RISK, SYNTHESIZED
Securitization has been largely avoided in Asia. A new instrument now gaining ground may get the practice rolling
By Diane Lam

The Asian financial crisis cut deep holes in the balance sheets of many Asian banks. Now, after a long, bumpy journey, the banks are on the mend. But the world in which they operate is miles apart from the 1990s boom years. Banks are more cautious, their prudence being helped along by new Basel Accord standards and stronger local regulatory regimes. Responding to these pressures, bankers are imposing new measures of performance, such as risk-adjusted return on capital and portfolio diversification. They are also being more disciplined in their use of bank capital.

This caution is manifest in what Asian banks are not doing. By and large, the region's financial institutions are avoiding the well understood, readily available tool of asset securitization. This is a shame, because securitization is beautiful in its simplicity and has many merits. Under securitization, banks can transfer risk off their balance sheets and free up capital. A typical approach to the practice is to bundle together assets, such as the receivables from a portfolio of mortgages, and sell them off to investors via bonds issued by a company set up for the purpose (a special purpose vehicle or SPV). The SPV would issue secured bonds to investors to raise funds to buy the porfolio. These bonds are non-recourse and transfer the risk of the assets to investors.

The practice has gained wide acceptance in the US and Europe, but in Asia its slow progress has been a disappointment to local CFOs. Securitization is a tool that would add much-needed liquidity to local capital markets. In South Korea, for example, banks turned to securitization following a stringent period of bank restructuring, adding an extra measure of liquidity in the post-chaebol loan market. South Korean finance companies raise funding almost entirely using securitization to tap low-cost funding.

Elsewhere in Asia, banks still avoid the practice for many reasons. Securitization is still developing and faces legal, tax and regulatory hurdles in some nations. In some jurisdictions, authorities require banks to obtain the consent of the borrower before packaging and selling the loans. This stricture impedes the time-honored Asian tradition of close-knit, long-standing relationships between bankers and clients. Bankers worry that informing the borrowers of a decision to securitize will imply that the borrower is regarded as a risk, and they are unwilling to convey that impression.

Banks in the better developed markets of Hong Kong, Singapore and Korea suffer from excess deposits and are more concerned about keeping loan assets than divesting them. Many Asian banks showcase their non-performing loan (NPL) ratios as evidence of tackling bad loan problems - and securitizing performing assets would only worsen the NPL ratio. Last, banks are often deterred by the longer time and potentially higher costs of completing a securitization.

Fortunately for Asia, there is an alternative instrument available, bearing many of the benefits of straightforward securitization, but skirting the difficulties. Called synthetic securitization, the basic structure involves a transfer of risk from a bank to investors via notes sold by an SPV. The key difference between it and the flesh-and-blood model is that these instruments do not involve the transfer of a physical asset, only a risk on the asset, through the use of credit default swaps. The bank buys protection against default from investors and an SPV, which issues the notes to investors and sells default swaps to the bank. The SPV uses the funds raised from investors to buy collateral, such as government bonds, which are in turn used to cover any losses on the default swaps. As losses are incurred, the investor assumes this loss and their notes are written off by the amount of the loss.

In other words, in a synthetic securitization, the bank buys credit risk protection, while the investor buys credit risk exposure. The benefits over and above traditional risk management tools are tremendous, especially in Asia. Firstly, synthetics do not involve any transfer of assets. Because of this, they avoid many of the taxation and other issues to which securitization is prone. This makes the synthetic version comparatively quick and easy to set up. More than that, the practice allows banks to bundle assets from different jurisdictions into one transaction. Many banks in Asia operate in a number of different markets in the region, with many of these operations being too small in scale to be suitable for securitization individually. These local operations are often very capital constrained as a result. The synthetic structure allows banks with this problem to offload risks on a regional basis, freeing up capital and greatly improving overall risk management.

Second, these structures allow banks a certain access to regional and global banking franchises, without the expense and time of building physical networks. In addition to managing the risk on their own portfolios by selling on portions to outside parties, banks in Asia can become investors in the synthetic securitizations of banks in other countries. This would, for example, give a Hong Kong bank exposure to consumer or corporate credit markets not only in Korea, but even California or Germany.

Finally, the nature of synthetics makes risk management much more responsive to changing business environments and strategies. Typical bank assets, such as project finance loans, have relatively long maturities. Especially in Asia, where the secondary traded loans markets are very thin, these assets are virtually fixed on a bank's balance sheet until maturity. By liquefying such assets, a bank's risk management improves greatly. No longer must a business line be prevented from seizing promising new opportunities because it is unable to secure capital internally from the bank. No longer can banks only adjust their risk profile through cumbersome disposals.

DBS Bank in Singapore, Mizuho Bank in Japan and ABN Amro in Hong Kong have all recently blazed the trail of synthetic securitization in Asia. Today, they are very much the exceptions. In fact, Asian banks are natural buyers and originators of this risk management tool, which enables them to meet multiple strategic objectives cheaply and efficiently, making them more locally and regionally competitive. Though just a trickle at present, synthetic securitization may just overtake traditional securitization in Asia as bankers here grasp the implications. The advantage would not be to bankers - and the health of their capital ratios and liquidity of their balance sheets - alone. The region's CFOs would benefit from the opportunity to customize, diversify, and add and subtract credit risk from their portfolios.

Diane Lam is director, structured finance ratings, Standard & Poor's, Hong Kong