Commercial banks are not on their own, and the difference between money market and capital market
I wrote yesterday “The banks in Australia hold a lot of power. Why? Because they hold a considerable amount of assets. When we talk about banks, we need to also consider all the other financial institutions as well.”
Commercial banks still hold the highest percentage of financial assets of all the financial institutions. It is considered to be around 60%. However, this percentage does not represent the full picture. Banks’ influence is even larger, and their range of activities does not include all those that are not recorded directly on their balance sheets (eg their managed funds activities).
Other participants in the financial industry include building societies, finance companies, Superannuation funds, insurance companies and securitisation vehicles.
What are securitisation vehicles? Do you remember what happened in 2008 with the sub-prime problems? These vehicles created the greatest financial crisis since the Great Depression of the 1930’s.
Securitisation vehicles showed great relative growth up until the GFC. The tightening of credit in the capital markets and lack of credibility in securitisation led to the fall.
What is securitisation and what is the difference between money market and capital market?
Money market transactions involve wholesale short term to maturity securities of less than 12 months. Medium to long term to maturity transactions are referred to as capital market transactions.
Money markets include primary money markets (maturity to one year) and secondary money markets (residual maturity up to one year). Money markets include short term domestic markets and international money markets.
Capital markets also include primary and secondary capital markets. The former include issuing of shares and long term debt issues and the latter includes trading in shares.
Now to securitisation! Financial institutions and corporations accumulated heaps of assets such as accounts receivable, mortgage backed housing loans, credit card receivables and utility rates, which generate future cash flows over time. So the process of securitisation evolved to allow the sale of non-liquid assets that have specified future cash flows attached. For example, housing loans have future cash flows attached in the form of interest payments and principal repayments. Securitisation is a form of financing in which the cash flows associated with existing financial assets are used to service funding raised through the issue of asset-backed securities. For example, the securitisation of mortgage loans involves the bundling together of a group of mortgage loans with similar characteristics such as term to maturity. The loan originator then sells the bundle of mortgage loans to the trustee of a special purpose vehicle. The trustee of the vehicle raises the funds necessary to buy the mortgage loans from the loan originator by issuing new securities to investors, particularly institutional investors who are attracted by the return and risk associated with the investment.
HOWEVER, this is subject to the cash flows continue as expected. What happened in the sub-prime fiasco, was that the cash flows stopped as there was a burst of the housing bubble in the US. Is securitisation good? YES and NO! It all depends if the cash flows are secured and continue without any interruption.