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The IUP Journal of Financial Risk Management
Understanding Credit Risk in Securitization and Measures to Build Effective Securitization Markets
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The emerging and developing economies continue to make the most important contribution to global growth. But that growth has slowed in the face of decelerating world trade, weak commodity prices, along with tighter credit conditions caused by market volatility and heightened risk aversion. Corporate profitability will start falling, stretching debt-servicing capacity and making corporate vulnerable. Refinancing pressures may become more acute, especially in commodity-exporting countries and commodity-related sectors. Over the past year, this situation has been exacerbated by widening spreads and rising capital outflows. Securitization enables credit expansion through higher leverage of the financial system as a whole. Securitization may create financial instability if the imperative to expand assets drives down lending standards. This paper attempts to address the implications for financial stability arising from securitization after the global financial crisis.

 
 
 

Healthy securitization might support both the financial system and the economy as a whole. Securitization can help financial institutions in lowering their funding costs and in efficient utilization of capital. Benefits generated may be passed along to businesses and consumers (Duffie, 2008). Through transformation of the pool of illiquid assets into marketable and tradable securities, securitization can help in increasing credit flow to worthy borrowers. It can further help investors and issuers by dispersing credit risk across classes of assets, market, industries, etc.

However, these potential benefits need to be weighed against the potential downside risks to the financial system, which can arise from sub-optimally functioning securitization markets. Securitization can increase the flow of credit inside or outside of the formal banking system. It would create a ‘financial accelerator’ effect that could result in excessive increase in credit growth and price of assets (Bernanke et al., 1996). Principal-agent problems combined with severely misaligned incentives, potentially worsened by asymmetric information, may also be an important feature of some securitization markets. The issues associated with highly complex and opaque product design (not well understood by regulators or investors) were also brought to light by the recent crisis. Finally, industry has a tendency to unduly rely on conventional credit without conducting its own due diligence. Hence, investor herding on the sole basis of external credit ratings can result and the impact of CRA modeling errors can be exacerbated across the industry. Against this backdrop, the present paper attempts to address the implications for financial stability arising from securitization after the global financial crisis.

 
 
 

Financial Risk Management Journal, Securitization, Build Effective Securitization Markets, Understanding Credit Risk.