2. Outline the Advantages and Disadvantages of the Securitisation of Bank Loans.

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1. Gap Management

In general, banks and other financial intermediaries have longer durations of assets than liabilities. This duration mismatch exposes them to interest rate risk whenever rates are volatile. Specifically, if the duration of a bank's assets is longer than its liabilities, rising interest rates will reduce the net worth of the bank and could threaten its capital adequacy position. One obvious way to manage this duration mismatch is for the bank to either lengthen the duration of its liabilities or reduce the duration of its assets. However, such a whole scale rearrangement of the balance-sheet could be an extremely costly and lengthy process. Alternatively a bank may take a hedging position in financial futures,
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Indeed, the incentives to engage in securitization may well increase as the U.S., Japan and other OECD countries, move toward integrating their capital-asset ratio requirements by
1992. These new requirements will require a 4% primary capital ratio and a 8% secondary capital ratio (based on capital to risky-assets). Since these new ratios assess the riskiness of bank assets in terms of credit risk, and loans by definition have the highest credit risk rating, banks may be able to significantly ameliorate their capital burdens by securitizing loans.

In a similar fashion most countries impose non­interest bearing reserve ratios as a function of the size of a bank's deposit base. Again, by shrinking the asset base by securitization- the average level of deposits will fall as will the average level of reserve
‘‘Taxes'' imposed by regulators on banks.

Finally, to the extent that deposit insurance premiums are levied on banks according to the size of their deposit-base (as in the U.S. and U.K. for example) rather than their risk, asset-securitization, by shrinking the balance-sheet, will reduce the size of deposit-insurance levies.

5. Contract Inflexibility And Default

The substitution of securitization and bond-type contracts for loan-type contracts has certain potential advantages in risk-control. Bonds unlike loans are basically inflexible contracts. Specifically, in the case of loans

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