Cass – ESSEC Conference Business models in banking by François Longin Department of Finance, ESSEC Cass Business School , London December 2, 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)

Securitization (3)

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)

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.

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)

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

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.”