The Role of Banks in Asset Securitization

Article excerpt

1. INTRODUCTION

It is probably safe to assume that Frank Capra's intentions in his classic film It's a Wonderful Life were to exalt the fundamental virtues of the human character and to caution us against the perils of material temptations. And yet, almost seventy years later, his film remains one of the best portrayals in Hollywood cinematic history of the role and importance of banks in the real economy. This film could easily be used in a classroom to describe a traditional model of financial intermediation centered on banks, defined here as deposit-taking institutions predominantly engaged in lending. (1)

The typical bank of the 1940s is embodied in the film's Bailey Building and Loan Association, a thrift institution that takes deposits and invests them in construction loans that allow the local residents to disentangle themselves from the clutches of the greedy monopolist, Henry F. Potter. We also see a bank run developing, and we learn of banks' intrinsic fragility when George Bailey, the film's main character and the manager of the thrift, explains to panicked clients demanding withdrawals that their money is not in a safe on the premises, but rather is, figuratively speaking, "in Joe's house ... that's right next to yours."

The film debuted in 1946, but Bailey's bank has remained the dominant model of banking throughout the decades that followed. Indeed, it is by and large the model that has inspired the supervisory and regulatory approach to financial intermediation, at least until recent times. Because of the significant social externalities associated with banks' activities, close monitoring of the banks' books is warranted in order to minimize the risk of systemic events (there is indeed even room for a bank examiner in the film!).

However, if we were to remake the film and fit it into the current context, many of the events would need significant adaptation. For instance, we could still have the bank, but it would be an anachronism to retain the idea that depositors' money is in their neighbors' houses. Most likely, the modern George Bailey would have taken the loans and passed them through a "whole alphabet soup of levered-up nonbank investment conduits, vehicles, and structures," as McCulley (2007) incisively puts it when describing financial intermediation's evolution to a system now centered around the securitization of assets.

Under the securitization model, lending constitutes not the end point in the allocation of funds, but the beginning of a complex process in which loans are sold into legally separate entities, only to be aggregated and packaged into multiple securities with different characteristics of risk and return that will appeal to broad investor classes. And those same securities can then become the inputs of further securitization activities.

The funding dynamics of such activities diverge from the traditional, deposit-based model in several ways. Securitization structures develop the potential for separate funding mechanisms, such as issuance of commercial paper backed by the securitized assets. And the creation of these new classes of securities fuels the growth of other nonbank-centered, secured intermediation transactions, such as repurchase agreements and securities lending, in need of what Gorton (2010) calls "informationally insensitive" collateral.

Under such a complex configuration, traditional banks may no longer be needed, as we witness the rise of what McCulley--apparently the first to do so--calls "shadow banks." The goal of our article is to delve more deeply into the analysis of asset securitization activity in order to address the following fundamental question: Have regulated bank entities become increasingly marginalized as intermediation has moved off the banks' balance sheets and into the shadows? Aside from the insights gained, furthering our understanding of the evolution of financial intermediation has first-order normative implications: If regulated banks are less central to intermediation and if intermediation is a potential source of systemic risk, then a diminished bank-based system would require a significant rethinking of both the monitoring and regulatory fields. …