The paper summarizes on the general performance of the Banks and Authorised deposit institutions (ADIs) in Australian economy. It starts by giving a detailed definition of liquidity risk and how it can be measured. During the global financial crisis, the four major Australian banks survived collapse. Other minor banks collapsed, and they were absorbed or bailed out of the financial turmoil by the government. To avoid future collapse of these financial institutions, the Australian financial regulators are in a process of taking a bold step to regulate the securitisation of illiquid assets a move that is highly rejected by the major banks. The regulators are now calling on banks and ADIs to hold more assets in liquid form. The paper also illustrates the process of securitisation and the role it plays in exchange of risks from the originator to the investor. It further explains how collateralized debt obligations may have contributed to the Global Finance Crisis. It further outlines the how securitisation affect the liquidity of a bank and lastly it displays some data regarding Australian securitisation of the banking market and how securities performed in the financial marketLet our writers help you! They will create your custom paper for $12.01 $10.21/page 322 academic experts online
Liquidity is a term that is usually used to refer to the ease at which a business is able to meet its payment obligations as when it’s required. Liquidity risk is the unsure change in portfolio worth caused by an exchange of assets with low liquidity with assets of high liquidity to meet the unforeseen cash necessities above and beyond future changes in prices. Liquidity risks arise when an asset manager or financial institution is required to raise a significant amount of money to meet its daily operation needs or for payment to creditors. Liquidity is necessitated by the fact that a business must meet its daily obligations for it to survive. Where cash is not available a business must dispose off its assets to obtain cash equal to the value of the asset disposed as well as cause only a minimal reduction in the net worth of the remaining assets. Liquidity transaction causes random shocks on portfolio managements that are insisted by liquidity traders (Fitch IBCA, 2000 p. 11).
Measurement of liquidity risk
Liquidity risk can be measured by use of various methods whereby value at risk model is used. The value at risk models are developed to measure daily business trading exposures. Many banks and other financial institutions have developed complicated liquidity risk measurement systems that assist them to measure and manage their asset liquidity risk. Most firms and especially banks measure their liquidity risk based on cash flow analysis for their day to day running of their activities in the short run. Good financially based banks can use ratio analysis method of measuring liquidity risks in the long run. Cash flow analysis assists the bank to realize its cash equivalents than the use of ratios (Basel Committee on Banking Supervision, 1999, pp.176).
Need for liquidity by the financial regulator
The Australian banking sector regulator has developed liquidity rules that require banks to hold more money in liquid form or in liquidity form or in more liquid assets such as treasury bills and government bonds. The Australian securitization market regulators argue that the Australian four banks are too large to fail. To avoid this, they are being mandated to increase their capital base and hold more as liquid assets during good economic times which they can run down during a recession. From the fall of large financial institutions like the Lehman Brothers, the Australian financial regulators could not assume the probability of the four major banks collapsing in event of recurrence of a major recession and therefore serious measures have to be taken to avoid their collapse (A.P.R.A., 2000, p. 26).
The process of securitisation
Securitisation basically is a process that has been developed to fund assets. It involves the process of converting less liquid assets such as loans and receivables which are non tradeable to tradeable securities such as mortgages or other securities which are asset backed or collaterised bonds. The securitisation market in Australia has developed to be one of the largest and most active markets. Securitisation process has made financial institutions in Australia to be more elastic in their ability to manage risks associated with funding credit and the liquidity risk. The securitisation process was developed to make sure that the associated risks are well taken care of by the regulated organization’s risk management systems. This is to ensure there are sufficient minimal capital guidelines which provide coverage for retention of risks other than being shed by organisations that are regulated. The diagram below illustrates a simple process of securitisation.
The securitisation process requires the creation of a special purpose vehicle which may be put into effect either under trust or corporations law. The concerned institution sells assets to the special purpose vehicle. The ownership of the pool of ‘assets’ and its rights is hence exchanged. The payment of the assets is done by issuing of the securities supported by the asset pool. Cash derived from the fundamental assets is used to offset the special purpose vehicle debt repayment responsibility and the principle. The PSV acts as a link of transfer of risks between the initiating institutions to the investors. Securitisation has been practiced in Australia as a form of structured finance from 1980s. The structured finance programs were started by the government to assist public housing loan scheme. This led to the growth of the Australian secondary mortgage market. Since then, securitisation has become one of the major financing instruments in the Australian financial market. Securitisation process has developed to provide finance backed by assets and especially residential mortgage, credit cards and commercial property loans. The securitisation process of corporate and commercial loans are gradually growing over time. In the securitisation process, the assets are pooled into a special purpose vehicle. The special purpose vehicle is supposed to fund itself through issuing of securities which are backed by the inflow of cash generated by the assets in the pool. Securitisation process offers the opportunity of repackaging and reallocating to others who are willing and able to bare such risks. This facilitates the risks and return trade-off to the potential parties involved (Fitch IBCA, 2000. pp. 98-103).Order now, and your customized paper without ANY plagiarism will be ready in merely 3 hours!
Collaterised debt obligation and the Global Financial Crisis
Collateralized debt obligations were a type of structured security or financial products that are backed by assets. These collaterised debt obligations were held by an accounting body, the special purpose vehicle, specifically created to pool assets together. They came to be known as asset- based securities. They were developed to cater for the widespread use of securitisation. Their values and payments are subject of a collection of fixed income fundamental assets. They are based on claims on payment flows generated from a pool of collaterals. Collateral debt obligations to a large extent contributed to the global financial crisis. The cause of the current credit crisis can be traced on the issue of the collateral debt obligation where by the unit risk was not eradicated but was instead transferred to a larger pool of asset backed securities to conceal it statistically. The more threatening way was that credit rating defined the regulatory risks. The more the credit rating rose, the more the risk exposure fell.
The rise of risk exposure results to a fall in credit rating and this generated more exposure to risks. This continued rise and fall of the credit ratings and risk exposures resulted to the fall of the financial market. The cash generated from the flow derived from the pool is bought by the investors. A collaterised debt obligation may be structured to compromise a pool of business loans, credit card loans and car loans which acts as the collateral. The proceeds from the loan repayment realized are the cash flows to the investor. The investor on the other hand buys a tranche which is a part of the inflow according to his or her wish to hold risks. To spread the extent of risks, collateralised debt obligations are divided into various tranches according to security accorded to them. Securitisation can also arise from use of market value collateral debt obligation. In this case, investors invest in a special purpose entity that concerns itself in buying and selling collateral asset in a bid to earn capital gains. In this case, an investor has no direct claim on the pool of assets but by being a member of the agreement to the pool of the assets. With the agreement, the investor earns a premium is the loan do not default. If the loan defaults the investor looses the capital contributed to buy the swap. As opposed to the cash flow collateral debt obligations, in the market value, the investor has the right to choose the level of risk and returns to get by choosing the class to invest in. Between the years 2000 and 2005, the collateral debt obligation market grew very rapidly. By 2005 and 2006 dollars valued at half a trillion worth of securities were issued. However besides spreading of risks, the collateral debt obligation has the role of increasing uncertainty about the worth of the assets used.
Another major factor that degenerated to the global financial crisis was the acceptance by the comptroller office of the currency and the Federal Reserves to allow banks that possessed credit default swaps insurance to include senior risks in their books of accounts without backing them with capital. These banks only needed to attach as little capital as 8% of the total liability. This meant that the banks were not mandated to hold enough currency in liquid form in case the risks degenerated (Moody’s Investors Service, 2000, pp.214-217).
Effects of Securitisation in the liquidity of a bank
Securitisation affects the liquidity of a bank by providing a new source of liquidity as the banks are allowed to change illiquid loans which are hard to sell into easily marketable securities. It also allows banks to replace cash and securities for hard-to-sell loans which decrease the sensitivity of the bank lending due to availability of external funding. Through the cost benefit factor, the banks tend to give out a lot of unsecured loans leaving very little liquid assets to cater for any economic shocks. The banks are left with little or no cash to trade in government bonds through the open market operations which increases the liquidity ratio of the bank. Securitisation makes bank lending costs less susceptible to the costs associated with fund shocks as it acts as an alternate source of funding. This in turn weakens the relationship between the monetary policy and the bank lending activity. The ability of the banks to convert illiquid loans into liquid assets reduces the amount of liquid securities and raises the banks loan portfolios (Fitch IBCA, 2000 p.123).
Analysis of data on securitisation in the Australian banking market
Data in the Australian banking market reveals that the process of securitisation in Australia is deep rooted and despite its shortcomings in provision of illiquid assets, it is highly valued in the banking market. The major banks were able to overcome the global financial crisis and hence they did not actually embrace the APRA recommendations on liquidation. Due to relatively good Australian economy the offshore funding markets become less unstable. The total fundamental cash earning dropped by $ 17 billion this was 2.4%. Prices for residential property have stabilised while that of commercial markets have gone up slightly. The banks have increased the total net interest income by between 19.8% from financial year 2008 to year 2009. This was as a result of banks re-pricing their loans. The assets and liabilities balances have raised to $160 billion in 2004 from $ 10 billion in 1995 as can be shown from the graph.
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Australian financial market players include the Banks and Authorised Deposit Institutions (ADI) such as Foreign Subsidiary Banks, Branches of Foreign Banks, Building Societies, Credit Unions, Specialist Credit Card Union, Providers of Purchased Payment Facilities and Authorised on – Operating holding companies. The Banks and ADIs have given out asset – backed securities amounting to $63 billion of domestic bonds and off shore bonds worth$59 billion. The commercial backed papers are worth $22 billion. The higher amount of asset – backed securities market is as a result of increased securitisation of residential mortgages. Securitised mortgages comprise 70% of the total assets held in the Australian security vehicles. Securitised residential mortgage have grown rapidly from $5 billion to $116 billion. The graph below shows the composition of securitised assets. A securitised mortgage takes the lead with the highest percentages in all years. This shows that mortgages loans guaranteed good returns compared to the other Securitised assets
It is evident that properly carried out securitisation can assist banks and other ADIs to increase their income and be able to control all the risks such as credit, and liquidity connected with advancing and funding of the loans. From the above data, banks and ADIs are better with residential mortgaged securities, and this can create confidence with potential investors to invest more on securitised assets (Standard & Poor’s, 1999, pp.154-159).
Australian Prudential Regulation Authority. (2000). ‘A New Capital Adequacy Framework’, Submission to the Basel Committee on Banking Supervision.
Basel Committee on Banking Supervision. (1999). ‘A New Capital Adequacy Framework’, Consultative Paper.
Fitch IBCA. (2000). ‘Australian Securitisation 1999 Year-End Summary’, Structured Finance International Special Report.Just $12.01 $10.21/page, and you will get your custom-written original paper by our team
Moody’s Investors Service. (2000). ‘1999 Year in Review and 2000 Outlook: Record Market Growth Accompanied by New Asset Classes’, Structured Finance Special Report.
Standard & Poor’s. (1999). Structured Finance: Australia & New Zealand, April.