…a case for securitisation
Despite evolving over the years, at its core, the primary function of banks remains that of financial intermediation. This involves the transfer of funds from surplus units (which encompass individuals, businesses, and governments with excess funds in their accounts) to productive deficit units (entities in need of funds for specific ventures).
This process, known as creative destruction, serves to direct funds toward businesses and technologies with the potential to revolutionise established norms.
This has been hindered, in no small way, by the three letter acronym NPLs, known formally as the non-performing loan ratio – particularly in a high risk environment such as Ghana.
Non-performing loans (NPLs) have long been a concern for financial institutions around the world, and it is no exception here. These are loans that borrowers have failed to repay according to the agreed-upon terms, leading to potential financial instability for lenders
At the end of June 2023, the NPL ratio across the industry stood at 18.7 percent, according to Bank of Ghana data. That means, for every GH¢100 that banks give out, they are likely to recover only GH¢81.3.
For context, the loan default rate in Australia and Canada stood at 0.7 and 0.3 percent at the end of 2022.
Surely, our contemporaries are having it just as bad. Not quite. Next door, Cote d’Ivoire has had the metric in single digits even through the height of the pandemic, standing at 9.7 percent in June 2021, declining to 8.8 percent in June 2022
Down the street in Nigeria, official data from the National Bureau of Statistics (NBS) show that the ratio of banks’ NPL stood at 4.4 percent at the end of May 2023. It had dropped by 10.61 basis points compared to 15.01 percent recorded in 2017, where the continuous decline in NPL was attributed to an improvement in recoveries, sound risk credit management as well as the overall growth in the loan portfolio, among others.
Securitisation
Securitisation has been touted as a potential measure of addressing the problem. Securitisation involves bundling client loans by a bank and indirectly selling them to investors, backed by securities such as bonds. The bank, as the originator, sells to a separate entity usually a special purpose vehicle (SPV) that is shielded from the bank’s bankruptcy risks. This transfer enhances credit quality, often leading to higher ratings for SPV securities. An investment bank, known as the arranger, assists the SPV in structuring, evaluating assets, determining prices and overseeing distribution.
Illustrative instances of securitisation: Noteworthy among the examples is the ESLA Bonds, encompassing Energy Sector Levy Act (ESLA) Plc.’s 7 and 10-year bonds. These bonds showcase how securitisation is functioning within the Ghanaian financial sector. ESLA Plc., operating as a special purpose vehicle and incorporated as a public limited liability company, issues long-term bonds to address energy sector debts owed to banks and trade creditors.
The issued securities are backed by a portion of the Energy Sector Levy Act (ESLA) receivables, assigned to the company to facilitate the settlement of coupons and principal repayments tied to these securities.
At its core, NPL securitisation entails a financial arrangement in which the owner of non-performing loans (NPLs) sells them to a dedicated entity. This entity funds the acquisition by issuing debt securities in the financial markets. Subsequently, the entity engages a firm to manage the NPLs on a daily basis, with compensation contingent upon their success in recovering funds from these loans. There are two main types of this setup:
Primary securitisation: This is when the original owner of the NPLs, often a bank, uses this method to remove the NPLs from their financial records.
Secondary securitisation: In this case, someone who buys NPLs uses this setup to increase their potential profits by using the securitised loans as a type of financial tool.
Proponents of securitisation assert that it reduces the level of risk in the banking system. Other benefits that have been suggested include, but are not limited to the following:
- Efficient NPL resolution: Securitization technology offers an effective solution for cleaning up bank balance sheets burdened by NPLs. By transferring portfolios of NPLs to SPVs, banks can rapidly remove a significant volume of distressed assets from their books.
- Accelerated recovery: Specialized servicing entities appointed by the SPVs are incentivised to maximize recoveries from underlying loans. This focused management can lead to higher rates of recovery compared to traditional approaches, potentially resulting in better financial outcomes for banks.
- Streamlined process: Securitization enables the swift removal of NPLs in one consolidated transaction or a series of transactions. This contrasts with the slower and less efficient process of selling NPLs through protracted auction processes.
- Optimized pricing: While NPL securitization does not guarantee optimal pricing, it incorporates features that enhance the likelihood of achieving better returns for banks. The involvement of capital markets and competitive pricing dynamics can lead to more favorable pricing outcomes.
- Strengthened capital position: Through securitization, banks can offload NPLs and reduce the amount of capital tied up against these assets. This capital relief can be redirected toward new lending activities, potentially promoting economic growth.
- Risk mitigation: Securitization transfers the risk associated with NPLs to investors purchasing the securities, contributing to a more stable financial system by diversifying risk across a broader investor base.
- Enhanced liquidity and funding: The issuance of NPL-backed securities introduces a new investment avenue, fostering increased market liquidity and providing investors with an opportunity to trade and invest in these assets.The process of securitization provides banks with a cost-effective source of funding, allowing for increased lending activity and efficient management of their capital resources.
- Support for SMEs and households: Efficient securitization enhances banks’ ability to extend loans to small and medium-sized businesses. Freed-up balance sheets allow for more lending to this critical market segment, which is pivotal for economic growth.
- Enhanced market growth potential and improved access to institutional investors: The process of securitizing non-performing loans (NPLs) not only paves the way for market expansion but also facilitates enhanced engagement with institutional investors within the private pension fund management sector in Ghana. By introducing securitization, the financial market landscape gains new dimensions, fostering diverse investment avenues.
Institutional investors, pension funds, and discerning individuals actively searching for alternative investment channels are drawn to securitization’s allure. Especially in an economic climate where conventional investment alternatives are characterized by diminished returns, securitized bank loans stand out for their ability to provide enticing yields that surpass risk-free rates.
- Diversification of risk: By converting illiquid assets into tradable instruments, securitization reduces credit risk on bank balance sheets, enhancing their overall risk profile and capital adequacy.
But…
Whilst the application of securitization technology presents a compelling solution for addressing the challenges posed by NPLs in Ghana’s banking sector it also has its share of critics, especially after the 2008 financial crisis, which many believe was caused by unregulated ‘over the counter’ transactions in subprime mortgage-backed securities that occurred outside the discipline of markets.
Most importantly, the systemic issues that have led to high NPLs will erode any benefits of securitisation in its current state. According to the CEO of the Ghana Association of Banks, John Awuah, the lack of integration within Ghana’s financial system makes it difficult to assess an individual’s creditworthiness comprehensively. Unlike in advanced economies where credit behavior affects creditworthiness and is accompanied by controls and consequences for breaches, Ghana lacks such a unified system. This, he believes, is one of the reasons why neighbouring countries have lower default rates and consequently lower cost of credit.
While Mr. Awuah acknowledged that there’s an existing market for securitization, he noted that Ghana faces unique challenges related to its legal regime and judicial system. Unlike other jurisdictions where the loan recovery process is streamlined, Ghana’s recovery process is often hindered by complexities and prolonged court involvement. Awuah cited instances from the 2008 US financial crisis, where assets were rapidly put on the market without court involvement, in contrast to Ghana’s multi-stage process.
“There is already a market for securitisation, but the unique challenges we face in Ghana are tied to the inefficiencies within our legal regime. In contrast to other jurisdictions where loan recovery is facilitated by a more streamlined legal process, Ghana’s recovery process is often hindered by complexities. Unfortunately, our judicial system sometimes extends sympathy towards customers at the expense of lenders, leading to prolonged recovery timelines when cases are in court,” says the GAB CEO.
He also addressed concerns about the complexity of securitization in Ghana’s financial markets. He stressed that investors don’t necessarily need to fully understand the intricacies of financial instruments, as investment advisory firms exist to provide guidance. He highlighted the importance of enhancing the advisory aspect of the market to ensure investors are well-informed about their rights and responsibilities.
And noted that the growth of the securitization market in Ghana relies on collaboration among market participants, including banks, fund managers, and regulators. The former banker further pointed out that the recent introduction of the Ghana Card is a step towards consolidating entitlements, including Social Security and tax records, which could streamline access to financial services.
An advocate for the exploration of broad asset securitisation in the banking space and Professor of Finance at the University of Ghana Business School (UGBS) Elikplimi Agbloyor believes, at this stage investors would shy away from NPLs. “Investors will not be interested in non-performing loans. They are interested in prime or good assets. Those will be easier to securitise,” he suggested.
He further says, “As mentioned earlier, if incentives are not well aligned, the AS process can bring the entire financial system to its knees. One of the areas of agreement is that a number of banks issued loans that were not of very high quality (sub-prime and alt A loans) and offloaded these loans to investors.
The banks had no interest in these loans as any losses would be borne by investors. One of the proposals to manage risk and align incentives after the 2007 financial crisis is for the sponsoring bank to maintain a piece of the securities issued (usually the riskiest or equity tranche). By doing so, banks know that if they originate bad loans, these loans will come back to bite them in the future since they will bear large losses if the loans default on a massive scale.”
Another challenge is the lack of a developed secondary market for NPLs in Ghana. This makes it difficult for banks to sell NPLs at a fair price. Another challenge is the high cost of debt collection in Ghana, which can make it difficult for investors to make a profit on NPLs. There is also some uncertainty about the legal framework for the securitisation of NPLs in Ghana. This can make it difficult for banks and investors to know what their rights and obligations are.
Other concerns include:
- Moral Hazard: If banks perceive that they can offload NPLs through securitization, they might not have strong incentives to improve their lending practices or diligently pursue debt recovery.
- Complexity: NPL securitization can be complex and involves various legal, financial, and operational aspects. Building the necessary expertise might take time.
- Market perception: The success of securitization depends on investor confidence. If investors are skeptical about the quality of the underlying NPLs, the market might not take off as expected.
Additional considerations include:
- Regulatory environment: The feasibility of securitizing NPLs in Ghana heavily depends on the regulatory framework. Regulations need to be clear about the process of NPL securitization, investor protection, and risk management. The Bank of Ghana, as the central bank, would play a crucial role in overseeing and regulating such activities.
- Investor appetite: Successful securitization requires a healthy appetite from investors. Institutional investors, such as pension funds and asset management companies, need to perceive NPL-backed securities as a viable investment opportunity. Investor education about the risks and potential returns would be vital.
- Credit quality and data transparency: The underlying NPLs’ credit quality and accurate data are pivotal. Investors would conduct due diligence to assess the risk they are taking on. Transparent and reliable data on NPL portfolios are essential to build trust in the market.
- Market sophistication: The development of the financial market is crucial. A mature market with active secondary trading of securities provides liquidity and stability. Ghana’s financial market infrastructure would need to support the trading and valuation of NPL-backed securities.
Conclusion
The overwhelming consensus appears to be that whilst there is a market for the securitisation of loans, if the challenges mentioned above can be addressed. The major stakeholders – regulators, market operators and institutional participants, all need to be at the forefront of wholesale changes to the financial risk environment.
P.S: The title is set to the tune of ‘Maria, sometimes known as ‘How Do You Solve a Problem Like Maria?’ from the 1959 Rodgers and Hammerstein musical, The Sound of Music.
References:
- Boudiaf, I. A., & Gonzalez, F. (2022). An empirical study of securitisations of non-performing loans. European Central Bank.
- Agbloyor, E. K. (2021). Need for Securitization of Loans Sitting on the Balance Sheets of Banks in Ghana.
- Balkwill, I. (2020). Navigating the NPL Securitisation Maze.
- Kommey, F. K. (2019). Securitization of Risk Assets in Ghana – The Solution to our NPL Problem?
