but syndicate participants can provide comments and suggestions when the syndication occurs prior to closing. The participants are not generally involved in the negotiations with the borrower, however. Acting as an intermediary, theagent bank attempts to satisfy the potentially competing objectives of the borrower and syndicate members. borrower and syndicate members. The agent bank also facilitates the administration of the loan, typically acting as a middleman for draws upon and repayment of the loan. The agent calculates required interest payments, obtains waivers and amendments to the loan documents, and in the case of a secured loan, holds all pledged collateral on behalf of the syndicate members. The agent bank collects a fee for its services, which typically falls in range of 10 to 40 basis points as a percentage of the facility. In some transactions, the roles of the agent are divided among several institutions. A “lead bank” negotiates the documents, puts together the syndicate, and closes the loan and an “administrative agent” handles post- closing loan administration. On occasion, a “collateral agent” is designated to monitor and administer the collateral backing the loan. Fees are split in the case of multiple agents. The “agency section” of the syndicated loan agreement formally designates the agent bank and will provide for its removal under specified conditions. The language typically exculpates the agent from any potential liability to the syndicate members except where it results from “gross negligence or wilful misconduct.” While the language is crafted to temper or negate 93 CU IDOL SELF LEARNING MATERIAL (SLM)

the presence of a fiduciary duty on the part of the agent, attorneys typically counsel the agent to administer the credit in good faith and exercise prudence and reasonableness.4 Although standard provisions permit the agent to declare an event of default, typically the agent will seek the prior advice of the member banks. Indeed, the loan agreement will identify which decisions require the consent of a designated proportion of the member banks. Unanimity is normally consent of a designated proportion of the member banks. Unanimity is normally required for any reduction in principal, interest or fees or for extensions of any terms of the credit. In brief, the syndicate participants delegate some monitoring responsibilities to the managing agent both at the loan origination or due diligence stage and at the post-closing loan review stage.5 The loan syndication market invites potential agency problems involving both adverse selection and moral hazard. The agent bank may possess information unavailable to the syndicate participants. If the borrower is a long-time customer, the originating agent bank may have obtained idiosyncratic information regarding prospective performance that is not reflected in financial statement data. Examples of such might involve judgments concerning management expertise, the nature of customer-supplier relationships, or the borrower’s capacity to adapt successfully to changing market conditions. The originating bank has an incentive to syndicate those loans on which its “inside information” is less favourable, to the potential economic detriment of the participant banks. As Gorton and Pennachi and others have noted, sales of loans also generate potential moral hazard problems, since the seller has less incentive to monitor once the loan is removed from the balance sheet. Monitoring is a costly activity, but after the sale of a loan the benefits accrue to the buyer rather than the loan originator. The moral hazard problem is potentially less severe in the case of a loan syndication than a loan sale, since the less severe in the case of a loan syndication than a loan sale, since the 10 purchasing bank in a syndication holds a note against the borrower and has the right to set off against deposits. Nonetheless, the participating members have delegated some monitoring responsibilities to the agent bank, in the sense that members rely on the agent’s loan documentation, its enforcement of covenants, and its administration of collateral. As the agent syndicates a larger proportion of an individual loan, its incentive to monitor ex post declines monotonically. In some instances, the agent bank will syndicate the entire amount of a loan facility. These “information asymmetries” between the agent bank and syndicate members are quite similar in nature to those which have been used to motivate the existence of financial intermediaries. Intermediaries have been shown to have a comparative advantage in solving these agency-related problems.. How are these similar problems overcome in the context of loan syndications? And what do the “solutions” to these problems imply about where syndications “fit” in the information spectrum? We hypothesize that the factors which determine when a loan can be syndicated include the characteristics of the borrower, the agent bank, and the loan contract itself. Research on loan syndications is relatively limited. In the only paper we could uncover in a literature search, Simons examines empirically the motives for syndications and addresses the issue of whether managing agents are likely to 94 CU IDOL SELF LEARNING MATERIAL (SLM)

“exploit” the syndicate member banks. She reports that the capital position of the agent bank is a major factor affecting syndication activity and suggests that diversification is the primary motive for syndication. Using bank examiner ratings for the syndicated loans in her sample, Simons finds that managing agents syndicate larger percentages of individual loans as the managing agents syndicate larger percentages of individual loans as the examiner ratings improve.6 These ratings represent ex post evaluations of loan quality, but Simons suggests “these loans may look less attractive to participants even before they are criticized by examiners “ and that “the lead banks concern with maintaining their reputations in the marketplace may lead them not only to avoid abuses, but to promote risky loans even less aggressively than safe loans”. 5.3 TYPES OF LOAN In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that debt until it is repaid as well as to repay the principal amount borrowed. The document evidencing the debt (e.g., a promissory note) will normally specify, among other things, the principal amount of money borrowed, the interest rate the lender is charging, and the date of repayment. A loan entails the reallocation of the subject asset(s) for a period of time, between the lender and the borrower. The interest provides an incentive for the lender to engage in the loan. In a legal loan, each of these obligations and restrictions is enforced by contract, which can also place the borrower under additional restrictions known as loan covenants. Although this focuses on monetary loans, in practice, any material object might be lent. Acting as a provider of loans is one of the main activities of financial institutions such as banks and credit card companies. For other institutions, issuing of debt contracts such as bonds is a typical source of funding. A mortgage loan is a very common type of loan, used by many individuals to purchase residential property. The lender, usually a financial institution, is given security – a lien on the title to the property – until the mortgage is paid off in full. In the case of home loans, if the borrower defaults on the loan, the bank would have the legal right to repossess the house and sell it, to recover sums owing to it. Similarly, a loan taken out to buy a car may be secured by the car. The duration of the loan is much shorter– often corresponding to the useful life of the car. There are two types of auto loans, direct and indirect. In a direct auto loan, a bank lends the money directly to a consumer. In an indirect auto loan, a car dealership (or a connected company) acts as an intermediary between the bank or financial institution and the consumer. 95 CU IDOL SELF LEARNING MATERIAL (SLM)

Other forms of secured loans include loans against securities - such as shares, mutual funds, bonds, etc. This particular instrument issues customers a line of credit based on the quality of the securities pledged. Gold loans are issued to customers after evaluating the quantity and quality of gold in the items pledged. Corporate entities can also take out secured lending by pledging the company's assets, including the company itself. The interest rates for secured loans are usually lower than those of unsecured loans. Usually, the lending institution employs people (on a roll or on a contract basis) to evaluate the quality of pledged collateral before sanctioning the loan. 5.3.1 Personal Loans Most banks offer personal loans to their customers and the money can be used for any expense like paying a bill or purchasing a new television. Generally, these loans are unsecured loans. The lender or the bank needs certain documents like proof of assets, proof on income, etc. before approving the personal loan amount. The borrower must have enough assets or income to repay the loan. In case of personal loans, the application is 1 or 2 pages in length. The borrower gets to know about the denial or approval of the loan within a couple of days. You must remember that the rate of interest associated with these loans can be on the higher side. The tenure of these loans is not that long. So, if you borrow a big amount, it can be difficult for you to repay without planning your finances properly. Personal loans can prove to be of great help when you wish to take a small amount loan and repay it as soon as possible. 5.3.2 Credit Card Loans When you are using a credit card, you must understand that you will have to repay for all the purchases you make at the end of the billing cycle. Credit cards are accepted almost everywhere, even when you are travelling abroad. As it is one of the most convenient ways to pay for the things you buy, it has become a popular loan type. In order to apply and avail a credit card, all you need to do is fill out a simple application form provided by the card issuer. You can also choose to apply for a credit card online. These plastic cards come with great rewards and benefits. It’s the loan where you need to repay on time but you are also handsomely rewarded for using it. Obviously, there are pitfalls associated with this type of loan. You must understand that there is a high amount of interest on the amounts you borrow on your credit card. If you do not pay your credit card bills on time, the interests will keep piling and might be difficult for you to manage your finances with the rising outstanding balance. But if you use a credit card wisely and clear all your debts on time, it can definitely prove to your best friend in your pocket. 96 CU IDOL SELF LEARNING MATERIAL (SLM)

5.3.3 Home Loans When you wish to purchase a house, applying for a home loan can help you to a great extent. It provides you the financial support and helps you buy the house for yourself and your loved ones. These loan generally come with longer tenures. The rates offered by some of the top banks in India with their home loans start at 8.30%. Your credit score is checked before the loan request is approved by the lender. If you have a good credit score, there is a fair chance that you will be able to enjoy lower rates of interest with your home loan. Home loans are primarily taken for buying new homes. However, these loan can also be used for home renovations, home extensions, purchasing land property, under-construction houses, etc. 5.3.4 Car Loans Buying a car can definitely a great sense of joy and happiness in you. A car will remain as your asset and it is going to be one of the biggest investments that you make. A car loan helps you to pave the path between your dream of owning a car and actually buying your car. Since credit reports are crucial for judging your eligibility towards any loan, it is good to have a high credit score when you apply for a car loan. The loan application will get approved easily and you might get a lower rate of interest associated with the loan. Car loans are secured loans. If you fail to pay your instalments, the lender will take back your car and recover the outstanding debt. 5.3.5 Two-Wheeler Loans A two-wheeler is pretty essential in today’s world. May it be going for a long ride or a busy road in a city bikes and scooters help you to commute conveniently. A two-wheeler loan is easy to apply for. This amount you borrow under this loan type helps you to purchase a two- wheeler. But if you do not pay the instalments on time and clear your debt, the insurer will take your two-wheeler to recover the loan amount. 5.3.6 Small Business Loans Small Business Loans are loans that are provided to small scale and medium scale businesses to meet various business requirements. These loans can be used for a variety of purposes that help in growing the business. Some of these could include purchase of equipment, buying inventory, paying the salaries of employees, marketing expenses, paying off business debts, meeting administrative expenses, or even to open a new branch or take up a franchise. The eligibility criteria for small business loans varies from lender to lender, but the common ones are the age of the business owner, the number of years the business has been operational, income tax returns, and statement of the previous year’s turnover that has been audited by a Chartered Accountant (CA). 97 CU IDOL SELF LEARNING MATERIAL (SLM)

5.3.7 Payday Loans Payday loans are also called salary loans. These are unsecured short-term loans that require the customer to be employed with a steady income. They usually have high interest rates. This is based on the applicant’s credit profile, age, and income. Documents required would be salary statements and other proof of income. 5.3.8 Cash Advances These loans are offered by credit card issuers and allow credit card users to withdraw cash from an ATM machine using the credit card. The amount of cash that can be withdrawn from a credit card in this way will depend on the credit limit available. The cash has to be paid back with interest, which is usually calculated from the day the cash has been withdrawn. There are also other fees associated with a cash advance, such as cash advance fees and ATM or bank fees. 5.3.9 Home Renovation Loan Home innovation loans are offered by most lenders. These can be availed to meet the expenses related to renovation, repairs, or improvement of an existing residential property. Depending on the lender, there is a lot of flexibility with what you can do with a home renovation loan. You can use it to buy products or pay for services. For example, you can use it to pay for the services of a contractor, architect, or interior decorator. You can also use it to buy furniture, furnishings, or household appliances such as a refrigerator, washing machine, air conditioner, etc. It can be used for painting, carpentry, or masonry work as well. 5.3.10 Agriculture Loan Agriculture loans are loans that are provided to farmers to meet the expenses of their day-to- day or general agricultural requirements. These loans can be short term or long term. They can be used for raising working capital for crop cultivation or to buy agricultural equipment. Gold Loan A gold loan can be used to raise cash to meet emergency or planned financial requirements, such as business expansion, education, medical emergencies, agricultural expenses, etc. The loan against gold is a secured loan where gold is placed as security or collateral in return for a loan amount that corresponds to the per gram market value of gold on the day that the gold has been pledged. Any other metals, gems, or stones that are in the jewellery will not be calculated when determining the value of the gold loan. Loan against Credit Card Loan against credit card is like a personal loan that is taken against your credit card. These are usually pre-approved loans that do not require any additional documentation. Depending on the lender, this can be converted into a personal loan that is interest free within a certain period of time. After that, it will attract a certain percentage of interest. 98 CU IDOL SELF LEARNING MATERIAL (SLM)

There is a processing fee associated with converting the credit limit that is pre-assigned into a loan. Education Loan An education loan is availed specifically to finance educational requirements towards school or college. Depending on the lender, it will cover the basic fees of the course, the exam fees, accommodation fees, and other miscellaneous charges. The student is the borrower with any other close relative being the co-applicant, such as a parent, grandparent, spouse, or sibling. It can be availed for courses in India or abroad. It can be taken for a wide variety of recognised courses which are either part time or full time. They cover vocational courses as well as undergraduate and postgraduate courses. Consumer Durable Loan Consumer durable loans are loans that are availed to finance the purchase of consumer durables such as an electronic gadgets and household appliances. Depending on the lender, they can be used to buy anything from mobile phones to television sets. Loan amounts range from Rs.5,000 to Rs.5 lakh. There is no security deposit required usually. Some lenders offer 0% interest on consumer durable loans with instant approvals and minimal documentation required as well. Overview on Loan Loan analysis is an evaluation method that determines if loans are made on feasible terms and if potential borrowers can and are willing to pay back the loan. It checks the eligibility of the potential borrower against the criteria set forth for lending. Loan analysis gives the creditor a measure of safety on the loan by determining the probability that the borrower will pay back the loan. Follow-up visits to the potential borrower, especially for individual loans, help the lending institution gauge the performance of the investments or assets that are intended to generate revenues to help settle the loans. Lenders work under governmental financial regulatory bodies, which provide various regulatory guidelines to guide the operations of the institutions. Every institution, however, follows its own internal guidelines in line with the regulatory guidelines imposed by the government or its agencies. Loan guidelines include eligibility rules, type of loans to be provided, conditions on loans, loan security, and procedures. Not everyone is eligible for a loan unless they meet the lending criteria provided by the specific lending institution. When conducting a loan analysis on a potential client, lending institutions analyse the financial statements of the client to determine their financial capability and their ability to honour the loan obligations without strain. Lenders can offer either long-term or short-term loans. Long-term loans come with a longer repayment period, and borrowers are required to repay the loan within a period 99 CU IDOL SELF LEARNING MATERIAL (SLM)

exceeding one year. Short-term loans offer a shorter repayment duration than long-term loans, and borrowers should repay the loan within a few months to under one year. The lending guidelines are specific to a lending institution and can be based on the maximum and minimum loan offers extended by the lender, associated fees, late- payment penalties, schedules, interest rates payable, and amount of loan based on the collateral provided. The guidelines also outline loan security measures and procedures laid out by the institution. Loan procedures may include disbursement steps, loan application guidelines, loan collection guidelines, loan supervision, loan approval, and review procedures. A loan application is an entire process starting from the negotiation of terms until the loan is reviewed and approved for disbursement. A loan application form is first provided to the client, and the client is required to fill it out correctly before the application form proceeds to the review stage. The client must provide truthful information, including their personal details, physical address, financial statements, evidence of asset ownership, etc. The information should be verifiable, and the credit officer should verify the accuracy and truthfulness of the information provided in the application document. Providing accurate and correct information helps the company in tracking the loan repayments through elaborate measures provided for loan security. The information is used in the initial loan analysis and assessment to determine the risk involved, adequacy of the collateral provided, and the borrower’s ability to make repayments in time. In case of default, the lender uses the information provided to make follow-up and force repayment. The balance sheet is a crucial loan analysis tool. It shows the status of both the current and fixed assets of a potential borrower. The status of the current assets assists loan analysts in determining how much the entity can comfortably absorb and still settle the debt in time. The assets can also be used as loan security, and if it is adequate, the lender can comfortably approve and disburse the amount of loan that’s been requested by the client. The balance sheet also shows the movement of inventory and cash flows, which are important in assessing the financial strength of the client. It also shows the financial transactions of the business for a period of one year, and it can be compared to the previous year’s balance sheets to determine if the business is on an upward or downward trend. Credit analysts can use the balance sheet to generate financial ratios that the lender can use to generate key performance measurements. 100 CU IDOL SELF LEARNING MATERIAL (SLM)