business models in banking

François Longin www.longin.fr

Cass – ESSEC Conference

Business models in banking

by François LonginDepartment of Finance, ESSEC

Credit Suisse, ParisNovember 17, 2009


Business models in banking

• Which business model for banks after the crisis?

• What were the bank business models before the crisis? The traditional business model : “originate-to-hold” The new (old) business model : “originate-to-distribute”

• What was the impact of the change in business model? Securitization Banking regulation Banks behavior, risk taking, incentives The change in the business model: an explanation of the

financial crisis


The traditional business model in banking

• Basics of the originate-to-hold model Banks provide loans to firms and individuals. Banks hold these loans in their balance sheet until their

maturity.

• Risk analysis: Banks bear the credit risk as the assets stay in their balance

sheet. If a client does not repay the loan to the bank, the bank

will incur a loss.


The new (old) business model in banking

• Basics of the originate-to-distribute model Banks provide loans to firms and individuals. Banks do not hold these loans in their balance sheet until

their maturity. They distribute these loans (credit risk) to other market participants through the securitization process.

Mainly US and UK banks.

• Risk analysis: Banks do not bear the credit risk on these loans anymore. Credit risk is born by other market participants.


Securitization (1)

• Definition A financial technique used to transfer illiquid assets of the

banks balance sheets to other market participants through a special purpose vehicle (SPV).

• Structured products ABS : asset-backed securities RMBS : residential mortgage-backed securities CDO : collateral debt obligation


Securitization (2)

Assets Liabilities

Bank balance sheet (before securitization)

Deposits

Cash

Trading book

Interbank loans

Loans to securitize€ 500 M

Investment book

SecuritiesReal estate loansCommercial loans

Credit cards…

Interbank debt

Long term debt

Equity


Securitization (3)

Assets Liabilities Assets Liabilities

Bank balance sheet (after securitization)Bank balance sheet (before securitization)

Deposits

Cash

Trading book

Interbank loans


Cash

+ € 500 M

Deposits

Interbank debt

Long term debt

Equity

Investment book


Credit cards…

Trading book

Interbank loans

Investment book


Credit cards…

Interbank debt

Long term debt

Equity


Impact of securitization for banks

• To free banks from the regulatory constraint in terms of minimum capital requirement

Bank regulation (Basel I / II) : minimum capital ratio of 8% of risk-weighted assets (loans) – Cooke/McDonough ratio

Decrease in the risky assets (loans) on the asset side Decrease in the regulatory minimum capital on the

liability side

• To develop the business Cash for new investments (new loans or other investments) Free capital to take more risk


Securitization (3)

Assets Liabilities Assets Liabilities

SPV balance sheetBank balance sheet (before securitization)

AAA tranche

AA tranche

Loans boughtfrom the bank

€ 500 M A tranche

BBB tranche

Equity tranche

Cash

Deposits

Trading book

Interbank loans


Investment book


Credit cards…

Interbank debt

Long term debt

Equity


Importance of securitization

• Some statistics for the US market (2007) Structured products based on residential loans (RMBS):

$ 5 200 bn Government bonds (Treasuries): $ 4 900 bn


Origin of the development of securitization

• A way to go around banking regulation To free regulatory capital to do more business (more

lending). Basel I / II – Cooke/McDonough capital ratio. Regulatory arbitrage

• The search for quick profit To develop a lucrative business with (apparently) low risk

At the time of the sale of structured products: gain immediately registered in the P&L of the bank

During the life of sold assets: servicing activity (cash flow management and relationship with clients)

To follow the competition trend To satisfy shareholders


Advantages of securitization

• At the microeconomic level For banks

A new source of financing Optimization of the assets side of their balance sheet (risk

diversification) To keep the client relationship

For the market participants (investors) Access to the credit market (not possible otherwise) Diversification of risks

• At the macroeconomic level Breaking risks in many parts (from few banks to many

investors) Better resilience to economic shocks


Consequences of securitization (1)• Appearance of a moral hazard problem

Definition: change of behavior of an economic agent in terms of risk taking when the agent bears only a part of the risk (instead of the entire risk).

Classical example: insurance • Application to the subprime crisis

In the originate-to-hold business model: Banks have an incentive to select their clients in terms of

credit risk because banks bear the risk. Banks hold their loans on their balance sheet until maturity.

In the originate-to-distribute business model: Banks have less incentive to select their clients in terms of

credit risk because banks do not bear the risk anymore. Banks distributed their loans to other market participants.


Consequences of securitization (2)

• Empirical evidence : subprime lending Proportion of subprime loans: 12% in 2001 and 38% in 2006

Banks lent money to riskier and riskier individuals (subprime borrowers).

(Role of public policy - The Community Reinvestment Act ) Proportion of securitized subprime loans: 9% in 2001 and

33% in 2006 Banks distributed more and more credit risk to other

market participant.


Consequences of securitization (3)

• Increase in systemic risk Unregulated market participants bought credit risk from

regulated banks. Bank regulation : minimum capital requirement / constraint

on leverage (limit to risk taking) Example: hedge funds (not regulated)

Main investors in structured products: 46% of structured products and even 19% of the equity tranche (source : OECD)

In case of credit problems: Forced sales due to deleveraging (liquidity problems) Other bankruptcies (domino effect /systemic risk).


Conclusion and recommendations (1)

• Summary Change in the business model of banks (before the crisis)

From the originate-to-hold model to the originate-to-distribute model

This change created a moral hazard problem. Banks had less incentive to select their clients in terms of

risk because they didn’t (completely) bear the risk anymore.

This change also increased systemic risk. Credit risk was transferred to unregulated investors from

regulated banks.



• The originate-to-distribute model is dead (for now on).• Lessons learnt from the crisis for the future business model

in banking: all about risk and regulation To avoid the moral hazard problem:

To give inventive to banks to select their clients in terms of risk (better due diligence process)

To fix some loopholes in the banking regulation and to avoid regulatory arbitrage

To link bank profit / bank employees’ bonuses to risk (for long-term products)



• Lessons learnt from the crisis for the future business model in banking : all about risk and regulation (cont’d)

To avoid an increase in systemic risk: To develop a level playing field in terms of risk taking To regulate other market participants: hedge funds, rating

agencies, and so on. A more general issue: banks / financial world



• One last thought by Alan Greenspan:

“Human beings make mistakes, I know of no supervisory action we can take that will prevent that.”

business models in banking

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