RBI changed the norms for securitisation of assets this year. The holding period before an asset is securitised was reduced from 12 months to 6 months. But what is securitisation? Here’s an explainer
Let us assume that a property loan company wants to raise funds. Under normal circumstances, it would take a loan from a bank or sell bonds to investors. The interest rate on the bonds depends on the company credit rating and other financial parameters. The company can also sell some of its loans directly to willing buyers, thereby converting a future income source into cash today. However, it may be harder for the buyer of such loans to trade it again in the secondary market. But the lender can raise money by pooling these property loans and selling it as a package to a Special Purpose Vehicle, which in turn converts this pool of loans into tradable securities that are sold to investors. This is known as securitization. It is the process of taking often illiquid financial assets and converting them into liquid marketable securities for the purpose of raising funds. Any type of asset with steady cash flows can be securitized, such as housing loans, gold loans, vehicle loans, personal loans, education loans, credit card receivables, trade receivables etc. Generally speaking, the securitization process involves three main entities: the original lender, a special purpose vehicle, and the investors. The originator or the original lender is the bank or an NBFC that has loaned the money to borrowers. These loans sit on its books as assets. The assets of the financial institutions are then securitized by an issuer, such as a special purpose vehicle or SPV in short.
The SPV converts the pooled assets into tradable, interest-bearing securities. The SPVs can be a company or a trust. Companies like Axis Trustee Services or IDBI Trusteeship Services provide trusteeship services to such Special Purpose Vehicles in India. In the final step, these instruments are sold to investors who will be receiving fixed or floating rate payments. The payments are funded by the expected cash flows from the underlying portfolio. Usually, the originator collects the payments from borrowers and passes them on to the SPV which then distributes it to investors. Securitization allows the original lender to remove the associated assets from its balance sheet, thus freeing up its capital for further lending. It is an alternate form for financial institutions to raise money. It also creates liquidity by letting small investors participate in instruments that would normally be unavailable to them. Most importantly, securitization enabled the transfer of credit risk for the lenders.