Business models in banking

1. Cass – ESSEC ConferenceBusiness models in bankingby François LonginDepartment of Finance, ESSECCass Business School , LondonDecember 2, 2009

2. 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

3. 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.

4. 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.

5. 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

6. Securitization (2)

7. Securitization (3)

8. 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

9. Securitization (3)

10. 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

11. 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

12. 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

13. 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.

14. 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.

15. 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).

16. 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.

17. Conclusion and recommendations (2) • 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)

18. Conclusion and recommendations (3) • 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

19. Conclusion and recommendations (4) • One last thought by Alan Greenspan: “Human beings make mistakes, I know of no supervisory action we can take that will prevent that.”