LO 34.3: Describe the originate-to-distribute model o f credit risk transfer and

LO 34.3: Describe the originate-to-distribute model o f credit risk transfer and discuss the two ways o f managing a bank credit portfolio.
Over the last two decades, portfolios of loans in the banking industry have become much more concentrated in less creditworthy borrowers. During periods of crisis, default rates increase and this creates significant losses for debtholders. In 1990, defaults cost approximately $20 billion, while in 2009 they cost $628 billion. At the same time, banks have developed strong relationships with large corporate borrowers and robust distribution networks for securitized loan transactions. These realities coupled with Basel capital adequacy standards have led financial institutions to switch from traditional, originate-to- hold, lending models to the portfolio-based, originate-to-distribute (OTD), model.
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Topic 34 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 12
OTD models have produced three primary benefits. The first benefit is that loan originators enjoy increased capital efficiency and decreased earnings volatility because the credit risks have been largely outsourced. The second benefit is that investors have a wider array of diversification options for the fixed income portion of their portfolios. The third benefit is that borrowers have expanded access to credit and lowered borrowing costs. From one vantage point, the 20072009 financial crisis occurred partly because banks did not pursue these three benefits through a pure OTD model, but instead held very concentrated risks on their balance sheets through SIVs.
Professors Note: According to the Federal Reserve Bank o f New York, in 1988, 21% o f term loans originated by a lead syndicator were held on their balance sheet. This percentage declined to 6.7% in 2007 and 3.4% in 2010.
Under the traditional originate-to-hold (OTH) lending model, credit assets are retained at the business unit level. Loans are originated using a binary (accept or reject) approval process. At loan origination, risk is measured based on notional value and then left unmonitored thereafter. The compensation structure in the OTH system is based on loan volume. More loans mean more profit potential.
At its core, the OTD model involves dividing loans into two groups: core loans and non- core loans. The bank will typically hold the core loans and either securitize or outright sell the non-core loans it has originated. Here, loan origination focuses on charging a sufficient risk-adjusted spread over the banks hurdle rate. After origination, the OTD model transfers credit assets to the credit portfolio management group who monitors the apparent risks until the asset is transferred off the originators books. One key function of the credit portfolio management group is to monitor credit risk concentrations and to outsource any risks that could potentially threaten bank solvency. Some credit portfolio strategies are therefore based on defensive risk mitigation and not solely on a profit motive. Ultimately, all returns are measured in a risk-adj listed format and compensation is based on risk- adjusted performance.
The OTD model enables financial institutions to provide access to capital for less creditworthy borrowers and then subsequently sell or hedge their lending risks through the use of credit risk mitigation techniques and credit derivatives.
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