The role of securitization in bank liquidity and funding management

The role of securitization in bank liquidity and funding management $Elena Loutskina nThe Darden School of Business Administration,University of Virginia,100Darden Boulevard,Charlottesville,VA 22903,United Statesa r t i c l e i n f oArticle history:Received 6April 2010Received in revised form 13July 2010Accepted 13August 2010Available online 3March 2011JEL classification:G21Keywords:SecuritizationBank management LiquidityLending channel Monetary policya b s t r a c tThis paper studies the role of securitization in bank management.I propose a new index of ‘‘bank loan portfolio liquidity’’which can be thought of as a weighted average of the potential to securitize loans of a given type,where the weights reflect the composition of a bank loan portfolio.I use this new index to show that by allowing banks to convert illiquid loans into liquid funds,securitization reduces banks’holdings of liquid securities and increases their lending ability.Furthermore,securitization provides banks with an additional source of funding and makes bank lending less sensitive to cost of funds shocks.By extension,the securitization weakens the ability of the monetary authority to affect banks’lending activity but makes banks more susceptible to liquidity and funding crisis when the securitization market is shut down.Published by Elsevier B.V.1.IntroductionSince the 1970s,the market for securitized loans in the United States has grown to dominate the mortgage market and has become an increasingly important factor in lending to both consumers and businesses (Fig.1).In2007,for example,$8.1trillion of loans outstanding were financed through securitization,or about 40%of all loans outstanding.Even in the aftermath of the 2007financial crisis,the securitization market activity by volume exceeds the size of the corporate bond market.A rapidly evolving body of academic research aims to understand whether and how securitization changed the traditional role of banks in the economy.1This paper contributes toContents lists available at ScienceDirectjournal homepage:/locate/jfecJournal of Financial Economics0304-405X/$-see front matter Published by Elsevier B.V.doi:10.1016/j.jfineco.2011.02.005$An earlier version of this paper was distributed under the title ‘‘Does Securitization Affect Bank Lending?Evidence from Bank Responses to Funding Shocks.’’I am indebted to Philip Strahan and Gary Gorton for invaluable guidance and suggestions.For helpful comments and discussions,I thank Murillo Campello,Mark Carey,Thomas Chem-manur,Robert DeYoung,Edward Kane,Alan Marcus,Jeremy Stein,and seminar participants at Boston College,University of Virginia,Indiana University,University of Texas at Dallas,Bank Structure and Competi-tion Conference (Chicago 2006),Western Finance Association meeting (2006)and European Finance Association annual meeting (2005).I gratefully acknowledge the financial support of the Foundation,Banque de France grant in the fields of money,finance,and banking.I alone am responsible for any errors or omissions.nTel.:+14342434031;fax:+143424312511.E-mail address:eloutskina@ 1For analysis of the impact of securitization on loan origination decisions,see, e.g.,Loutskina and Strahan (2009),Mian and Sufi(2009),Demyanyk and Van Hemert,2009,and Keys,Mukherjee,Seru and Vig (2010).For analysis of the changing mortgage rates under the evolving asset-backed securities market,see,e.g.,Black,Garbade,and Silber (1981),Kolari,Fraser,and Anari,1998,and Heuson,Passmore,and Sparks (2000).For analysis of the role of the government-sponsored enterprises (GSEs)and the effect of government subsidies to GSEs,see Passmore (2004),Ambrose and Warga (2002),and Nothaft,Pearce,and Stevanovic (2002).For analysis of the effect of securitization on the efficacy of monetary policy in influencing real output,see Estrella (2002).Journal of Financial Economics 100(2011)663–684this strand of research by examining how securitization changed the ways individual banks manage their funding and liquidity and how these changes have in turn altered the traditional links between bank liquidity,cost of funds,and loan supply.I show,first,that securitization creates a new source of liquidity by allowing banks to convert illiquid,hard-to-sell loans into marketable securities.Second,by providing a new source of funds in the form of existing loans,securitization reduces the sensitivity of bank lending to the availability of the external sources of funds such as traditional liquid funds and deposits.As a result,securitization alleviates the impact of the local economic shocks and weakens the ability of the monetary authority to affect bank lending through open market operations.At the same time,it makes banks more vulnerable to various economic shocks when the market for securitized loans is disrupted.I propose a new bank-specific index of ‘‘bank loan portfolio liquidity’’(S it )that effectively captures banks’ability to sell loans.The index is a weighted average of the potential to securitize loans of a given type (based on market-wide averages),in which the weights reflect the composition of an individual bank’s loan portfolio.Thus,market trends generate time variation in the index,whereas differences in bank loan portfolio structures generate variation across institutions.I first analyze whether securitization has reduced banks’need to carry liquid assets to meet unexpected demands from depositors and ing the new loan liquidity index (S it ),I show that securitization acts as a substitute for traditional liquid funds on banks’balance sheets.Because banks choose liquidity levels and lendingjointly,I adopt two approaches to adjust for this endo-geneity.2First,I implement the instrumental variable regressions using a synthetic instrument similar to the loan liquidity index (S it ).In constructing the instrument,I use fixed bank portfolio choices as of the beginning-of-period values.This constant-over-time loan portfolio structure removes the effect of the managers’discretion and ensures that the instrument varies only as a result of the deepening of the securitization market.Second,I implement a difference-in-differences analysis around two sets of regulatory interventions and market shocks that significantly changed securitization market ability or willingness to absorb new loans.The results suggest that as banks’ability to securitize loans has increased,their holding of liquid assets on balance sheets has decreased.The magnitude of this decline is both statistically and economically significant (Fig.2).From 1976to 2007,the percentage of total assets held as liquid securities decreased on average by 7.33percentage points due to the expanding secondary loan market.This decline is equivalent to roughly 69%of bank capital and cannot be explained by any time trends such as the increase in average bank size and changes in banking regulation.Because liquid funds and loans are two core components of bank assets,the decrease in the liquid funds holdings indicates a comparable increase in0.000.100.200.300.400.500.600.701976S h a r e s e c u r i t i z e dHome mortgages Multifamily home mortgages Commercial mortgages Farm mortgagesCommercial and industrial loansConsumer credit197819811983198619881991199319961998200120032006Fig.1.Securitization of loans in the US economy.The figure presents the percentage of loans securitized relative to total loans outstanding for six categories of loans:(1)home mortgages,(2)multifamily residential mortgages,(3)commercial mortgages,(4)consumer credit,(5)business loans,and (6)farm mortgages.The data are from ‘‘Flow of Funds Accounts of the United States.’’For the exact description of the methodology see Appendix A.2For example,banks that prefer more liquid assets are likely to have both more liquid funds and a more securitizable loan portfolio (which can be achieved by,e.g.,issuing more mortgages and fewer commercial and industrial loans),thus creating a positive bias in the relations between traditional liquidity levels and bank loan portfolio liquidity.E.Loutskina /Journal of Financial Economics 100(2011)663–684664lending.Thus,securitization increased the supply of bank lending per dollar of capital in the industry.If banks can liquidate loans to finance their liquidity need,they can also do so to finance new credit,making banks less dependent on the traditional sources of funds.The increasing liquidity of bank loans ought to change the link from banks’funding availability (e.g.,deposits)to their willingness to supply credit.The existing literature shows that the availability of additional internal (Kashyap and Stein,2000)and external (Campello,2002;Ashcraft,2006)sources of funds partially alleviates the effect of restrictions in availability of funds on bank loan supply.Because securitization provides banks with an additional source of both loan financing and liquidity,it should also shield banks’willingness to supply credit from the exter-nal cost of funds shocks.To test this argument,I follow the regression frame-work of Kashyap and Stein (2000),which allows me to take advantage of both time series and cross-sectional variation in the loan liquidity index (S it )and its interaction with the cost of external funds.Due to the endogeneityproblem,instead of measuring the cost of funds directly from banks’balance sheets,I exploit the Federal Reserve’s ability to affect bank cost of funds via open market operations and construct shocks to bank funding costs that are exogenous to financial intermediaries’decisions.3Considering the relation between bank liquidity,lending,and loan liquidity under these exogenous shocks allows me to adjust for the endogeneity that arises due to managerial discretion.I find that securitization has made loan growth (espe-cially growth in business loans)less sensitive to cost of funds shocks.A bank with a more liquid loan portfolio (e.g.,one that holds a significant amount of mortgages)incurs a smaller on-balance sheet decrease in lending0.050.10.150.20.250.30.20.240.280.320.360.41976L o a n p o r t f o l i o l i q u i d i t yO n -b a l a n c e s h e e t l i q u i d i t y0.20.250.30.350.40.45O n -b a l a n c e s h e e t l i q u i d i t y1978198119831986198819911993199619982001200320061976197819811983198619881991199319961998200120032006Fig.2.Traditional liquidity,bank loan portfolio liquidity,and size relations.Panel A presents the relation over time between average level of liquidity (B it )maintained by banks (solid line,left-hand-side scale)and the average bank loan portfolio liquidity (S it )(dashed line,right-hand-side scale).Panel B presents the evolution of the average level of liquidity (B it )for the full sample of bank-quarters,as well as for the lowest and highest size quartiles of the sample.See Appendix A for exact methodology for calculating B it ,S it ,and size of the banks.The sample contains bank-quarters from 1976:I through 2007:IV.3The Federal Reserve’s ability to affect bank lending behavior via open market operations is called the bank lending view of monetary policy transmission.For a review of this literature,see Bernanke and Blinder (1992),Bernanke and Gertler (1995),and Kashyap and Stein (1994).The empirical evidence is shown in Kashyap and Stein (1995,2000)and Jayaratne and Morgan (2000).E.Loutskina /Journal of Financial Economics 100(2011)663–684665under a monetary tightening than a bank with a less liquid loan portfolio (e.g.,a bank focused on business lending).Fig.3illustrates the result intuitively by plotting average loan growth during tight and loose monetary regimes for banks with high and low loan liquidity (S it ).4One can see that during the period of monetary tighten-ing,banks with more liquid loan portfolios exhibit sig-nificantly higher business loan growth than banks with illiquid loan portfolios.Given that business loans are still one of the least liquid loan categories,such funding is not mere evidence of substitutions of loans on the balance sheet.The results of more rigorous regression analysis indicate that a 100basis point increase in the federal funds rate would reduce loan growth by 0.7%to 1.3%less at a bank with a more liquid loan portfolio (S it at 90th percentile)compared with a bank with a less liquid loan portfolio (S it at 10th percentile).The effect is sig-nificantly more pronounced for C&I loans,reaching 5.25%smaller decline for the first bank.The ability to securitize their existing loans insulates banks’willingness to supply credit from a monetary policy induced cost of funds shock to the availability of external financing.5I obtain similar evidence from a difference-in-differences analysis around exogenous regulatory changes that affected the securitization market’s ability to absorb new loans.This paper contributes to the line of research exploring how the advancements in securitization have changed the nature of banking.A number of recent studies tied secur-itization to excessive credit supply (Mian and Sufi,2009;Demyanyk and Van Hemert,forthcoming;Keys,Mukherjee,Seru,and Vig,forthcoming;Loutskina and Strahan,2009;Rajan,Seru,and Vig,2010);lack of ex post monitoring incentives (Piskorski,Seru,and Vig,forthcoming;Parlour and Plantin,2008);and deterioration of credit quality (Purnannandam,forthcoming;Loutskina and Strahan,forthcoming ).In contrast to these studies that mostly explore the shadow banking,off-balance sheet implications of securitization,this paper illustrates that securitization leads to material changes on banks’balance sheets and their risk exposure.Such changes are of particular impor-tance to the regulatory authority.First,securitization has become an integral part of bank liquidity-risk management.Bank loan liquidity should now be considered along traditional balance sheet measures of liquidity,such as cash and marketable securities.Second,securitization increases banks’credit supply across sectors.Banks’ability to securitize liquid mortgages increases their willingness to supply illiquid business loans.This repre-sents the beginning of the structural shift in the lending industry in which segmentation occurs with liquid loans financed through securitization and illiquid loans financed from deposits.Such a structural shift suggests changing risk profiles of financial institutions.Third,securitization weak-ens the link from the cost of traditional sources of funds to banks’willingness to supply credit and,by extension,makes bank lending activity less prone to local economic shocks as well as global monetary authority interventions.With securitization,it might be necessary to make larger policy moves to achieve a significant contraction in bank lending.But because every coin has two sides,overreliance on securitization in financing liquidity and fundingneeds0.511.522.533.5Banks with illiquid loan portfoliosC &I l o a n g r o w t h (p e r c e n t )Monetary tightening, 1993:IV to 1995:IMonetary loosening, 2001:II to 2003:IVBanks with liquid loan portfoliosFig.3.Bank loan portfolio liquidity and commercial and industrial loan growth.The figure presents the value-weighted C&I loan growth for two types of banks under the monetary tightening of 1993–1995and monetary loosening of 2001–2003.I consider banks with the loan liquidity in the top 10%of S it distribution to have liquid loan portfolios and banks with the loan liquidity in the bottom 10%of S it distribution to have illiquid loan portfolios.4In contrast to the multivariate panel model,this simple univariate comparison does not control for loan demand.Hence,loan growth is higher during the period of tightening than during the period of loosening.5For comparison,two equal-sized banks with the same access to the securitization market but with levels of on-balance sheet liquidity around 10th and 90th percentiles of the level of liquidity distribution will have 0.4%to 0.7%loan growth differentials four quarters after a 100-basis-points increase in the federal funds rate.E.Loutskina /Journal of Financial Economics 100(2011)663–684666made banks vulnerable to the 2007crisis when the market for securitized loans was disrupted.The remainder of the paper is organized as follows.Section 2describes the structure and magnitude of the market for securitized loans as well as possible channels of its influence on bank operations.Section 3describes data and sample selection.Section 4presents the intuition and methodology behind the bank-specific index of liquidity of a bank loan portfolio (S it ).Section 5presents the empirical tests and results for the hypothesis of substitutability between liquid funds and securitizable loans on banks’balance sheets.Section 6describes empirical evidence for the argument that securitization alleviates the sensitivity of bank lending to the cost of funds shocks.Section 7concludes the paper.2.The securitization marketThe US economy has seen an enormous expansion of the securitization market.6Table 1presents the amount of loans outstanding and loans securitized for various loan categories over the sample period 1976:I to 2007:IV.Consider,for example,home mortgages.In 1976:I,the amount of securitized home mortgages was $27.7billion.By the end of 2007,the total amount of securitized home mortgages grew 230times,reaching $6.42trillion.At the same time,the amount of home mortgages outstanding grew only 22times,from $489billion to $11,135billion.In 1976,neither commercial mortgages,nor C&I loans,nor consumer credit were securitizable types of loans.The securitization market outpaced loan origination by ten times.By the end of 2007,the securitized loan volume totaled $652billion of commercial mortgages,$80billion of C&I loans,and $682billion of consumer credit.Through the years,C&I loans remain the least liquid loan category due to their heterogeneity,which complicates pooling and pricing processes.Fig.1shows how the aggregate,economy-wide share of securitized loans in total loans outstanding has been changing over the years.The share of securitized home mortgages climbed from around 5%in 1976:I to almost 60%in 2007.In 2007:IV,28%of the commercial mortgages outstanding,3%of C&I loans,and 27%of consumer credit were securitized.On the aggregate level,securitization has dramatically expanded from 2.2%of the total loans outstanding securitized in 1976:I to around 40%in 2007:IV.T a b l e 1E c o n o m y -w i d e l o a n s o u t s t a n d i n g a n d s e c u r i t i z e d .T h e t a b l e p r e s e n t s t h e a g g r e g a t e ,e c o n o m y -w i d e a m o u n t s o f t h e l o a n s o u t s t a n d i n g a n d l o a n s s e c u r i t i z e d f o r s i x l o a n c a t e g o r i e s o v e r t i m e p e r i o d 1976:I t o 2007:I V .T h e l o a n c a t e g o r i e s c o n s i d e r e d a r e :(1)h o m e m o r t g a g e s ;(2)m u l t i f a m i l y r e s i d e n t i a l m o r t g a g e s ;(3)c o m m e r c i a l m o r t g a g e s ;(4)c o n s u m e r c r e d i t ;(5)b u s i n e s s l o a n s [c o m m e r c i a l a n d i n d u s t r i a l (C &I )l o a n s ];a n d (6)f a r m m o r t g a g e s .T o t a l m o r t g a g e s r e p r e s e n t t h e a g g r e g a t e o f h o m e m o r t g a g e s ,m u l t i f a m i l y r e s i d e n t i a l m o r t g a g e s ,c o m m e r c i a l m o r t g a g e s ,a n d f a r m m o r t g a g e s .T o t a l l o a n s r e p r e s e n t t h e a g g r e g a t e o f a l l s i x l o a n c a t e g o r i e s .A l l fig u r e s a r e i n m i l l i o n d o l l a r s .T h e d a t a a r e f r o m t h e ‘‘F l o w o f F u n d s A c c o u n t s o f t h e U n i t e d S t a t e s .’’F o r t h e e x a c t d e s c r i p t i o n o f t h e m e t h o d o l o g y s e e A p p e n d i x A .1976:I1981:I1986:I 1991:I1996:I2001:I2007:I V O u t s t a n d i n gS e c u r i t i z e dO u t s t a n d i n g S e c u r i t i z e dO u t s t a n d i n gS e c u r i t i z e dO u t s t a n d i n gS e c u r i t i z e dO u t s t a n d i n gS e c u r i t i z e d O u t s t a n d i n g S e c u r i t i z e d O u t s t a n d i n gS e c u r i t i z e d H o m e m o r t g a g e s 489,06327,700977,592110,2641,554,381410,6412,654,5911,083,5613,532,5301,806,2395,301,1292,988,22411,135,7926,419,087M u l t i f a m i l y r e s i d e n t i a l m o r t g a g e s 100,6001,446142,7986,111212,0338,991288,34127,900267,92140,027386,091117,347809,733259,953C o m m e r c i a l m o r t g a g e s 162,1680266,2310553,2721,377825,08712,509729,01144,6281,135,225192,7142,339,017652,555F a r m M o r t g a g e s 50,7972,006100,097885103,99442778,8802484,8614109,9830117,4974,618L o a n s t o b u s i n e s s (C &I l o a n s )409,0060766,10701,191,75401,464,7434,2671,673,70930,2182,387,841107,5722,993,75780,433C o n s u m e r c r e d i t 204,9080353,9020606,7990802,20783,2511,162,807226,4201,724,595580,2092,550,586682,110T o t a l m o r t g a g e s 802,62831,1521,486,718117,2602,423,680421,4363,846,8991,123,9944,614,3231,890,8986,932,4283,298,28514,284,5427,331,595T o t a l l o a n s1,416,54231,1522,606,727117,2604,222,233421,4366,113,8491,211,5127,450,8392,147,53611,044,8643,986,06619,946,3828,098,7566Securitization is a process of creating new financial instruments by pooling cash flows from a number of similar assets such as mortgages or credit card accounts and putting them into a separate legal entity [or special purpose vehicle,(SPV)]often with some additional implicit or explicit guarantee or extra collateral.Creating this separate SPV isolates the cash flow generating assets or collateral so that the security is not a general claim against the issuer,just against those assets.The pooling process results in a diversified portfolio of cash flows that can be further stripped and repackaged based on various characteristics (e.g.,the prepayment behavior),thereby reducing the need to monitor each underlying payment stream.For a detailed discussion of the securitiza-tion process and the role of SPVs,see Gorton and Souleles (2005).E.Loutskina /Journal of Financial Economics 100(2011)663–6846672.1.Origins of securitizationSecuritization evolved as early as the1970s out of concern that,at the time,the existing thrift system could notfinance the growing demand for housing.While the thrifts were not in trouble,the core concern lay in their inability to attract a sufficient amount of deposits at a reasonable cost andfinance the baby boomer generation reaching home-buying age in the mid to late1970s.The major contributors to the development of bank loan securitization have been the government-sponsored enterprises(GSEs)–the Federal National Mortgage Asso-ciation(Fannie Mae or FNMA)and the Federal Home Loan Mortgage Corporation(Freddie Mac)–that were created by the US Congress to provide stability and ongoing assistance to the secondary market for residential mort-gages and to promote access to mortgage credit and home ownership in the US.GSEs fostered securitization by being the largest buyers of mortgages in the US.Fannie Mae and Freddie Mac combined purchase almost one-half of all conventional single-family mortgage loans originated each year(Frame and White,2005).More important,GSEs facilitate small bank access to the securitization market by standing by to purchase individual mortgages as well as mortgage pools.They have created an environment in which the ability to securitize mortgages is similar across banks of different size.The evolution of mortgage compa-nies and various pulling agents performing functions similar to GSEs,but on a much smaller scale,has been crucial to attain a similar equality in the nonagency securitization markets.Nevertheless,large banks continue to have economies of scale in accessing other sectors of the securitization market in which there are few or no intermediaries willing to pool and securitize loans from multiple lenders(e.g.,C&I loans securitization).2.2.Regulation of the securitization marketOver four decades of continued tremendous growth, up to the2007Crisis,the securitization market had not experienced any dramatic speed bumps.In fact,all sig-nificant regulatory changes that have been introduced since securitization conception were nothing but friendly and market enhancing.In the early1980s,the securitiza-tion market was facing two important problems:convo-luted and unfair tax treatment and a legal investment problem that prevented regulated investors from holding securitized assets.On October3,1984,Congress passed the Secondary Mortgage Market Enhancement Act (SMMEA)that preempted the state laws and allowed almost any investor to hold rated mortgage backed securities.SMMEA was followed by the1986Tax Reform Act that created a friendlier tax environment by introdu-cing a new tax vehicle called the Real Estate Mortgage Investment Conduits(REMIC).SMMEA and REMICS opened the door for a significantflow of capital to the securitization market and by extension dramatically enhanced loan liquidity.In fact,these two acts created an environment that had not seen any regulatory inter-vention(apart from minor disclosure regulations)up until the end of2001when Enron collapsed.In early2002,the role that off-balance sheet vehicles played in hiding Enron’sfinancial liabilities led the reg-ulators to reexamine the treatment of the securitization conduits.The securitization market reaction was swift. For example,the asset-backed commercial paper market stalled(Acharya and Schnabl,forthcoming).In January 2003,the Financial Accounting Standards Board(FASB) issued guidance that required consolidation of no-recourse conduits on banks’balance sheets under US GAAP(FASB46).The industry considered it a real possi-bility that the guidance would result in a corresponding regulatory change.Such a ruling would have had a dramatic impact on banks’balance sheets and,given the bank capital requirements,would have rendered the securitization of loans too costly to be considered a source of liquidity or capital.In July2004,US bank regulators issued a ruling that allowed banks to leave the conduits off balance sheets and required them to hold capital against some conduit liquidity enhancements at only a 10%conversion factor,much lower than the capital required for on-balance sheet assets.The market responded by a vivid growth in the volume of new securities issued.As a robustness test,I conduct a differ-ence-in-differences analysis in which I exploit the1984–1986regulatory changes and2002–2004events as exo-genous shocks to the depth of the securitization market.2.3.Implications of securitizationIn light of the2007credit crisis,it is hard to overstate the importance of securitization in shaping banks’opera-tions.It provides banks with a new source offinancing their investment opportunities.With securitization,banks can fund new loans by securitizing them(or other out-standing loans).It changes the traditional view on the deposit institutions as liquidity providers(Diamond and Dybvig,1983;Holmstrom and Tirole,1998;Kashyap, Rajan,and Stein,2002)and transforms them to pure intermediaries between borrowers and capital markets. Loan portfolios that were considered to be too cumber-some and expensive to sell25to30years ago were becoming more and more liquid.There are other channels through which securitization significantly affect the nature of banking.Securitization provides an opportunity for banks to hold more diversi-fied loan portfolios,thus protecting them against local economic shocks while at the same time making them more prone to the global economic slowdowns(Loutskina and Strahan,forthcoming).Although deregulation has eliminated most of the legal restraints on geographic segmentation,many banks continue to originate loans in the regions or industries in which they have a superior knowledge of market conditions.With securitization, these loans can be bundled with others,bought and sold all around the country.Money canflow from the regions with excess deposits to the regions with the unsatisfied loan demand.The benefits come at a cost.Alongside eroding banks’core role of liquidity provider,securitization jeopardizes banks’fundamental screening and monitoring roles (Loutskina and Strahan,forthcoming;Rajan,Seru,andE.Loutskina/Journal of Financial Economics100(2011)663–684 668。