Between the Buyer and the Seller by Shashidhar Karthik

Author:Shashidhar, Karthik [Shashidhar, Karthik]
Language: eng
Format: epub
Publisher: Takshashila Institution
Published: 2017-09-05T16:00:00+00:00

Nine

T HE RISE AND FALL OF THE THREE - LETTER ACRONYMS

If you owe your bank a hundred pounds, you have a problem. But if you owe a million, it has

- John Maynard Keynes , Economis t

The difficulty of trading loans

While the loan is the most fundamental of all financial instruments, it is not easy to trade - for a buyer of a loan needs to convince himself that the borrower will repay. The process of determining whether a borrower will repay can be rather complicated and expensive, and in most cases, not worth the effort. As a result, the traditional practice has been for banks to hold the loan on their books until maturity, when they will hopefully be repaid.

There are several advantages for a bank, however, if a loan can be traded. For starters, a bank can sell a troubled loan at a loss to avoid the uncertainty involved in holding it to maturity. Secondly, a bank might want to frequently adjust its exposure to various businesses and sectors, and the ability to trade a loan makes this process easier. Finally, selling a loan can free valuable bank capital which can be used to make fresh loans. This can have a significant (downward) impact on a bank’s lending costs, and can be passed on to customers in the form of a lower interest rate.

One of the earliest innovations in making loans easily tradable was the credit rating system. The idea was that rather than having each potential lender, or loan buyer, evaluate whether a borrower would repay, a “trusted third party” would assess the borrower’s creditworthiness, and provide a rating which would be updated periodically. Lenders or loan buyers could now make their decisions to lend based on the credit rating of the borrower rather than conducting their own investigations.

The first publicly available credit ratings were published in 1909 by Moody’s, who published credit ratings for municipal bonds. Fitch, another major rating agency, used letter ratings for the first time in 1924 (letter ratings continue to be standard practice among all agencies 59 ). And in 1936, credit ratings made their entry into regulatory rulebooks. Issued in the wake of the Great Depression in the United States, these regulations forbade banks from investing in “speculative investment securities”. Whether an investment security was “speculative” or not was to be determined by “a reputed credit agency”. 60

Credit rating agencies’ role in financial regulation has carried over into the 21st century, with the Basel II norms for international bank regulations (first issued in 2004) linking the minimum amount of capital a bank had to issue to the credit rating of the assets it held. In the last decade, though, the credibility of credit rating agencies has taken a nosedive.

While credit ratings were largely successful in bringing down the difficulty of trading loans, they only solved part of the problem. Loans to small borrowers without the financial power to pay for these ratings 61 still had to be evaluated by banks themselves. Eventually, it took a different kind of innovation to make these loans tradable.

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