Academic journal article Economic Commentary (Cleveland)

The Evolving Loan Sales Market

Academic journal article Economic Commentary (Cleveland)

The Evolving Loan Sales Market

Article excerpt

Nearly everyone. from daily readers of the American Banker to devotees of It's a Wonderful Life or Bonnie and Clyde, somehow learns a few basic facts about banking. Most people know that a bank accepts deposits and uses the money to make loans. Many people believe that if too many depositors want their money back at once, the bank will fail. What would people think if they knew banks could make loans without taking in deposits, and sell loans when depositors want their money returned?

The loan sales market allows just that. This practice may only mildly inconvenience Hollywood producers, but it raises deeper and more fundamental questions for bankers and policymakers.

Traditionally, policymakers have viewed banks as "special because they invest primarily in highly illiquid assets and, by and large, finance these assets with extremely liquid liabilities--checkable deposits. Bank portfolios, which consist of illiquid loans, are difficult to value and costly to liquidate. This makes banks a vital resource for the important small-to-medium-business sector. But the ability to fund high-information assets comes at a cost. Depositors, especially small savers, may find it difficult and expensive to evaluate the quality of bank assets. Therefore, in lieu of routinely monitoring the institution to protect themselves from loss, they rely on their ability to cash out their deposits at the first sign of trouble.

Thus, the consequence of funding illiquid, information-intensive loans with liabilities that are essentially "payable on demand" is a banking system that is vulnerable to runs, panics, and systemic collapses. This "banks are special" view is the rationale for government supervision and regulation of banks, including federal deposit insurance and Federal Reserve discount window operations.(1)

The existence of loan sales modifies the traditional view in three ways: 1) a bank can reduce the need for deposits by selling its loans; 2) a bank can sell the now-liquid loans when it needs cash; and 3) a widely observable price for loans makes it easier for small depositors to ascertain the true health of their bank.

From the banker's perspective, loan sales offer both the possibilities of profit and the danger of a decline in the importance of banks. A small bank with few deposits or low capital can turn over a large number of loans, collecting the origination fees and pocketing the sales profits. A bank of any size can buy loans to diversify its portfolio, becoming less dependent on the ups and downs of local industry. On the other hand, loan sales imply an unbundling of the origination and investment functions of bank lending and a reduction in the advantages associated with funding loans with deposits. To the extent that this erodes the competitive advantage of banks in lending markets, loan sales reduce the size and importance of the banking industry.

Yet, if it's so easy to make and sell loans, why haven't Wall Street firms replaced banks in this market, just as commercial paper has replaced short-term bank loans to Fortune 500 firms? Do banks sell loans because they have new ways to signal their traditional proficiency in monitoring and evaluating them as a result of advances in information and communications technology? Or is it simply because regulation has made such sales profitable? The answers to these questions will help us to determine whether loan sales indicate a dispersal of traditional banking services or represent an expansion of banks' fundamental role as financial intermediaries. In either case, all of us scholars, regulators, managers, and customers --must rethink what a bank does, as well as how it is supervised, regulated, and protected.

In this Economic Commentary, we hope to stimulate that discussion by examining the loan sales contract itself and the impact of legal and accounting issues in shaping the loan sales market. By documenting the market's growth during the second half of the 1980s and its subsequent downturn in the early 1990s, we try to establish who buys and sells loans, how mergers and acquisitions affected the market, and what impact the 1990-91 recession had on loan sales. …

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