Securitisation

Indian Economy glossary

Also called: Asset securitisation · Topic: Banking Regulation, NPAs and Financial Stability · NCERT: Beyond NCERT

Meaning

Securitisation is a process where a lender pools many illiquid loans (loans that cannot easily be sold one by one) and turns them into tradable securities that it sells to investors. The loan repayments then go to those investors.

It matters because the bank gets cash today instead of waiting years for EMIs. The loans also leave its balance sheet, so the capital held against them is freed and can be lent again.

Explanation

How it works

Step 1 – Originate: the bank gives many similar loans, such as home loans or vehicle loans. The bank that makes the loans is called the originator.
Step 2 – Pool: it groups these loans into one bundle, the pool.
Step 3 – Package: the pool is usually moved to a Special Purpose Vehicle (SPV). This is a separate company set up only to hold the pool. If the bank later fails, the pool stays safe for investors.
Step 4 – Sell: the SPV issues securities backed by the pool. Mutual funds, insurers and other investors buy them.
Step 5 – Pay through: borrowers keep paying EMIs. The money now flows to the investors, not to the bank.

Worked example

A bank holds 1,000 home loans worth Rs 500 crore in total.
It pools them and sells securities worth Rs 500 crore to investors.
Borrowers' EMIs now go to the investors.
Result: the bank has Rs 500 crore of fresh cash to lend. The capital it had tied up against these loans is freed.

Main types and parts

By the loans behind them:
Mortgage-Backed Securities (MBS): backed by home loans.
Asset-Backed Securities (ABS): backed by other loans, such as car loans, credit-card dues or microfinance loans.
By the health of the loans:
Securitisation of standard assets: the loans are healthy and borrowers are paying. This is the normal market.
Stressed assets: bad loans go to Asset Reconstruction Companies (ARCs), which pay for them partly in security receipts (SRs). An SR gives its holder a share of whatever the ARC later recovers.
Tranches (slices): the securities are often cut into senior and junior slices.
Senior slices are paid first. They carry less risk and earn lower returns.
Junior slices take losses first. They carry more risk and earn higher returns.
Minimum Retention Requirement (MRR): the originator must keep part of the risk. This is its "skin in the game".

What makes it grow or shrink

Grows when:
Banks need cash or capital to keep lending.
Investors want steady, loan-backed income.
The loan pools are of good quality, so investors trust them.
Shrinks when:
Defaults rise and investors lose trust. This is what happened after the US subprime crisis of 2007-08.
Rules become tighter or unclear.
Banks already have a lot of spare cash and do not need to sell loans.

In India

Legal base – SARFAESI Act, 2002: the full name is the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act. This one law does three jobs:
It gives the legal base for securitisation.
It gives the legal base for ARCs.
It lets lenders enforce their security interest (their legal right over pledged assets) without going to court.
Regulator – RBI: the RBI Master Directions 2021 cover:
securitisation of standard assets (healthy loans), and
transfer of loan exposures (selling loans directly to another lender).
MRR in India: the originating bank must keep part of the risk.
Why: if the bank bears some of the loss itself, it has a reason to lend carefully in the first place.
Stressed-asset side – ARCs:
ARCs are registered with the RBI under SARFAESI.
They also need skin in the game. An ARC must invest in SRs at the higher of 15% of the transferors' SR investment or 2.5% of total SRs issued [2].
NARCL (India's bad bank): it buys stressed loans and pays 15% in cash and 85% in SRs [1].
These SRs carry a government guarantee of up to Rs 30,600 crore for 5 years.
The guarantee covers the shortfall between the SR's face value and the amount actually recovered [1].

Don't confuse with

Asset reconstruction (ARCs): securitisation usually sells healthy loans to investors for cash. An ARC buys bad loans at a discount and then tries to recover the money.
Transfer of loan exposures: here one lender sells a loan directly to another lender, and no securities are created. Securitisation turns the loans into tradable securities. Both are covered by the RBI Master Directions 2021.
SARFAESI enforcement: under s.13(2) and s.13(4), a lender seizes and sells a defaulter's pledged asset. Securitisation involves no seizure. It is a sale of loans to raise money. Both come from the same 2002 Act.
Bad bank (NARCL): a bad bank takes over stressed loans to clean up bank balance sheets. Securitisation is a normal funding tool for standard loans.

Prelims Hooks

Securitisation = pooling illiquid loans and turning them into tradable securities sold to investors. It frees the lender's capital so it can lend again.
The legal base is the SARFAESI Act, 2002. Its full name starts with the word "Securitisation".
The RBI Master Directions 2021 cover securitisation of standard assets and transfer of loan exposures.
The Minimum Retention Requirement (MRR) makes the originator keep part of the risk ("skin in the game").
Its aim is to stop the "originate-to-distribute" behaviour behind the US subprime crisis (2007-08). In that chain of MBS/CDOs, originators kept no risk.
Trap: ARCs are registered with the RBI under SARFAESI, not with SEBI. ARCs pay banks partly in security receipts (SRs). For NARCL the split is 15% cash : 85% SRs [1].

Mains Points

Liquidity versus risk:
Securitisation turns locked-up loans into cash, so banks can give more credit to the economy.
But if banks can sell every loan, they may stop checking borrowers carefully.
The US subprime crisis (2007-08) showed how this risk can spread from the originator to investors and to the whole financial system.
Aligning incentives is the core design principle:
India applies the same lesson in several places: the MRR in securitisation, ARC investment in SRs (at least 15% / 2.5%) [2], and the government guarantee on NARCL's SRs [1].
The idea is that whoever decides on a loan should share its loss.
Link to the wider recovery system:
Securitisation of healthy loans keeps credit flowing.
The SARFAESI tools (enforcement and ARCs) deal with loans that have already gone bad.
Together with DRTs and the IBC, these channels helped scheduled commercial banks recover Rs 10,16,617 crore over the nine financial years to 2022-23 [3].

Related concepts

Recovery channels: DRTs, SARFAESI, securitisation, ARCs and the bad bank