[Banking] Shadow Banks, Wholesale Banks, Securitization: Functions & Features Nachiket Committee’s recommendations

securitization in home loans

[Banking] Shadow Banks, Wholesale Banks, Securitization: Functions & Features Nachiket Committee’s recommendations

  1. Prologue
  2. Securitization
  3. What happened in Sub-prime crisis?
  4. Shadow Banking
    1. Shadow Banks: Why bad?
    2. Shadow Banking in India?
    3. Should India be worried?
    4. Gold Loan Companies as Shadow Banks?
    5. RBI’s safeguards on Gold loan NBFC
  5. Wholesale Bank?
    1. Wholesale Investment Bank vs Wholesale Consumer Bank?
    2. Benefits of Wholesale Banks?
  6. Mock Questions

Prologue

Under [Banking] Nachiket Committee article-series, so far we’ve seen following

  1. What is financial inclusion, steps taken by RBI and Government to achieve it.
  2. Nachi gave six point vision to achieve financial inclusion. Under that, Universal Bank account for everyone. Access to banking within 15 minutes of walking distance.
  3. Priority sector lending: meaning, benefits, constrains and Nachiket’s recommendation for 50% PSL target and 0% SLR.

If you’ve not read those articles, go to Mrunal.org/economy.

Securitization

As such very technical topic and not important for exam but basic understanding necessary before dwelling into Shadow Banking, Whole-sale banking. So, first let’s construct a technically-not-so-correct model:
securitization in home loans

  • A retail Bank has given home loans worth total 100 lakhs to 50 families @10% interest rate. (if anyone defaults, bank snatch their house.)
  • An investment banker, Hrithik Roshan, buys these loan-files from the normal bank.
  • Hrithik makes a new company/entity, backed by those home loan files worth Rs.100 crores.
  • Then he breaks down those 100 lakhs into (10 lakh bonds x worth Rs. 10 each) and promise to pay 8% interest rate.
  • Aam Aadmi/retail investors/Mutual funds/insurance companies etc. buy these bonds.

Securities =some piece of paper that promises to some money to someone.

  • Shares, bonds, IPOs, Debentures these are all examples of “securities.”
  • So, What did the investment banker do in above example? He turned those “mortgages” (homes loan files) into “securities“. [and made some profit in between].
  • This is called securitization.

So, is it good or is it bad?

  • Good for banks because they can gather some new cash, look for new clients. (rather than waiting for EMI payments for 20-30 years.)
  • Good for investors, because they can earn interest by buying those bonds.
  • Bad? Yes, when the game is played without good faith- as it happened in Sub-prime crisis.

What happened in Sub-prime crisis?

  • (normal) Banks gave loan to people who did not have the aukaat to repay the loans (hence they were called “Sub-prime” Borrowers.)
  • But banks were smart, they “securitized” those loans, recovered money from investment bankers in wall street.
  • Investment bankers in turn, sold securities (bonds) to aam aadmi/retail investors/pension funds/mutual funds/hedge funds etc.
  • Then investment bankers used that money to buy even more loan-files from (normal) banks, and created even more mortgage backed securities.
  • Everyone is happy. Bubble keeps blowing.
  • But soon, one after another, those sub-prime borrowers default on EMIs.
  • Wait, we shouldn’t worry right? Because we’ve their loan papers, we can attach their property and auction it to recover money.
  • But unfortunately, as many people defaulted on loans, there is over-supply of houses on sale/auction => Real estate prices go down. if the house was originally worth 3 lakh dollars, now it’d sell not even for 30,000 dollars.
  • Thus whole system collapsed.=>2007’s subprime crisis.
  • World: Since investors all over the world had joined this game, they also suffered losses=>2008 global financial crisis. Ripples were felt even in India.
  • Europe: Since European investors also lost money in Subprime crisis + Decline trade, tourism, export+ Their own governments had MNREGAish Maai-baap mindset with huge fiscal deficits and loss making PSUs=> PIGS crisis, sovereign default crisis, Greece crisis. (more on that, explained in old articles under Mrunal.org/Economy)

Shadow Banking

  1. Shadow Banks = organizations that function like banks but outside the banking regulation. American examples- hedge funds, securitization companies, Special Investment Vehicles (SIV), Money Market Funds (MMFs) etc.
  2. This term came after “subprime crisis” in USA, 2007.
  3. Shadow banks helped creating that asset bubble. But one day, home loan borrowers defaulted and the bubble collapsed =>crisis.
  4. Shadow banks have significant presence in Netherland, Hong Kong, USA, EU= they continue to remain vulnerable to such crisis even in future.

Shadow Banks: Why good?

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