During a recession, banks generally fail because they become victims of wildly fluctuating market interest rates vis a vis regulated bank interest rates. De-regulation has not been successful either, in preventing the credit crunches that often force banks to shrink their balance sheets primarily by reducing loans, in order to satisfy capital to asset ratios that are determined by regulators (Rosengren and Simons, 1992). Banks with a high percentage of bad debts or non performing loans will be faced with a poor rating ascribed to them by financial institutions, which affects a bank’s ability to attract more capital and thereby results in an increase in the cost of funds (www.usacapitallloans.com, n.d.). When a bank is faced with the prospect of shrinking its loan base, it must consider selling off all or part of its loan assets in order to improve its liquidity position. Three principal methods are used by UK banks to sell their loan assets: (a) novation (b) assignment and (c) sub participation.
This is one of the commonly used methods and is akin to a direct sale of assets. The ownership of the bank’s loan assets is transferred into the hands of a third party and it is reflected as a sale in the balance sheets of the selling bank. All rights and obligations of the selling bank are transferred to the third party. This is the clearest way to sell off bank assets and loans which have been issued by the originating bank will be transferred to the new owner, who will become the new party with whom the bank’s customers loan customers interact.
The sale of loan assets by assignment involves a transfer of ownership rights from the selling bank to the buyer. There are two kinds of assignment – statutory and equitable. Statutory assignment transfers both beneficial and legal title on the loan assets, resulting in a transfer of all rights to principal and interest from the selling bank, including all legal means available to collect on the loans. However equitable assignment transfers only the beneficial ownership title, legal rights are retained jointly by the selling bank and the buyer and decisions on legal aspects of the loans will have to be made on a joint basis (Reddy, 1999).
Sub participation is the opposite of an outright transfer of assets on a sale basis. By this method of sale of loan assets, the selling bank does not transfer any of the rights on the loans, neither is the loan removed from the bank’s balance sheets.(Reddy, 1999). It is a method whereby a buyer silently agrees to buy selected assets and provides funds to a selling bank in return for the assumption of incoming revenues and the credit risk on loans. It is purely a funding arrangement. A potential purchaser who buys a bank’s loans is faced with the prospect of borrower defaults and must be prepared to take on that risk, since he does not obtain any rights or obligations against the borrower. In many instances therefore, such sales are made on a “with recourse” basis, whereby the loans assets are not removed from the seller’s books but retained, with the seller still being subject to the lending and capital limits imposed by Government regulatory agencies.(McLatchey, 1997). Thus, in the event the selling bank declares bankruptcy or becomes insolvent, then the “sale” will be deemed to have been an unsecured loan obtained by the seller bank from the purchasing entity. The buyer acquires the loan from the bank with the payment of some initial advances and then uses incoming payments on the book debts to repay the financing. When a loan is assigned to a sub participant in this manner, it may be divulged to the borrower or alternatively, it may be revealed only when the buyer takes action to collect on the book debt (Laird, 2004)
Securitization of assets:
This process involves the grouping of assets into one portfolio. The originating bank solicits and gathers together a sufficiently large pool of borrowers. Their loan assets are transferred into a special portfolio which is assigned or sold to a special purpose vehicle company (SPV) which retains ownership of the assets while administration of the assets is carried out by the originating bank.(Gupta, 1999). This method is increasingly being favored by banks and companies alike, as a means to acquire funding against the full value of their assets while simultaneously retaining their equity on the assets (Laird, 2004).
New methods of loan transfer:(www.ganz-recht.de, n.d.)
New methods of loan transfer in use are: (a) TLC – Transferable Loan Certificate: This is a document that is issued on behalf of a borrower and syndicated banks by the agent bank, whereby the borrower’s loan may be transferred to another party and all parties agree to accept the new transferee as the borrower. (b) TLI- Transferable loan instrument: This is a document of indication of debt, whereby a borrower acknowledges his debt and agrees to transfer rights over it to the registered holder of the instrument. (c) Transferable participation certificate: whereby debtors and loan asset holders may transfer the loan asset and all concomitant rights will be simultaneously transferred to the new owners/debtors.
Advantages of loan sub structures as opposed to other sales methods:
(a)The most notable advantage that a bank acquires through the creation of a sub structure is the ability to derive financing equivalent to the full value of the loan assets without compromising their hold in equity (Laird, 2004).
(b) The bank also reduces its risk of exposure to default and the possibility of non performing loans or loans that have gone bad.
( c ) As per the Basle Agreement, there are limits on capital holdings of a bank and by transferring or assigning its loan assets, a bank is able to restore its capital adequacy and can reduce its capital requirements by transferring high risk loan assets.
(d) The direct financial benefit that is gained by banks through the transfer or assignment of loans is the improved debt to revenue ratios. This improves the financial standing of the bank and enhances its profitability ratios. This presents a healthier picture of the financial institution to investors which results in better gains for the banks.
(e) This method is also favored by investors because it means that they can take on syndicated loan assets and responsibilities are distributed, so that any individual buyer is responsible only for his share of the asset.
Many of the sub structure loan assignments/ sales pose the problem of lack of complete ownership and legal title. The lack of recourse over defaulting borrowers is an issue of concern to many international investors, since most forms of assignment indemnify the principal lender. Agreement with other lenders also poses legal problems that arise in the event of a dispute on resolution of defaulting loan asset borrowers. Title and ownership to a particular asset may also not be clear and financial assistance can prove to be a legal minefield (Laird, 2004). Additionally, negotiations of the documentation may prove to be a problem, since most of these transactions are carried out without the knowledge of the borrowers and can pose a potential legal problem. Since it is difficult to assign parts of a loan in a legal sense, there are difficulties that may arise in legal execution. Some forms of assignment, such as equitable assignment, require the participation of the lender in initiating legal action against defaulting borrowers. The security of book debts is also one of the most important legal issues of concern.
“International Finance Law”(No Date): Available at: http://www.ganz-recht.de/stlehre/Ausland/finl4.htm
Laird, Paula. (2004). Asset backed finance – an alternative solution. Birmingham Post, September 2004. Available at http://www.wragge.com/news/default_3333.htm
Rosengren, Eric S and Simons, Katerina. (1992). The advantages of “transferable puts” for loans at faild banks. New England Economic review, March-April 1992. Available at http://www.findarticles.com/p/articles/mi_m3937/is_1992_March-April/ai_12929059
Reddy, DR. Y.V. (1999). Securitisation of Assets – As Existed in India before the Promulgation of the Ordinance in June 2002, [Excerpts from the Inaugural Address by Dr.Y.V.Reddy, Dy.Governor RBI, delivered at the
Seminar on Government Securities Market at Chennai on 17.04.99.] Available at: http://www.geocities.com/kstability/inbank2/arc/securitisation.html
Rosenthal James A. and Ocampo, Juan M.. (1998). Securitization of Credit: Inside The New Technology of Finance, John Wiley & Sons, Inc., New York, 1988, p. 40.
“Why sell distressed loans?” : Available at http://www.usacapitalloans.com/opportunities/