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Journal ArticleDOI

Disentangling the impact of securitization on bank profitability

01 Jan 2019-Research in International Business and Finance (Elsevier)-Vol. 47, pp 519-537

Abstract: We empirically evaluate the channels through which securitization impacts bank profitability. To this end, we analyze the role played by bank risk, cost of funding, liquidity and regulatory capital in explaining the relationship between securitization and bank profitability. We find that securitization activities tend to boost profitability. We also show that bank risk, cost of funding, liquidity and regulatory capital individually and jointly act as transmission channels in the securitization-profitability relationship. In addition, we break down the securitization effects on bank profitability into direct and indirect effects and identify the contribution of each individual transmission channel in the overall impact on bank profitability. Our findings have several implications for banks, financial markets, and regulators.
Topics: Capital requirement (58%), Market liquidity (58%), Securitization (54%), Profitability index (54%), Financial market (52%)

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Disentangling the Impact of Securitization on Bank Profitability
Mohamed Bakoush
a,b,
* Rabab Abouarab
b
Simon Wolfe
a
a
Southampton Business School, University of Southampton, Highfield, Southampton, SO17 1BJ, UK
b
Faculty of Commerce, Kafrelsheikh University, Elguish St, Kafrelsheikh, 33511, Egypt
August 5, 2018
. .
Abstract
We empirically evaluate the channels through which securitization impacts bank
profitability. To this end, we analyze the role played by bank risk, cost of funding, liquidity
and regulatory capital in explaining the relationship between securitization and bank
profitability. We find that securitization activities tend to boost profitability. We also show
that bank risk, cost of funding, liquidity and regulatory capital individually and jointly act as
transmission channels in the securitization-profitability relationship. In addition, we break
down the securitization effects on bank profitability into direct and indirect effects and
identify the contribution of each individual transmission channel in the overall impact on
bank profitability. Our findings have several implications for banks, financial markets, and
regulators.
Keywords: Securitization, Bank Profitability, Bank Risk, Regulatory Capital, Liquidity,
Cost of Funding.
JEL Classification: G21, C31
. .
_____________________________
* Corresponding author (Email address: m.bakoush@soton.ac.uk).

1
1 Introduction
Securitization has fundamentally altered the way in which financial intermediation is organized
as it has provided banks with various incentives to improve efficiency and performance. The
bank may aim to improve its cost of funding (Pennacchi, 1988), to improve its risk management
(Cebenoyan and Strahan, 2004), or to improve its profitability (Affinito and Tagliaferri, 2010).
Although theory suggests that securitization benefits both issuing banks and investors, empirical
evidence does not uniformly support these theoretical conclusions. In addition, securitization was
blamed for being a primary cause of the 2008 US mortgage crisis where it acted as the vehicle
for the increase in lower-quality subprime debt.
In the aftermath of the 2008 credit crisis, securitization markets became subject to intensive
regulatory reforms which implied the curbing of certain higher risk activities. These reforms led
to significant impairment in securitization markets as shown by the large decline in securitization
issuance in both the US and Europe (Association for Financial Markets in Europe, 2017). This
impairment has contributed to the decline in bank’s revenues from capital market-related
activities –including securitization– compared to commercial banking activities. It has also
contributed to keeping the post-crisis bank profitability subdued (Bank for International
Settlements, 2018). Nevertheless, there have been several attempts to revive securitization
markets to boost banking efficiency and risk sharing in capital markets (Mersch, 2017). These
attempts require a deep revision of the securitization effects on both banks and financial markets
to avoid any unintended consequences for bank performance and stability.
In this paper, we empirically evaluate the impact of securitization on bank profitability. Our main
contribution is to analyze the channels through which securitization impacts bank profitability. In
so doing, we argue that the impact of securitization on bank profitability is transmitted through
four main channels, namely bank risk, cost of funding, liquidity and regulatory capital. That is,
securitization affects these four variables which in turn affect bank profitability. To test this
argument, we break the relationship between securitization and bank profitability down into four
individual intermediate relationships, then test them empirically. This allows us to individually
and simultaneously assess the role of these proposed channels in shaping the relationship
between securitization and bank profitability.

2
This paper contributes to the strand of literature that studies the impact of securitization on bank
profitability. In particular, our paper is closely related to Loutskina and Strahan (2009) who
consider the impact of securitization on bank liquidity and Loutskina (2011) who considers the
impact on cost of funding. We add to these studies by integrating both channels of securitization
effects and further investigating their simultaneous impact on bank profitability. In addition, our
paper is closely related to Casu et al. (2013) who study the effects of securitization on bank
performance. However, our paper differs in that we aim to disentangle the impact of
securitization on bank profitability instead of just limiting the focus to whether there is an
association between securitization and bank profitability. Unlike Casu et al. (2013), we consider
four different transmission channels for the impact of securitization on bank profitability.
Therefore, the main contribution of our paper to the existing literature on bank profitability is
providing an answer for the question: “How does securitization affect bank profitability?”
instead of asking whether there is an impact.
We use a novel empirical model that thoroughly investigates how securitization affects bank
profitability while considering the causality between different variables. Also, our empirical
framework is based on a Structural Equations Modeling (SEM) approach that can simultaneously
test the different relationships comprised in the proposed empirical model. This approach allows
us to break down the securitization effects on bank profitability into direct and indirect effects. It
also allows us to identify the contribution of each individual channel in the overall impact on
bank profitability.
Our findings provide insights into the complex relationship between securitization and
profitability. There is evidence that securitization activities increase the bank risk due to the
credit enhancements and the recourse associated with securitization transactions. Also,
securitization is found to increase the cost of funding which can be attributed to the increase in
the explicit and implicit costs resulting from recourse. The results also suggest that securitization
enables banks to reduce their holdings of liquid assets given the availability of the option to
securitize. Regulatory capital increases as a percentage of total assets when banks securitize their
high-quality loans while keeping the worst loans.

3
In addition, we show that bank risk and cost of funding have positive impact on bank
profitability. This occurs when banks accept to take more risk, but seek to achieve more income
from servicing and trading activities. In addition, results indicate that while higher holdings of
liquid assets are associated with lower bank profitability, higher regulatory capital is associated
with higher profitability as it secures the bank against risk and failure.
We also show the mechanism in which securitization contributes to improving bank profitability.
We use a novel empirical model that provides an accurate and thorough representation of the
relationship between securitization and bank profitability. Our results show that bank risk, cost
of funding, liquidity and regulatory capital work as transmission channels in the securitization-
profitability relationship. Considering these four channels together provides an additional
explanatory power regarding how securitization affects bank profitability. In addition, our
findings shed light on situations in which the total effect of the securitization on bank
profitability is not significant while the direct and indirect effects are significant, but with
opposite signs.
Our findings have several implications. First, the ability to divide the effects of securitization
between different components of the securitization-profitability relationship enables the bank to
control this relationship. In other words, the bank can alter its decisions regarding which loans to
securitize, what type of enhancements and recourse to provide, and the timing of transactions.
These decisions together would improve the design of securitization transactions. Second,
investors in financial market would improve their assessment of the change in perceived risk of a
bank due to a securitization transaction. The investors would then be able to adjust their required
rates of return on the bank equity capital based on the new risk expectations, which implies a fair
share price. Finally, our findings might help regulators in imposing regulations that ensure a fair
and transparent securitization market.
The remainder of this paper is divided as follows. Section 2 provides institutional background.
Sections 3 provides an overview of related literature and develops the research hypotheses.
Section 4 provides an overview of the methodological framework and data. Section 5 presents
the empirical results. Section 6 concludes the paper.

4
2 Developments in the US Banking Industry and Securitization Market
The US banking industry has experienced an enormous transformation over the course of the last
few decades. One of these transformations was a trend of increase in the portion of industry
income generated from fees-based activities (such as securitization) rather than interest-
generating activities starting from the 1980s. This trend has fundamentally altered the risk-return
profiles of US banks over the last few decades (DeYoung and Roland, 2001). Particularly, banks
costs of production were static or declining and there has been an increase in total revenues from
traditional and non-traditional sources. This meant that by the mid-2000s, US banks profitability
was very strong (Carlson and Weinbach 2007). Indeed, until mid-2007 it was widely perceived
that the US banking system was sound and performing well, particularly because banks capital
holdings and profitability appeared to be high and at record levels. Nevertheless, Clark et al.
(2007) emphasize how the increasingly fee-focused strategies of large US banks expose these
banks to economic and business cycle volatility. With the onset of the mortgage crisis, problems
in the housing market spelled over to the banking industry. The increased number of foreclosures
and defaults in mortgages led to a decline in the value of securitized assets and reduced
investors’ appetite for such securities and accordingly problems within the US banking industry
(Gerardi et al., 2008).
In the US, securitization origins go back to the early 1970s, when Government National
Mortgage Association (Ginnie Mae) started to sell mortgage loans (Ibanez and Scheicher, 2012).
Then, In the 1980s, the market grew with the issuances of securities by the semi-governmental
agencies, Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National
Mortgage Association (Fannie Mae). Initially, securitization processes included mortgage loans
forming what is known as Mortgage Backed Securities (MBS). Later, they expanded to include
other types of loans forming what is known as Asset Backed Securities (ABS). Furthermore, in
the run up to the 2008 credit crisis, more sophisticated forms of securitization were developed
such as Collateralized Mortgage Obligations (CMO). Securitization activities played a pivotal
role for the housing market in the run up to the credit crisis of 2008 as the Asset Backed
Securities (ABS) and covered bonds provided between 20 and 60 per cent of the funding for new
residential mortgage loans originated in mature economies (IMF, 2009).
Historically, the MBS activities have denominated the securitization market. The total volume of
outstanding MBS in the US increased from $347 million in 1970 to nearly $8.92 trillion at the

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