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A comprehensive literature review on the impact of securitization is provided in this section, including the pros and cons, determinants and restrictions of securitization.

2.1.4.1 The advantage of securitization

The reason why securitization has enjoyed a dramatic growth before the 2007-09 financial crisis is due to the following benefits. First, securitization

improves bank’s liquidity by transforming the illiquid loans into marketable

securities. Traditionally, banks tend to hold their loan portfolios until maturity. Since liquid funds and loans are two core components of bank assets, the increase in loan proportions indicates a decrease in the liquid funds holdings. In this case, the insufficient liquidity may prevent banks from pursuing other profitable investment opportunities or finance new credit based on their own willingness. Although loan sale can be considered as an alternative option for banks requiring additional liquidity, loan portfolios are identified as too cumbersome and expensive to sell by traditional literature (Diamond and Dybvig, 1983; Holmstrom and Tirole, 1998; Kashyap, Rajan, and Stein, 2002). With securitization, banks are able to liquidate loans to finance their liquidity need by removing some of the illiquid assets off their balance sheets (Pennacchi, 1988; Jiangli et al., 2007; Jiangli and Pritsker, 2008; Affinito and Tagliaferri, 2010; Martin-Oliver and Saurina, 2007), making themselves less dependent on the traditional sources of funds (e.g., deposits).

Second, by removing some of the risky assets off the balance sheet, a securitized bank is able to transfer the credit risk associated with the securitized

assets to outside security investors. Under the risk transfer hypothesis, banks can

use securitization to shed undesirable risks and rebalance their credit portfolios and achieve a different combination of risk and return. Moreover, the risk transfer of securitization may also lower the capital requirements. Banks are required to maintain a certain proportion of capital to absorb potential risk they are facing due to the regulations. Higher bank risk thus is associated with higher regulatory

investment portfolios by holding a higher amount of liquidity. With securitization, banks are able to adjust their capital level by securitizing some risky assets.

Third, securitization could positively impact on bank’s balance sheet. On

one hand, the liability book or the funding comes from borrowing in most banks and financial sectors, which often at a high cost. Securitization allows these institutions to create a self-funded asset book, which in turn lower the funding costs. On the other hand, securitization could help banks to lock in profits on the balance sheet. Although holding the loans until maturity generates streams of interest income, the total profits are not yet known, and also, remain uncertain

due to the possibility of borrowers’ default. However, securitization allows issuers

to record an earning bounce as soon as the loans have been securitized without any real additional burden to the banks.

2.1.4.2 The disadvantage of securitization

Although securitization could provide originators with many benefits, the costs of securitization means that not all banks are active securitizers, based on the following arguments. On the one hand, securitizations involve substantial one- off costs, including consultancy and organizational costs related to the bundling and tranching of loan portfolios, payments to the agencies responsible for assigning a rating to the different tranches, underwriting fees, and legal expenses. According to Davidson et al. (2003), the upfront costs of a typical securitization can easily exceed $1 million U.S. dollars, mainly from legal fees and from those

responsible for structuring and arranging the operation. Thus, the fixed-costs

hypothesis suggests small banks are not likely to be active securitizers, because the fixed costs of setting up securitization transactions could be a heavy burden for those banks.

On the other hand, since banks have private information on the quality of their loan portfolios, this information equality leads to a lemon discount that is required by the outside security investors (Gorton and Pennacchi, 1995). Under

this lemon discount hypothesis, the securitized assets are likely to be underpriced

during the transactions. Hence, banks that pay a lower lemon discount are more likely to securitize their loans. Previous studies show that the lemon discount is likely to be lower if: (i) the bank can credibly certify the quality of the assets it is

selling (Focarelli et al., 2008); (ii) private information is less relevant because the loans are less opaque or more standardized; (iii) the loss given default is lower, for example because the loans are collateralized.

According to this hypothesis, banks with higher reputations built up in previous years had a lower level of charge-offs and problem loans are more likely to be active securitizers. Since mortgage loans, credit card receivables, and automobile loans enjoy a higher degree of standardization in practice, those loans are less subject to asymmetric information. Thus, banks with larger proportions of such loans are more likely to be active securitizers. Listed banks might also pay a lower lemon discount and are more likely to securitize their assets, due to the fact that, their balance sheets are typically under close scrutiny by external analysts.

Most importantly, the 2007-09 financial crisis highlights that securitization could encourage securitizers to take on more risk and lower the credit standards. The idea of securitization to reduce bank risk is to share the potential credit risk with a large number of security investors. Since securitizers realize that the potential losses are able to be diversified, they become more aggressive to grant loans without sufficient screening and monitoring efforts. Loan quality is in turn decreased.