In the past few decades, Banks have remained key players in the process of transferring funds from lenders to borrowers and vice versa. Recently, FinTechs have revolutionized the system, albeit not matching the scale in banks. With numerous changes in financial systems around the world, it’s important to direct our focus towards an important phenomenon: the substitution of the originate-to-hold model for the originate-to-distribute model.
What Are the Originate-To-Hold and Originate-To-Distribute Models?
Here’s a brief overview of each model.
With the Originate-To-Hold model, lenders (that is banks and non-banking organizations) make loans and hold them through maturity. Under this model, lenders don’t sell these loans to investors or other financial institutions.
In the Originate-to-hold model, banks focus on managing risks associated with solvency and leverage, funding stability, and maturity mismatches.
Originate-To-Distribute (OTD) Model:
In the OTD model, the originator of a loan sells it to third parties through securitization (the process in which illiquid assets- through financial engineering- are converted into securities).
The OTD model holds significant potential in creating an efficient risk-sharing tool, in the global financial system. Especially by enabling banks to diversify their portfolios.
In the past, the originate-to-distribute (OTD) model has accorded banks the flexibility to vary the volume of loans they make without making large adjustments to their asset portfolio or equity capital.
However, potential incentive problems and conflict of interest between stakeholders have the potential to erode the noble objective of risk-sharing and portfolio diversification.
Prior to the Subprime Mortgage Crisis, for instance, banks with aggressive involvement in the OTD market had lower screening incentives. The OTD model allowed lenders to benefit from high origination fees without considering the borrowers’ credit risk. In turn, banks and third parties accumulated loans that had overly poor soft information.
Accumulation of low-quality OTD loans led to excessively high charge offs and borrower defaults, in the period leading to the subprime financial crisis.
What catalyzed the shift from Originate-to-hold to originate to distribute model?
Historically, lenders (banks and non-banking organizations) used deposits to fund loans that they included in their balance sheets until maturity. Over time, however, lenders began expanding their sources of funds to include commercial paper financing, bond financing, and repurchase agreement (repo) funding. With the need to diversify their sources of funds, banks also started replacing the traditional originate-to-hold model of lending with the so-called originate-to-distribute model.
#1. Optimize asset management and multiplying loans issued
Initially, banks limited the OTD model to credit card credits, mortgages, student and car loans. But, over time they began applying the OTD model to corporate loans. The main aim being to optimize asset management, multiplying loan volumes issued at the same level of invested capital, and to save on regulatory capital.
After the adoption of OTD, Banks distributed more corporate loans through syndication and selling in the secondary market. This change promoted the spectacular growth of collateralized loan obligations (CLOs) driven by the demand for corporate loans. Thanks to the OTD model, banks could distribute large portions of corporate loans they’d originated.
#2. Increased need for higher profits
The need for higher revenues from banking stakeholders was a major contributor towards increased adoption of the OTD model. Notably, the sale of loans under the OTD model improved banks’ profitability.
The sold loans could benefit banks when banks retained the right to service the loans. Servicing of loans offered a lucrative flow of fees over a loan’s lifetime.
As well, banks that sold loans received a fee. Since the fees were proportional to the size of the loan sold, banks continuously adopted the OTD to benefit from the increased sale of their loans. With the increased demand for corporate loans and CLOs, banks had an opportunity to earn boatloads of cash by transitioning to the OTD model.
Relationship between the OTD Model and The Subprime Crisis
As lending practices shifted towards the OTD model, originating banks lowered the conditions attached to their screening and monitoring activities. Notably, as the originating banks shed off the credit risk and distanced themselves from the ultimate bearer of default risk, incentives for their officers to collect soft information decreased. This resulted in originating banks making loans of inferior quality and selling them to third-party lenders. This phenomenon contributed to the sublime financial crisis.
Following the financial crisis, Basel III standards were introduced to address financial regulation deficiencies.
So, What are Basel III Standards?
Basel III standards are internationally recognized set of guidelines developed by the Basel Committee on Banking Supervision(BCBS) following the 2007–2009 financial crisis. The standards seek to strengthen processes of regulating, supervising, and managing risks in banks.
Basel III standards specify the minimum requirements that internationally active banks should adhere to. Largely, the standards require banks to maintain proper leverage ratios and meet certain minimum capital requirements.
BCBS members committed to implement entirely, timely, and consistently adopt the Basel standards within their jurisdiction. Through the Regulatory Consistency Assessment Programme (RCAP), established in 2012, the BCBS sought to monitor and assess the timeliness and consistency of the implementation of the Basel III standards.
Building on Basel I and Basel II documents, Basel III sought to enhance the banking regulatory framework. The improvements sought to enhance the banking sector’s ability to handle financial stress, strengthen the banks’ transparency, and improve risk management. Another focus of Basel III was to foster resilience at the individual bank level and reduce the risk of system-wide shocks.
This was achieved by:
- Enhancing the robustness and risk sensitivity of standardized approaches in credit valuation adjustment (CVA) risk, credit risk, and operational risk.
- Constraining the application of internal model approaches, by introducing limits on inputs used in the calculation of capital requirements under the internal ratings-based (IRB) approach for credit risk, and by removing the utilization of internal model approaches in the assessment of CVA risk and operational risk.
- Replacing Basel II output floors with more robust and risk-sensitive floors that are based on the revised Basel III standardized approaches.
- Introduce a leverage ratio buffer that further limits the leverage of global systemically important banks (G-SIBs).
- Implementation of the Basel III standards to transform the traditional lending model into a more robust sub-prime model.
Figure 1: Transformation from traditional to more robust sub-prime model with Basel III.
Trade Finance and the Originate-to-distribute model.
What’s trade finance?
Local and international banks support trade through a variety of products that enable customers to manage international payments, associated risks, and provide required working capital. That said, the term “trade finance” refers to bank products that are associated with international trade transactions (that is exports or imports).
Banks and Fintechs have a role to play in addressing why trade is failing to achieve its potential as a key propellant of economic growth and job creation. Specifically, banks have a role to play in bridging the “trade finance gap”.
What’s the trade finance gap?
Trade Finance Gap is the amount of world trade that can’t access traditional trade finance products, especially among small and medium-sized enterprises (SMEs) in emerging markets. While estimates of the financial gap vary, the most eye-catching is the figure is based on a report by the Asian Development Bank (ADB).
According to the report, a stubbornly high global trade finance gap (approximately $1.5 trillion) holds back global efforts to deliver important jobs and growth amid the ongoing economic uncertainty.
According to the report by the Asian Development Bank (ADB), roughly 45% of trade finance applications by surveyed SMEs are rejected. That’s compared to 39% for mid- and large-sized firms and 17% for multinational corporations surveyed.
Similarly, a recent survey by the British Business Bank indicates that 46 percent of SMEs looking to grow were unaware of financing or funding sources after being rejected by banks.
The rejection rate among women entrepreneurs, meanwhile, stands at 44% compared to 38% among male-owned firms. Providing better access to trade finance for SMEs and businesswomen will contribute to sustained growth and development, and narrow the gap.
More than 75% of the surveyed banks also indicated that Anti-Money Laundering (AML) and Know-Your-Customer (KYC) regulations are a major hindrance to the expansion of trade financing operations. Whilst anti-money laundering (AML) and know-your-customer (KYC) regulations are crucial to ensure that the global financial system isn’t used to launder money and fund terrorism, their structuring can inadvertently exclude legitimate companies in developing markets. This increases trade finance gaps.
As well, the ADB survey indicates that other factors that hindered trade finance include: high transaction costs and low income from trade financing, alarmingly low credit ratings for the country in which firms are located, low credit ratings of banks in developing nations, and low credit ratings among firms.
What’s more, roughly 60% of surveyed banks indicated that they expect an increase in the trade finance gap over the next 2years. That said, SMEs will continue experiencing restricted access to trade finance, hindering prospects for economic growth and development.
In Africa, a trade finance gap estimated to be US$91 billion is a hindrance to trade. Inadequate costs coupled with rising compliance costs have created the perception that trade finance is both costly and risky, in Africa. These factors cause some international banks to limit correspondent banking relationships or withdraw from the African banking space.
The overall effect of these perceptions is a reduction of trade financing capacity in Africa. For SMEs that are less likely to meet strict KYC and collateral requirements, these changes will further limit their access to trade finance.
Are there shifts from bankers to non-banker lenders in trade finance?
Since the subprime financial crisis, trade finance lenders’ rations among banking and nonbanking entities have grown considerably. Over the past five years, for instance, private lender based debt has grown to USD 677 Billion.
According to Global Trade View, HSBC had distributed US$20bn assets by the close of 2018. That was a 900% increase from US$2bn in 2015. However, the portion associated with alternative investors like insurance companies, family offices, and funds accounted for only 10% of the investment.
What’s the way forward?
Banks are struggling to bridge trade finance gaps following the introduction of tighter regulations following the subprime financial crisis. Notably, only 1,000 Financial institutions are in the SWIFT Network, despite there being over 25,000 banks, over 15,000 Non-Bank financial institutions and over 15,000 Fintechs in the world. All these look for pass-through capital for them to originate.
But: the global shortage of funding, today, spurs a wave of innovation in the trade finance market. Notably, alternative private credit providers, fintech solutions, and blockchain platforms have created huge opportunities for innovators and entrepreneurs in trade finance.
However, there’s a need for a Standard Distribution network in which Financial institutions can participate in Distributing Trade Finance assets. As well, there is a need for a system that promotes the elimination of fraud, real-time traceability, and the reduction of manual transactions.
What role can TradeFinex Network play?
What’s Tradefinex Network? Tradefinex network is a peer to peer decentralized platform in which trade finance originators ( banks and non-bank investors) can transact or trade assets.
Figure 2: TradeFinex Network
Lending solutions should incorporate designs that not only handle loans to hold but also to loans to distribute. With banks having the ability to offer bilateral loans, syndicated loans and loans on the secondary market, they can easily meet all requirements by different types of clients. Since the solution will support aspects like master agreement, participant transfer, and income sharing, banks can easily select between different financing options. As banks select between different financing options, they’ll also reduce their risk, which is normally higher when they chose the complete self-funding route.
TradeFinex Network offers a De-Centralized way to manage letters of credit and electronic presentations. Buyers, sellers, banks, and carriers can electronically exchange letters of credit, electronic bills of lading, insurance certificates and other trade documentation over a decentralized Blockchain network.
Standards Origination Tool to support Distribution.
TradeFinex offers Standardized Trade Finance origination tools. Top among them, invoice tokenization, invoice factoring, Supply chain track and trace for the banks and fintech to get standards origination to the network for trade finance investors.
Network members or Investors (Banks and Non-banks) get access to available Trade Finance distribution deals. Interested in becoming a Network member and/or access funding option as a funder? Here’s a video that’ll guide you through the process.
The Trade Finance Distribution Initiative’s aim is to push more non-bank investors towards the asset class, thereby increasing banks’ capacity to originate new trade finance lending.
Why adopt XinFin Blockchain Network?
Blockchain has immense potential in addressing issues in trade finance through its ability to reduce processing time, enhance automation, promote fraud prevention and eliminate documentation. All this is accomplished whilst boosting transparency, security, and trust.
The XinFin Blockchain Network replaces the PoW consensus algorithm (Proof of Work ) to a stake based consensus algorithm network that has a KYC enforced MasterNodes. This makes XinFin Blockchain Network a more institution-grade blockchain network.
Figure 3:The XinFin Blockchain Ecosystem At A Glance
Source:( https://xinfin.org/ )
Current status of Trade Finance Network:
Currently, the Trade Finance Network has more than 20 Million worth Trade Finance instruments that are available for distribution to the bank and non-banker funders.
With the global trade finance market size exceeding US$15 trillion and the trade finance gap exceeding US$ 1.4 trillion, TradeFinex Network has a big role to play.
Citing the current stamp of approval in the International chamber of commerce and the World Trade Organization’s whitepaper and the recent adoption by Ramco, Air France, KLM Labs for a PoC of supply chain finance, the network holds considerable potential. Its adoption will unlock development and job creation potential in various economies around the world.