Asset Securitization

Asset Securitization: Prospects and Challenges for the Financial Sector of Bangladesh Introduction 1.1 Preamble Asset securitization enables firms to obtain financing in exchange for the rights to cash flows generated by certain financial assets. In the event of a securitization transaction, a firm transfers financial assets to a special purpose entity (SPE) which is popularly known as special purpose vehicle (SPV), to separate the assets from the balance sheet of the transferor.

Different purposes of Asset securitization: i. ii. iii. iv.

Carry out public policy objectives like development of financial markets particularly the capital market; Providing an alternative means of raising finance from capital market.

To cope with regulatory requirements for financial institutions, especially capital adequacy and lending caps; and To transfer risk, particularly in terms of nonperforming assets and portfolio diversification;

Asset securitization shows a new direction to the traditional commercial banking in terms of not only to new low cost sources of fund but also provide an approach to minimize risk.

Banks that actually want to transform their non-liquid assets into liquid assets can use asset securitization which allows them to use their capital more efficiently.

1.2 Financial System of Bangladesh The financial system is a set of institutional arrangement through financial surpluses in the economy are mobilized from surplus units and transferred to deficit spenders. The financial system of Bangladesh consists of Bangladesh Bank (BB) as the central bank and Securities and Exchange Commission (SEC) who act as regulator. The main constituents of any financial system are: financial institutions, financial instruments and financial markets.

1.3 Financial Institutions The modern name of financial institution is financial intermediary; it mediates or stands between ultimate borrowers and ultimate lenders. Financial institutions are generally classified under two main heads: a) Banks and b) Non-Bank Financial Institution.

There are 48 commercial banks and 29 non-bank financial institutions operating in Bangladesh. The banking financial institution includes 4 State Owned Commercial Banks (SCBs), 5 state-owned development financial institutions (DFIs), 30 private commercial banks (PCBs), and 9 foreign commercial banks (FCBs). Among the non-bank financial institutions, 1(one) is govt. owned, 15 (fifteen) are local (private) and the other 13(thirteen) are established under joint venture with foreign participation. Moreover, Micro Credit Regulatory Authority (MRA) has given license to 298 Micro-credit Organizations. The financial system also includes insurance companies, stock exchanges and co-operative banks.

Insurance sector consist with 21 general insurance and 6 life insurance. It is dominated by the two large, state-owned companies, Sadharon Bima Corporation (SBC) for general insurance

and Jibon Bima Corporation (JBC) for life insurance which together command most of the total assets of the insurance sector.

The commercial banking system dominates the financial sector with limited role of NonBank Financial Institutions and the capital market. The Banking sector alone accounts for a substantial share of assets of the financial system. The banking system is dominated by the 4 State Owned Commercial Banks, which together controlled more than 30% of deposits and operates 3394 branches as of June 30, 2010.

1.4 Financial Instruments Financial Instrument is the financial claim of the holder against the issuer. Financial Instruments are of two types: Primary or Direct and Secondary or Indirect Financial Instruments. Primary or direct financial instruments are financial claims against real sector units. It includes loans & advances, shares, debenture. Secondary or indirect financial instruments are financial claims against financial institutions or intermediaries. It includes deposit, mutual fund, unit certificate etc.

1.5 Financial Markets Financial market is the market where financial instruments are purchased and sold. From duration point of view the market is classified into two: money market and capital market.

Money market is a market where financial securities maturing in less than one year that is short-term fund are transacted. In Bangladesh the money market instruments are certificates of deposits, treasury bills, post office savings etc. The Capital market is a market for longterm funds. It is an important ingredient of the financial system, plays a significant role in the economy of the country. It facilitates an efficient transfer of resources from savers to investors and becomes conduits for channeling investment funds from investors to borrowers.

The SEC has issued licenses to 27 institutions to act in the capital market. Of these, 19 institutions are Merchant Banker & Portfolio Manager while 7 are Issue Managers and 1(one) acts as Issue Manager and Underwriter. There are two stock exchanges, Dhaka Stock Exchange (DSE) and the Chittagong Stock Exchange (CSE) which deal in the secondary capital market. As of March 2011 the total number of enlisted securities with DSE and CSE were 476 and 235 respectively.

Exposure of bond market is very limited though there is prospect of development of bond market. It mainly comprises with some government bonds and zero-coupon bond of different financial institutions. To promote bond market Bangladesh bank has taken many initiative like changing legal and regulatory framework and tax regime for zero-coupon bonds.

1.6 Rationale of the Study The concept of asset securitization is very much new for the financial sector of Bangladesh.

Though the concept introduced early in 2001, the actual issue of asset securitization begin through the issuance of Tk. 0.359 billion by Industrial Promotion and Development Corporation (IPDC) in 2004. Compare to other developing country Bangladesh is very much lack behind in this respect. There has been a lot of discussion about the potential of securitization in Bangladesh but little studies have been done about asset securitization.

Securitization has tentatively started in the late 1970s. In 2007, Asset Backed Securities (ABS) issuance amounted to $3,455 billion in the US and $652 billion in Europe.

1.7 Objectives

i. ii. iii. iv. v.

To describe the theoretical background of securitization.

To see the current status of securitization in Bangladesh.

To highlight the prospect of securitization in the financial sector of Bangladesh To identity the challenges faced by the issuers of asset securitization To provide some recommendation

Asset Securitization Process 2.1Asset Securitization Defined Asset securitization is a financial instrument of structured finance in which loan interest and receivables are packed and sold in the form of asset backed securities (ABS) securities. Asset securitization maximizes capital & minimizes risk due to its diversification nature.

"Securitization" in its widest sense implies every such process which converts a financial relation into a transaction. (Kothari, 1999). It is a process of distributing risk by aggregating debt instruments in a pool, then issuing new securities backed by the pool (Dictionary of Finance and Investment Terms). It includes conversion of bank loans and other assets into marketable securities for sale to investors. Securities offered for sale can be purchased by other depository institutions or nonbank investors (Dictionary of Banking Terms).

Securitization is a structured finance process that distributes risk by aggregating assets in a pool (often by selling assets to a special purpose entity), then issuing new securities backed by the assets and their cash flows. The securities are sold to investors who share the risk and reward from those assets (Wikipedia).

Bank

Pool of Loan

Special Purpose Vehicle (SPV)

Pool of Loan

Investors

Generally securitization implies that it is the process where financial claims are converted into marketable securities. In the broader sense it is a process whereby cash flow or claim against third parties are recognized, combined, separated from the originator and then transformed into securities that can be offered to the investors.

So, securitization is a process by which: i. ii. iii. iv.

Intangible and illiquid assets are pool together Risks related to the specific assets are separated from the transferor's Then it is sold to a special purpose entity(SPE) Securities are issued to investors by the SPE

Thus, the securitization concept is a combination of two aspects of today’s finance world: structured finance and capital markets. As the issued security are not in respect to generic risk of the entities all assets but to some specific asset which are bankruptcy remote from the entities balance sheet it leads to structure finance. It results into creation of security which is a capital market product.

2.2 The Cash Flow of Asset Securitization In case of regular deal, cash flows received by the servicer of principal and interest payment are paid to the SPV. The SPV then pays the agreed interest and principal to the investors. The originating bank or company will normally continue to service the collections of receivables communicating with borrowers, collecting their payments and earning a fee for doing so.

Borrowers

Interest and Principa l

Bank

Interest and Principal

Special Purpose Vehicle (SPV)

Interest and Principal

Investors

Figure-2: Cash flow of Asset Securitization Additionally, the originator also retains the excess of servicing that incur from the assets, minus the interest and other costs incurred by the SPV. The originator may sell the servicing rights to a third party.

2.3 Issuers of Asset Securitization Following are the some of the common sponsors of asset securitization:  Banking financial institution  Non-bank financial institution  NGOs  Mortgage companies  Insurance companies  Quasi-government agencies  Other companies 2.4 The Process of Asset Securitization Description of the Structure The above diagram shows a typical structure for a true sale securitization.

Step-1: Cash flow from obligator: The obligators/borrower remits principal and interest payments to the originator or servicer.

Step-2: Pooling and sale of asset: The originator initially owns the assets engaged in the deal.

It creates a pool of assets and executes a legal true sale of the same to a special purpose vehicle (SPV). The assets will be serviced by the servicer (often the originator), for instance with respect to assets sold to the issuer, the originator will continue, on behalf of the issuer, to collect principal and interest from borrowers on such loan.

Step-3: Issue securities: The SPV funds the purchase of those assets by selling asset-backed securities with the help of underwriter. Investors will be free to sell the securities (the bonds) or retain them. Design of the instrument however would be based on the nature of interest

that investors would have on the asset pool. In the case of pass-through issuances, the investors will have a direct ownership interest in the underlying assets, while pay-through are debt issued by the SPV secured by the assets and their cash flows.

Step-4: Distribution of securities: An investment bank will typically advise the originator on the business aspects of the securitization and will often structure the securitization transaction and the asset backed securities to the needs and risk profiles of the investors. The investment bank can also serve as placement agent, initial purchaser or underwriter of the asset-backed securities. Individual securities are often split into varying degrees of subordination. Each has a different level of credit protection than another: there is generally a senior (“A”) class of securities and one or more junior subordinated (“B,” “C,” etc.) classes that function as protective layers for the “A” class. The senior classes have first claim on the cash that the SPV receives, and the more junior classes only start receiving repayment after the more senior classes have repaid.

Step-5: Proceeds of issue of securities: The investors of the asset backed securities, which are typically pension funds, life insurance companies, mutual or hedge funds and other investors seek predictable and steady cash flow streams with a managed risk investment and easily tradable in a ready market purchase the securities. The investor purchases the securities, either through private placement and public offering. The proceeds are transfer to the underwriter.

Step-6: The underwriter transfers the proceeds from the investors to the special purpose vehicle (SPV).

Step-7: The SPV than paid the purchase price of the underlying asset of securitization transaction to the originator.

Step-8: A trustee or administrative agent is typically engaged to oversee the activities of the Issuing SPE. It sometime act as custodian, is typically engaged to hold the securitization assets and collateral security documents related to the transferred assets and the funds in cash reserves from the servicer and the liquidity enhancer. The servicer forward principal and interest payment of the cash flow from the securitized asset.

Step-9: The trustee forwards the proceeds from the servicer to the investors.

Step-10: The asset backed securities are often, but not always, rated by a nationally recognized statistical credit rating agency, who will evaluate the credit risk of the assets and the originator and the overall design of the securitization transaction, and recommend structural changes and credit enhancements to the securitization transaction to increase the likelihood of repayment of the asset backed securities.

Step-11: Liquidity enhancer support timely payments of interest and principal to the investor in case of hurdle to get the expected cash flow from the servicer.

Participants and Basic Elements of Asset Securitization 3.1 Brief History of Asset Securitization

Before 1970s banks generally funded their loan portfolio primarily by deposit and secondarily by debt. To cope with increasing demand of housing credit after World War II bank as well as other financial intermediaries sought ways for alternative sources of mortgage funding.

The asset securitization started in United States in February 1970 when U.S department of Housing and Urban Development created the transaction using a mortgage-backed security.

The Government National Mortgage Association (GNMA or Ginnie Mae) sold securities backed by a portfolio of mortgage loans (Wiki).

Investment banker eventually establishes an investment vehicle to structure the cash flow from the isolated mortgage pools with segmented credit risk. Loan originator quickly realized that this process can be followed for other types of loan. Since 1980s the combination of superior technology and sophisticated investors helped to build up asset securitization as the fastest growing activities in the capital market.

In 1985, securitization techniques had been used for the first time to a class of non-mortgage assets like automobile loans. The marine Midland Bank made securitization of $60 million auto loan. In 1986, the first securitization of the credit portfolio of credit cards took place, amounting to 50 million dollars. In 1990s, securitization spreads to products from insurance, with issues that reach 15 billion dollars in 2006(wiki). As estimated by the Bond Market Association, in the United States, total amount outstanding at the end of 2004 at $1.8 trillion.

As the result of the credit crunch precipitated by the subprime mortgage crisis the market for bonds backed by securitized loans was very weak in 2008 unless the bonds were guaranteed

by Government agency.

In Europe the securitization marked developed in the late 198os. It developed rapidly in UK, Germany, Italy, France, Spain, Belgium and Netherlands in 1990s. Securitization also got attention in the Asian countries like China, Japan, Thailand, Hong Kong and India in 1990s.

In Bangladesh first asset securitization were made by Industrial Promotion and Development Company (IPDC) of Bangladesh on November 08, 2004. Since then the securitization market has grown exponentially with aggregate securitization volumes exceeding $2.08 trillion worldwide at December 31, 2005.

3.2 Basic Elements of Asset Securitization The Assets: Though mortgage loans are pioneer in the asset securitization market, but other financial claims can be securitized. Securitization can be done on any income producing assets with acceptable performance and risk. Consumer finance receivables like car loans, credit card receivables are important asset category that can be securitized. there are some other assets that are commonly used in the securitization which includes home equity loan, student loan, staff loan equipment loan and leases.

The Securities The security issued under asset securitization is a financial claim on the originator asset by the investors. It represents an accommodation between the originator’s needs, the payment characteristics of the underlying assets and investors’ preferences. The instruments may take a wide range of forms like fixed or floating rates, long and short term, fixed maturity or callable under conditions, publicly issued and privately placed.

3.3 Participants in Asset Securitization The key parties involve in the securitization process are as follows:

The Originator Originator is the party who intends to securitize assets. They create and often service the assets that are sold to the special purpose vehicle (SPV). The originator includes commercial banks, investment banks, finance companies, thrift institutions and other companies.

Special Purpose Vehicle (SPV) SPV is a bankruptcy remote entity, which purchases the assets that is to be securitized. It funds the purchase by issuing asset-backed securities into the capital markets. It is usually a subsidiary company with legal structure that makes its obligation secure even if the parent company goes bankrupt.

Servicer Servicer services the assets that are securitized. It includes collection of receivables from the underlying debtors. Basically originator act as servicer in most of the securitization transaction but third party can also work as servicer of the securitized assets. The servicer is paid with mutually agreed servicing fee.

The obligators The debtors are the person who has obligation to pay to the originator. They are not the active parties to the transaction, but their obligation to pay to the originator is transferred to the SPV. The Trustee The trustee is a third party retained for a fee to administer the trust that holds the underlying assets in the securitization transaction. The trustee is primarily concerned with preserving the rights of the investor as well as creditor. Generally, the trustee oversees the disbursement of cash flows as prescribed in the servicing agreement, and monitors compliance with appropriate covenants by other parties to the agreement.

Investors Investors are buyers of the asset-backed securities. Examples of investors in the securitization market are: pension funds, banks, mutual funds, hedge funds, insurance companies, central banks, international financial institutions and corporate bodies and individuals.

The Underwriter The underwriter is the deal maker who undertakes to get the issuance subscribed. It is responsible for advising the seller about the structure, pricing and marketing. Underwriter has their relationships with the institutional investors and familiar with the legal and structural requirement.

The Liquidity Enhancer

The liquidity enhancer provides liquidity facility in relation to certain disruption in the cash flow from the securitized assets. When the SPV issues securities of short term nature and it is unable to refinance the maturing securities because of difficulties in getting expected amount of cash flows.

Rating Agencies To evaluate the credit quality of the transactions, in terms of credit risk associated with the issuance of securities credit rating agencies plays an important role in case of structured finance like securitization. In case of public issue of securities credit rating is credible to investor for taking investment decision. Investors are generally accept rating by the major rating agencies. Standard & Poor’s, Moody’s and Fitch are the three reputable rating agencies. In Bangladesh there are four credit rating agencies available, Rating Information and Service Ltd. (CRISL), Credit Rating Agency of Bangladesh (CRAB), National Credit Rating Agency and Emerging Credit Rating Agency.

Cost of Asset Securitization 4.1 Cost of Asset Securitization Benefits of securitization do not come without any costs. The cost of securitization is the cost that SPV needs to pay in order to securitize its assets successfully. We can divide the asset securitization cost into two groups: flexible cost and fixed cost.

Table-1: Cost Structure of Asset securitization Fixed cost: Trustee fees Servicer fees Legal fee Rating agencies fee Audit fees Tax Other expenses

Flexible cost: Interest cost Liquidity support fees Underwriting fees

Fixed costs The fixed cost includes trustee fees payable to the trustee, legal fees payable to the regulator, audit and tax fees, rating agencies' fees and other expenses. This part of the cost tends to be stable and it is not relevant to the quality of securitized assets.

Flexible costs The most direct flexible cost is the interest payment of the debt. It is the coupon payment that used to attract investors to purchase the securities. The rate of the coupon payment depends on several factors, such as the rating received for the securities, the credit and other risks inherent in the asset pool, expected prepayments and timing of the various cash flows, and other transaction risks such as servicer risk and potential forms of event risk. For interestbearing assets, the coupon is normally paid from the interest payments, or yield, received from obligors. For assets that do not bear interest or whose yield is insufficient, the coupon is

generated in the form of a discount upon issuance.

In addition to the interest cost, the transaction will incur ongoing costs for liquidity support fees. It refers to the taken by the originator in a securitization structure to enhance the security. Both of the coupon payment and liquidity enhancement are closely related to the quality of assets. As the quality of securitized asset changes, the flexible cost will change.

Costs may be recognized in the financial statements of either the originator or the SPV. However, in both cases, the eventual economic obligation lies on the originator.

Probable Cost of Issuing ABS The following table demonstrates the probable costs of securitization in Bangladesh under public issue and private placement options. It has been construed assuming issuance of 5-year maturity Asset Backed Securities (ABS) with a face value of Tk 5000 backed by a pool of assets worth Tk 200 million.

Table-2: Probable Cost Issuing ABS Cost Item Rates and Tenure Amount(Tk. Accruing in Millions) Period (Yr) Expenses for Private Placement (Common Expenses): Investment Advisor/Issue Manager 2.00 One-Off (Structuring & Marketing) Trusteeship and facility 10.00 5 management Fee Stamp on Conveyance 10.00 One-Off Servicing Fee 1.50 5 Legal Fee and Charges 0.10 One-Off Certificate Printing & Holograms 0.28 One-Off Stamp on Certificate 0.80 One-Off SEC fee for capital issue 0.20 One-Off Total (With Only Private Placement) Total Per Annum Additional Expenses for Public Issue: Underwriting Commission 5.00 Allotment letters, Refund Warrants, 0.04 Envelops etc.

Prospectus Publication (2 papers) 0.40 Rating Fee Brokers Commission 2.00 Bankers' Commission 0.50 Data Processing 0.10 Lottery Conduction 0.08 Initial Listing Fee (2 exchanges) 4.00 Annual Listing Fee (2 exchanges) 0.55 SEC fee for public issue 0.66 Total

Total Percent 1.00%

1.00%

1.00%

5.00%

5.00% 0.15% 0.05% 0.14% 0.40% 0.10%

5.00% 0.75% 0.05% 0.14% 0.40% 0.10% 12.44% 2.49%

One-Off One-Off

2.50% 0.02%

2.50% 0.02%

One-Off One-Off One-Off One-Off One-Off One-Off 5 One-Off

0.20% 1.00% 0.25% 0.05% 0.04% 2.00% 0.06% 0.30%

0.20% 1.00% 0.25% 0.05% 0.04% 2.00% 0.28% 0.30% 6.63%

Total Additional Per Annum (For Public Issue) Total for Life of Issue (Public) Total Per Annum (With Public Issue) (Source: AIMS of Bangladesh)

1.33% 19.07% 3.81%

Current Status of Asset Securitization 5.1 Current Status of Asset Securitization in Bangladesh Asset Securitization in Bangladesh Asset securitization provide prospect to the financial sector of Bangladesh to boost the income from better management of their idle assets. It provide efficiency in managing asset liability in terms of uncover low cost sources of funds. Now commercial bank of Bangladesh is facing difficulty in managing their liquidity. They do not have adequate long term sources of fund to meet the credit demand from the different economic sector. Asset securitization can help to work with the problem by giving an easy solution to meet the long term fund requirement. It brings together the expertise of commercial banks, investment bank, other financial institutions and even the individual investor. In Asia, securitization has taken an important place in the capital market development.

Asset Securitization in Bangladesh Originator

Year

Amount issued

IPDC

2004

Tk. 35.9 ICB Crore

NBFI

Dhaka Bank, Jammuna Bank, Mutual Trust Bank, South East bank and International Leasing and Financial Services Ltd.

ULC

2005

Tk. 40 ICB Crore

NBFI

IDLC

2005

Tk. 19 ICB Crore Tk. 37 crore

NBFI

Tk. 1260 EBL Crore

NGO

BRAC Bank Ltd. The City Bank Ltd. Dhaka Bank Ltd. Eastern Bank Ltd. International Leasing and Financial Services Ltd. Jammuna Bank Ltd. Mercantile Bank Ltd. And United Leasing Company.

Commercial Bank of Ceylon Ltd. BRAC Bank Ltd. The City Bank Ltd., Green Delta Insurance Company Ltd. And Reliance Insurance Ltd FMO, Citi Bank N.A., The City Bank and Pubali Bank.

2007 BRAC

2007

Trustee

Types of Investors Institute

Source: Annual Report of Respective Banks

From the beginning to till now securitization does not attain its proper stage of achievement in the financial sector of Bangladesh. There are many problems that are creating the hurdle like regulatory barriers, tax and incentive problems, knowledge and skill shortage and capital market problem.

5.2 Asset Securitization by IPDC Industrial Promotion and Development Company (IPDC) of Bangladesh formally issued the country’s first asset-backed securitized bond on November 08, 2004, which opened the new window for the long term fund mobilization for the financial sector of Bangladesh. Loan and leases are transferred out from the books of accounts of IPDC to the Securitization Trust 2004-A, the Special Purpose Vehicle (SPV) created for securitization. Than the SPV issued of Zero Coupon Bonds that is backed by those pool of loan and leases. The Investment Corporation of Bangladesh (ICB) has been act as a trustee for the SPV which issued 35.9 crore worth of zero coupon bonds against debt receivables of IPDC. As the instrument is floated through private placement arrangement and credit rating is not mandatory for private placement, there is no credit rating agency involved in the process. Investors of the asset backed securities include Dhaka Bank, Jamuna Bank, Mutual Trust Bank, Southeast Bank and International Leasing and Financial Services Ltd. The move will obviate the dependency of IPDC on costly bank funds and provide it with funds at low cost. As a trustee of IPDC securitization, ICB will receive payments from the servicer and forward these to the investors.

Borrower of IPDC

Originator/servicer: IPDC

Trustee: ICB

Figure-5: Asset Securitization by IPDC

Special Purpose Vehicle (SPV): IPDC Securitization Trust 2004-A

Investors: Dhaka Bank, Jamuna Bank, Mutual Trust Bank, Southeast Bank and ILFS Ltd

Because of high cost involvement and low demand for bond in the public placement IPDC issued the zero coupon bond in private placement. There is also legal compliance requirement from various regulatory authorities like SEC, Bangladesh Bank, NBR etc. As it a complicated instrument general investors have lack of knowledge about financial instrument like asset backed security.

5.3 Asset Securitization by IDLC IDLC is finance company operating in Bangladesh. It at first issued Asset Backed Securitized Zero Coupon Bonds with an issue value of BDT 19 core million on February 9, 2005 (IDLC, 2005). This was a significant achievement for the IDLC in terms of mobilizing funds, at

lower cost that are using to assist in the industrial development of Bangladesh. The Investment Corporation of Bangladesh (ICB) is nominated as the trustee. IDLC Securitization Trust 2005 was formed to serve as the Special Purpose Vehicle (SPV). The SPV issued Zero Coupon Bonds against lease receivables of IDLC. ICB, being the trustee will handle the transaction receiving payments and forwarding these as per agreements. The investors under private placement includes Commercial Bank of Ceylon Limited, BRAC Bank Limited, The City Bank Limited, Green Delta Insurance Company Limited and Reliance Insurance Limited. Their drive to reduce funding costs, diversify funding sources and diminish reliance on conventional sources continued to witness significant progress in 2008. As per Trust Deed signed between IDLC Finance Limited (IDLC) and Investment Corporation of Bangladesh (ICB), a Trust named “IDLC Securitization Trust 2007-A” was formed and IDLC sold lease receivables approximately of Tk. 37 crore to the Trust to issue asset backed securitized zero coupon bonds. The Trust issued 50 class A bonds and 5 class B bonds of Tk. 5,000,000 each of which IDLC purchased all class B bonds bearing coupon rate of 7.75% per year. All class B bonds are subordinated to class A bonds. Any loss due to non-collection of lease receivables will be adjusted upto the amount of class B bonds held by IDLC. Borrower of IDLC

Originator/servicer:

IDLC

Trustee: ICB

Special Purpose Vehicle (SPV): IDLC Securitization Trust 2005-A

Investors: Commercial Bank of Ceylon Limited, BRAC Bank Limited, The City Bank Limited, Green Delta Insurance Company Limited and Reliance Insurance Limited.

Originator/servicer: Special Purpose Figure-6: ULC Asset Securitization by IDLC Vehicle (SPV): ULC Securitization Trust 2005-A 5.4 Asset Securitization by ULC As per Trust deed dated February 7, 2005 between United Leasing Company Limited (ULC) and Investment Corporation of Bangladesh (ICB) a Trust in the name of “ULC Securitization Trust 2005-A” was formed and ULC sold lease receivable of Tk 40 Crore to the Trustee (ICB) to issue Asset Backed Zero-Coupon Bonds. Thereafter the Trustee issued 37 Class A and 3 class B Bonds of Tk 10 million each of which ULC purchased 3 class B bonds as credit enhancement to secure the interest of class A bond holders. Any loss due to non-collection of Investors: lease receivable in respect of class-A bonds ICB held by the investors will be adjusted Trustee: BRAC Bank Ltd.against The the amount of class B bonds held by United Leasing Company Limited.

City Bank Ltd. Dhaka Bank Ltd. Eastern Bank Ltd. International Leasing and Financial Services Ltd. Jammuna Bank Ltd. Mercantile Bank Ltd. And United Leasing Company.

Borrower of ULC

Figure-7: Asset Securitization by ULC

5.5 Asset Securitization by BRAC In July 2006, BRAC entered into an asset securitization financing arrangement involving the sale of a designated pool of micro finance loan receivables (“Designated Loans”) to Eastern Bank Limited, to raise funds of up to an aggregate of Taka 1260 crore over a period of 6.5 years in return for financing through a trust formed for this purpose, known as the BRAC Micro Credit Securitization Trust. Eastern Bank Limited (EBL) is working as Trustee in the securitization arrangement. The investors are FMO, Citi Bank N.A., The City Bank and Pubali Bank. Under this arrangement, the Trust purchases the Designated Loans from BRAC and in turn, finances the purchase of the Designated Loans by issuing asset backed securities.

BRAC retains the responsibility for collections and administering of the Designated Loans from VO members. Cash flows from the loan collections are remitted, based on agreed terms, to the Trustee according to the repayment patterns as per the VO loan agreements. Under the current arrangement, all the Designated Loans sold are for a maturity period of not more than 12 months.

Apart from the sale of the Designated Loans, BRAC is also obligated to ensure that collateral represented by other microfinance loan receivables (“Collateral Loans”) valued at not less than 50% of the Designated Loan outstanding balance, is maintained as additional security for the financing arrangement. In addition, BRAC is required to make a security deposit to the Trustee which may be applied towards payments for any amounts due to the Trustee in the event of insufficient funds. In the event of default by the VO members, BRAC is obliged to replace, substitute or reassign the Designated Loans or Collateral Loans in accordance with agreed pre-set criteria. As a result, the Designated Loans do not meet the derecognisation requirements and are therefore recognized in the financial statements even though they have been legally sold.

VO Members of BRAC

Originator/servicer: BRAC

Trustee: EBL

Special Purpose Vehicle (SPV):

BRAC Micro Credit Securitization Trust

Investors: FMO, Citi Bank N.A., The City Bank and Pubali Bank.

Figure-8: Asset Securitization by BRAC Funds received from the sale of the Designated Loans are recorded as a liability in the Securitized Financing Account. Upon collection from VO members, BRAC is required to remit the collections based on the agreed terms to the Trustee, and this is accounted for through the Securitized Financing Account. Any prepayment of loans are separately accounted for, and applied as payments against the Securitized Financing Account as the loans mature.

Prospect of Asset Securitization 6.1 Scope of Asset Securitization in Bangladesh The financial sector of Bangladesh is dominated by the banking industry, which now is facing an immense competition in terms of deposit mobilization and managing other sources of funds. Asset securitization can provide a new opportunity for the financial sector as it provide long term fund with comparable low cost. It also helps to build efficient capital market through flotation of security like bond, commercial paper etc. A vibrant secondary capital market in Bangladesh will benefit all the stakeholders in the financial chain. This includes issuers, investors, borrowers and financial sector as a whole. Recently, retail credit and mortgage-financing has been growing significantly. Specialized financial institutions and commercial banks have either started their mortgage financing. The major challenge for this financing remains with the availability of long term fund. A developed ABS market can play a great role in the development of overall financial sector of the country.

6.2 Benefits of Asset Securitization Benefits to Issuers / Originators Originators (the selling bank) gain from securitization by obtaining many of the benefits of high-credit quality financing without retaining the debt on their books and without forgoing profitable aspects of the assets, including origination, servicing, expansion of business, and

retention of excess spread. The technique for determining the price paid can be complex and may require a significant initial investment of managerial and financial resources. Some relevant advantages include the following: Improve balance sheet efficiency A true sale securitization may move the assets off the originator’s balance sheet, contributing to an improvement of the relevant balance sheet ratios. For instance, to the extent that proceeds of the securitization are used to repay existing liabilities, this may reduce the originator’s leverage. Securitization can allow the originator to reduce its assets and debt, thereby increasing its scope for borrowing.

Reduce funding costs Cost reduction is one of the most important motivations in securitization. Well-regarded pools of assets owned by a company or bank can be used to structure a security of higher credit quality, and therefore, of lower market cost than the corporate entity could issue itself.

The weighted average cost of the securitization may be lower than the cost of the originator’s current composition of debt. Notably, this is often the case if the credit quality of the securitized assets is higher than the credit quality of the Originator’s balance sheet as a whole.

Sources of Financing Funding in the form of the purchase price is to be paid by the SPV upon the sale and transfer of the securitized assets. Securitization allows the originator to diversify its funding sources away from banks and tap the capital markets (almost) directly, without having to issue securities on its own.

1Retention of servicing revenues 2 3The seller normally continues as servicer, retaining the servicing fees, the excess of the SPV’s revenue over costs, and surplus collateral once the ABS are redeemed.

4 5Transfer of risks 6 7Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does.

8 9Liquidity 10 11Future cash flows may simply be balance sheet items which currently are not available for spending, whereas once the book has been securitized, the cash would be available for immediate spending or investment. This also creates a reinvestment book which may well be at better rates.

Benefits to Investors Asset-backed securities are not suitable for all investors as because they are more complex, but less liquid than other debt securities. Nevertheless, we can identify several reasons how

investors in asset-backed securities can benefit in a number of ways, including the following reasons: Superior return Asset-backed securities have been known to offer a yield premium over comparably rated government, bank and corporate bonds. The main benefit from the investor's viewpoint is a higher return or spread than is generally available on corporate or sovereign debt of a similar rating.

Liquidity The securitization structure offers far greater liquidity than do the individual loans backing the transaction.

Low volatility Asset-backed securities have historically often been less volatile as compared to corporate bonds.

Diversification Investors gain an opportunity to diversify their portfolios by participating in a different asset classes and risk trenches of their choice and generate the associated returns, which is otherwise not possible to invest in.

Mitigation of event risk Unlike similar, high-rated corporate bonds, ABS are largely immune from event risk, which results from takeovers, restructurings and other phenomena that effectively alter the credit status of senior unsecured corporate obligations.

Coping with constraints Many institutional investors are constrained to purchase only investment grade securities, and some are even limited to AAA rated instruments. Both requirements can be met in the ABS market.

Opportunity to invest in a specific pool of high quality credit-enhanced assets Due to the stringent requirements for corporations (for example) to attain high ratings, there is a dearth of highly rated entities that exist. Securitizations, however, allow for the creation of large quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required to invest in only highly rated assets, have access to a larger pool of investment options.

Portfolio diversification

Depending on the Securitization, hedge funds as well as other institutional investors tend to like investing in bonds created through Securitizations because they may be uncorrelated to their other bonds and securities.

Isolation of credit risk from the parent entity Since the assets that are securitized are isolated (at least in theory) from the assets of the originating entity, under Securitization it may be possible for the Securitization to receive a higher credit rating than the "parent," because the underlying risks are different. For example, a small bank may be considered more risky than the mortgage loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest (or, just as likely, the bank would be paying higher interest to its creditors, and hence less profitable).

Better matching with investment objectives Securitization instrument have a great flexibility to match with the investment objectives of the investors. Those who are looking for high grade investment can invest in Class A group security but with lower yield and can get high yield from investing in Class B with lower grade security.

Benefits to Borrowers • Securitization reduces the cost of fund which leads the bank to lend fund in lower rate.

• Greater availability of funds for credit expansion.

• Availability of funding for lower income groups.

• Creation of formalized credit scoring systems which ultimately result into a decentralized, formula-driven approach to mortgage origination and make the process extremely fast.

Benefits to Financial Industry • • • • •

Lender access to alternative funding sources Improved sustainability of longer term funding through long term debt market with reforms of contractual savings institutions like pension funds and insurance companies Potentially larger investor-base Lenders able to broaden target market, through risk sharing Long term debt market funding can help smooth financial cycles

6.3 Economic Impact of Securitization The effect of securitization on the economies of different countries is still difficult to assess because the technique is in its infancy in many parts of the world. Nevertheless, in countries such as Australia, Canada, United Kingdom, and United States, where a high proportion of residential mortgages and other claims have been securitized, the gains to the national economy can be measured in the billions of dollars. In the United States alone, for example, at least $1,600 billion of mortgage- and asset-backed securities are outstanding. According to a conservative estimate, securitization in the United States reduces the annual cost ($1,600

billion) of financing for homeowners and others by 0.5%, freeing up $8 billion of resources each year.

But the case for securitization is actually even stronger than this. Asset securitization, if introduced in a transparent and orderly fashion, offers Asian countries additional gains from.

Securitization is as necessary to the economy as any organized markets are. While this single line sums up the economic significance of securitization, the following can be seen as the economic merits in securitization: Creation of markets for financial claims By creating tradable securities out of financial claims, securitization helps to create markets in claims which would, in its absence, have remained bilateral deals. In the process, securitization makes financial markets more efficient, by reducing transaction costs.

Disperses holding of financial assets The basic intent of securitization is to spread financial assets amidst as many savers as possible. With this end in view, the security is designed in minimum size marketable lots as necessary. Hence, it results into dispersion of financial assets. One should not underrate the significance of this factor just because most of the recently developed securitization has been lapped up by institutional investors. Lay investors need a certain cooling-off period before they understand a financial innovation. Recent securitization applications, viz., mortgages, receivables, etc. are, therefore, yet to become acceptable to lay investors. But given their attractive features, there is no reason why they will not.

Promotes savings The availability of financial claims in a marketable form, with proper assurance as to quality in form of credit ratings, and with double safety-nets in form of trustees, etc., securitization makes it possible for the lay investors to invest in direct financial claims at attractive rates.

This has salubrious effect on savings.

Reduces costs As discussed above, securitization tends to eliminate fund-based intermediaries, and it leads to specialization in intermediation functions. This saves the end-user company from intermediation costs, since the specialized-intermediary costs are service-related, and generally lower.

Diversifies risks Financial intermediation is a case of diffusion of risk because of accumulation by the intermediary of a portfolio of financial risks. Securitization further diffuses such diversified risk to a wide base of investors, with the result that the risk inherent in financial transactions gets very widely diffused.

Focuses on use of resources, and not their ownership

Once an entity securities its financial claims, it ceases to be the owner of such resources and becomes merely a trustee or custodian for the several investors who thereafter acquire such claim. Imagine the idea of securitization being carried further, and not only financial claims but claims in physical assets being securitized, in which case the entity needing the use of physical assets acquires such use without owning the property. The property is diffused over an investor crowd. In this sense, securitization carries Gandhi's idea of a capitalist being a trustee of resources and not the owner. Securitization in its logical extension will enable enterprises to use physical assets even without owning them, and to disperse the ownership to the real owner thereof: the society.

Bank Regulation and Securitization Regulation of bank capital began to link required minimums to a bank’s asset risk with agreement among international regulatory authorities in 1988 to the Bank of International Settlements (BIS) Capital Accord (implemented in 1992). According to the regulation bank needs to hold a minimum level of regulatory capital. Under Basel I framework, that capital was a very rough function of the level of risk held in their assets. For instance, a loan to a firm needed 8% of capital, no matters what the risk of the firm was. That is one of the main reasons why banking supervisors engaged in 1999 in a thorough revision of the current capital regulatory framework. That process ended up in the so-called Basel II framework 2, in which the capital requirements of banks will be better aligned with the risk profile of their portfolios. In this way, they will be obliged to hold a higher level of capital for loans granted to high-risk borrowers. The commercial banks may attempt to reduce their required regulatory capital-asset ratio by securitizing assets. Thus, capital regulation may be driving the increase in securitization.

Capital requirements and mandatory reserves give financial institutions an incentive to fund assets at a lower cost and free up their capital. On this basis, securitization has been adopted by many banks and savings institutions -- as a means of reducing regulatory capital requirements without noticeably raising their cost of capital. In general, regulatory costs or rigidities create an incentive for banks to shrink their balance sheets by securitizing loans.

Yet regulatory factors alone cannot explain why securitization has grown so fast. Many nonbank financial institutions and corporations have also chosen to finance their assets off the balance sheet. Where investors have poor information about the issuing company, or do not like its management, or where the capital market suffers other imperfections, asset securitization can be a technique that benefits both issuer and investor. The key lies in the idea that investors often prefer assets (and hence are satisfied with a lower rate of return) that have been legally removed from the company’s ownership and/or control.

6.4 Securitization and Risk Management Securitization is more than just a financial tool. It is an important tool of risk management for banks that primarily works through risk removal but also permits banks to acquire securitized assets with potential diversification benefits. When assets are removed from a bank's balance sheet, without recourse, all the risks associated with the asset are eliminated, save the risks retained by the bank. Credit risk and interest-rate risk are the key uncertainties that concern domestic lenders. By passing on these risks to investors, or to third parties when credit enhancements are involved, financial firms are better able to manage their risk exposures.

In today's banking, securitization is increasingly being resorted to by banks, along with other innovations such as credit derivatives to manage credit risks.

Challenges of Securitization 7.1 Challenges of Securitization for FSB The concept of securitization is complex and sophisticated in terms of its legal aspect and administration aspect. It legally isolates securitized assets from the books of originator to the SPV-a bankruptcy remote entity. To successfully achieve the goals of securitization it must be true sale-the originator does not retain any residual beneficial interest in the underlying asset. True sale mainly focuses on whether the transaction has transferred the economic benefits and risks to the SPV. This includes fulfillment of conditions like the fair value of assigned assets and payments for them to be matched, and the originator having no repurchase obligation and has no recourse to the assigned assets. Besides being unaffected by the originator’s bankruptcy, it is imperative that the SPV be remote from its own bankruptcy.

This is accomplished by restricting the scope of operations of the SPV in order to secure its independence. Usually the central bank or other respective authority has laid down certain criteria to secure the independence of SPV. This includes clauses such as originator holding of equity in the SPV or having any of its directors, officers, or employees on the board of SPV. To cover all those issues, it is better to have a separate law for asset securitization. In Bangladesh, there is no such law. India has enacted a separate law titled Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests Act, 2002.Bangladesh Bank, SEC, and NBR have already settled a number of crucial issues to facilitate the launching of securitized bond in the country. To establish bond market, government has drastically cut interest rate on different government securities. The stamp duty and registration fess for transfer of assets to the SPV have been substantially lowered.

NBR has cut down tax rate on return on investments (ROI) for the instrument. But these initiatives are insufficient for the development of a bond market.

7.2 General Impediments for Securitization Credit Rating Agencies There are four credit rating agencies operate in Bangladesh. It includes Credit Rating Information Services Limited (CRISL), Credit Rating Agency of Bangladesh (CRAB), National Credit Rating Agency, and Emerging Credit Rating Agency. Ratings are paid for by the issuers of bonds and other forms of tradable debt, not by investors. So there is prospect that higher rating is given with the influence from the originator. Charge of the credit rating also increases the cost of the securitized funds. Issuers can do little but grouse quietly because they need the rating in order to issue bonds (The Economist, 2005). This is a global problem regarding the rating agencies. The credit rating agencies operating in Bangladesh lack the required experience and sometimes fall short of international standard. Basically credit rating is done by the banking industry of the country on the basis of overall balance sheet exposure.

But the individual corporation is lack behind in this perspective.

Third Party Servicers There are no third party servicers available for securitization in Bangladesh. Servicers are required to provide customer service and payment processing for the borrowers in the securitized pool and collection actions in accordance with the pooling and servicing

agreement. Servicers also provide default management and collateral liquidation. It becomes crucial if the originator fails to act as the servicer in a proper and timely manner.

Secondary Market for Securities The bond and debenture market in Bangladesh is very thin. The total amount includes only Tk. 54.40 crores of nine companies listed on the two bourses (namely Dhaka Stock Exchange Nevertheless, the bond market is still in its childhood. Absence of credible yield curve hinders the pricing of securities.

Regulatory Expenses Although the government has lowered the stamp duty and registration fess for transfer of assets to the SPV, stamp duty still remain a major hurdle. For example, in case of reassigning the benefits or changing the registration, the investors are required to pay full registration fees, which make the transaction very expensive. High and flat costs (Tk. 2,500) for trust deed registration fee irrespective of bonds, debenture or mutual funds have added extra burden for the issuer.

Investors’ Education Investors are also apparently unaware of their rights and obligations under existing rules and regulations. Investors are not able to understand the mere balance sheets or income statements of an entity. How they can understand a complex and technically sound instrument like ABS? Nevertheless, if the credit rating would transparent and reliable, investors can rely on that. Only SEC and recently CSE have launched an investors’ education program to educate the public about the capital market of the country. However, these training programs cover only a few people. For example, forty eight participants in three batches took part in the SEC education program so far.

7.3 Challenges on Regulatory and Policy Perspective There are a number of key legal issues which must be addressed in most securitization transactions. As Bangladesh does not have a separate law covering securitization transactions, things are being worked just by brushing up some existing laws which in many grounds fall short. The concept of securitized debt instruments are not inconsistent with the provisions of the Trust Act, Bankruptcy Act, Registration Act, Negotiable Instruments Act, the general securities market regulatory regime or any other pertinent legislation, including the listing rules of the stock exchanges. The local legal experts lack the requisite experience regarding securitization whereas compliance with the existing and applicable rules and regulations of the land is vital for development of a new but complex instrument, like ABS. Followings are the major topics of discussion on issuing securitized instruments that may rely on legal interpretations: Establishment of SPV It is possible under existing Bangladesh laws to establish a SPV in the form of a society, company or trust or even government corporation in the form of a statutory body. The different forms of SPVs are governed under different set of laws – the Societies Registration

Act 1860, the Voluntary Social Welfare Agencies (Registration & Control) Ordinance 1961, the Companies Act 1994, the Trust Act 1882 and the Registration Act 1908.

SPV as Trust: An SPV formed as a trust is not a separate legal entity and accordingly, its trustees will contract and be responsible for its activities in accordance with the provisions specified in the trust deed. SPV trust can be established with Trustees independent of the Originator under the Trust Act 1882 and registered with the Sub-Registrars’ Office under Registration Act 1908. SPV trusts are usually flexible and can take shape of a perpetual, limited or predetermined maturity entity. Its’ establishment, registration and operating costs are also low. Registration cost is only Tk 2,500, which is fixed irrespective of capital. The trust does not require any statutory or periodic reporting to the registering authority like that of a company. Additionally, it is customary in Bangladesh to issue debt instruments under a trust. All listed debentures in Bangladesh approved by the SEC have Trustees and the SEC has also selected this form for mutual funds in Bangladesh Transfer of Assets The principal legal concern for securitization pertains to the characterization of the transfer of assets to the SPV. The transfer may be characterized as having been either a 'true sale' or having resulted in investors obtaining a 'first perfected security interest' in the assets transferred. It is the generally held view that in order to structure the SPV as a bankruptcyremote entity it is necessary to achieve ‘true sale’ status on the sale of assets by the originators i.e., the receivables should be made isolated from the insolvency of the originator.

Purview of Authority There is a gray area in the securities market regulatory regime pertaining to division of authority between Bangladesh Bank and the Securities and Exchange Commission (SEC) on the issuance of long-term debt instruments. We hold that a simple ruling from the Bangladesh Bank can remove confusions, if any, for the purpose of asset securitization. It is the generally held view, with reference to the Securities & Exchange Ordinance 1969, that securities under 12 month tenure characterizing as ‘money market instruments’ should fall under the jurisdiction of the Bangladesh Bank and those with tenures exceeding 12 months under the SEC regime. However, if public subscription (IPO) is involved, irrespective of the tenure of the securities, consent from SEC shall be mandatory.

Transfer of Security The status of transferability of loans secured by mortgage is another pertinent concern of NBFIs. The Bangladesh Transfer of Property Act 1882 stipulates that the transfer of loans secured by mortgage of immovable property or by hypothecation or pledge of movable property requires the transfer of the collateral property as well. The relevant section of the Act states that the transfer of a debt or other actionable claim shall necessitate the transfer of the securities thereof. The issue has been elaborately dealt with at the foregoing sections.

However, it should be noted that in case of mortgage of leased assets this should not be a vexing problem since the objective could be achieved at a comparatively reasonable and low cost, generally at around Tk 8,000 only.

Collection Enforceability

The originator cannot transfer right more than it possesses. Several prospective participants expressed their concern that the transfer of right on the receivables to the SPV may, in practical operation, ease the collection ability of the SPV. Bangladesh have only taken initiative to develop the structured instruments. The more practical approach, as it is common to all the neighboring countries, would be to appoint the originator as the sole servicer of the SPV under a separate and independent servicing agreement.

Approval Requirement from Bangladesh Bank The concern on transfer of loan assets centers on transferring of good assets leaving all the bad assets on the books of the transferor/originator. Bangladesh Bank, as a regulator, may control such transfer, especially the large loans, to protect the banks and financial institutions from deteriorating their asset quality. Also the central bank may be uncomfortable on disintermediation of the financial system through securitization as it may impact on the effectiveness of monetary policy. At this early stage of development, it is expected that the transfer of assets by the financial institutions for the purpose of securitization should be freed from any strict restriction from Bangladesh Bank. However, it is advisable that the central bank shall provide approval to the transfers, both true and equitable, with a view to check any fraudulent transfer and to keep the records as well as a tab on provisioning and capital adequacy requirements.

7.4 Taxation Issue for Asset Securitization The existing tax laws have no specific provision dealing with securitization. Hence, the market practice is entirely based on generic tax principles in which a trustee is liable to tax in a representative capacity on behalf of the beneficiaries – therefore, there is a prima facie taxation of the SPV as a representative of all end investors. Moreover, tax disparities exist between zero coupon bonds and other fixed income securities, which eventually make ABS market unattractive to investors. At present, the income tax rate has been fixed at 10% for these types of investment vehicles. Taxation issues remain one of the prime concerns in securitization regime. Taxation issues may arise in the following areas in the process of asset securitization: Tax Status of the SPV The tax on SPV shall essentially increase the cost of securitization and consequently shall force the originators to reduce the coupon of the instruments, which will be inhospitable from the marketing perspective. In order to encourage securitization, the SPV needs to be a tax neutral entity whether it is in the form of a trust or a corporate structure. It is reasonably expected that the SPV shall enjoy a tax-exempt status if formed as a trust or a not-for-profit company. However, there is a need for specific determination by the National Board of Revenue (NBR) on the tax treatment of the SPV as has been the practice in almost all the neighboring countries.

Capital Gain Tax Sale of assets (lease/loan) to the SPV may create a one-time capital gain for the originator.

The provisions of the Income Tax Ordinance 1984 require capital gain tax at a flat rate of 15% regardless of the period of holding of the asset from the date of its acquisition.

Double Taxation In case the SPV is subject to entity taxation, there would be a double taxation of incomes to the extent of residual interest of the originator, i.e. where the income of the SPV is taxed at the entity-level, the earnings of SPV shall be taxed and again the residual amount could be taxed at the Originator’s hand when those will be reverted back – which tantamount to double taxation on a single sum of income. Attaining the recommended tax-exempt status for the SPV shall remove the possible impediment.

Stamp Duty on Conveyance of Assets Like in other common law jurisdictions, stamp duty is viewed as the most vexing stumbling block to securitization in Bangladesh. As stated earlier, the transfer of receivables could be regarded as ‘actionable claims’ under the Bangladesh Transfer of Property Act 1882. The transfer of such actionable claims requires conveyance and hence such transfer should be subject to stamp duty according to the Bangladesh Stamp Act 1899. Currently the duty is 5% on the value of transfer, which is too high to make ‘true-sale’ asset securitization cost effective or even possible at all.

It is recommended that the prospective originators should follow the model of equitable assignment for the time being, which does not involve any stamp duty. However, it is expected that the government shall exempt the conveyance from stamp duty altogether for the purpose of asset securitization so that the debt market develops, as it has been done in the neighboring countries. Meanwhile, urgent and forceful measures should be initiated under the auspices of the Bangladesh Bank for seeking stamp duty exemption against Stamp Duty on Issuance of Securitized Instruments If the SPV issues Pass-through Certificate (PTC) or other document evidencing the right or title of the holder to any shares, each of the issued certificates shall be affixed with stamp of Tk 20 irrespective of face value, according to item 19 of the Schedule I of Stamp Act 1899.

We would not consider such duty as a major problem for securitization. Initially, as we contemplate, securitized issues should be placed with few selected investors. Therefore, the number of certificates shall be minimal possibly with higher value market-lots and so the cost negligible.

Withholding Tax The question of withholding tax may arise in the following two areas: When SPV collects from the obligators: Securitization transaction does not upset the original practice of payment that exists between the originators and their debtors. Fortunately, there is no practice of withholding tax that is being followed in the transactions of the prospective originators like leasing and housing finance companies, banks and development finance institutions.

When SPV distributes payments to the investors: In this situation the withholding tax may invoke more argument from different parties. However, it may be argued that the tax shall not arise if the SPV is constituted as a pass-through structure. In a pass-through structure, the payments made by the SPV to the investors are deemed to be carrying interest, i.e., SPV acts merely as a conduit and directly passes the payments to the investors without any reconfiguration of the cash-flows. On the contrary, in a pay-through and bond structure, the

SPV, not merely redistributes the cash-flows but rather reconfigures cash-flows and makes interest payment, and as a result may suffer withholding tax.

In the event of equitable transfer of assets, the withholding tax shall not arise while making payment to the investors irrespective of the SPV structure. Equitable transfer essentially results in borrowing from the part of the originator. Therefore, the payments to the investors shall be deemed as payment of interest. However, to be on the safe side, it is highly recommended that the Ministry of Finance and the NBR be approached for a definitive direction in this regard.

7.4 Accounting Rules for Securitization It is naturally desirable that the participating financial institutions shall follow a uniform accounting practice for securitization transactions to continue comparability among the financial statements of different companies and also to avoid taxation ambiguity, as well as setting the standards. In order to apply the ‘true sale’ concept in accounting the transactions shall result in removing the transferred assets from the balance sheet of the originator to the SPV, in a best practice environment. It is gathered from an earlier World Bank sponsored study that reputable local auditors affiliated with a major international accounting/auditing firm confirmed that sale of lease assets through the CLO program will receive true sale status if there is no recourse to the originator. The auditors have also affirmed that the reinvestment by the originator in the subordinated CLO component or equity residual will be considered as separate transaction (investment), independent of the sale of assets.

The current Bangladesh GAAP does not include any accounting guidelines for the transfer of assets under the securitization scheme. It is highly recommended that the ICAB adopt either FASB 125 (Accounting for Transfer and Servicing of Financial Assets and Extinguishments of Liabilities) or IAS 39 (Accounting for Financial Instruments) as the common standard.

Approach should be made by the CBSF in this regard to ICAB on a priority basis.

Depending on the accounting rules applying in the individual case, true-sale securitization will in many cases have an impact on the financial statements of the transaction participants, notably the originator. The effects of securitization on the originator’s financial statements will vary depending on the jurisdiction and the accounting rules, which have to be applied.

The following accounting standards deal with securitization, such as FAS 140 – Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (FASB, 2005) and IAS 39 – Financial Instruments: Recognition and Measurement (IAS, 2005).

Bangladesh is yet to introduce these standards.

Disclosure Issues ICAB has adopted International Accounting Standards to improve the financial reporting of listed companies. Moreover, the SEC has amended the Securities and Exchange Rules 1987 requiring financial statements of listed companies to be audited within 120 days after the end of the accounting year and submit to SEC and Stock Exchanges within 14 days. Amendments have also been made for financial statements be audited by a partnership firm of at least two Chartered Accountants having not less than 7 years of experience. The new provision also empowers the SEC to order special audits at the cost of the companies involved in unfair practices. This will ensure greater accountability of the listed companies (SEC Annual Report, 2000-2001).

7.6 The Appropriate Pricing Strategy The appropriate pricing strategy shall depend upon the nature of the pool of assets. For example, the coupon on a debt instrument backed by a pool of commercial loan assets may use prime rates as its base. The investment advisor shall determine the appropriate spread for the issue considering the cash flow pattern and default history of the pool, the standing of the originator as well as the investors’ required return. It would therefore vary on a case to case basis and should be attempted as and when specific assets have been identified for securitization by the respective PFIs. 7.8 Risks Involve in Securitization Developing an appropriate legal structure and managing credit risk are the two biggest challenges in ensuring the success of an asset-backed issue. Many investors who recognize that asset-backed securities can be a rewarding component of their portfolios are unwilling or unable to perform the complex analysis required. They may also be unable or unwilling to bear the credit and other risks associated with these instruments. Fortunately, in the United States and certain other countries, the ABS market is sufficiently well developed that the risks can be carefully identified and reallocated to those best able to bear them. Today, the techniques for doing so are being transferred to Asia. Since investors rely heavily on the detailed assessments and ratings assigned by the principal rating agencies early involvement of these agencies in the risk-management process makes good sense. The rating agencies focus on such issues as the following: Credit risk Credit risk arises from the possibility that the issuer of an ABS, usually a special purpose vehicle, may default on its liabilities. Since the SPV is normally structured to have no assets or business other than holding the securitized assets, the principal focus is on the cash flow from the assets themselves. The most important possibility to be considered is default by the underlying borrowers, such as the car owners in the case of automobile loan securitization.

While a small but predictable loan loss ratio is manageable, the rating agencies must carefully analyze the variations in default and delinquency rates and evaluates any factors that might trigger an escalation in defaults.

Sovereign risk Sovereign risk takes many forms, but is most evident when the underlying assets are in one country and investors are in another. Sovereign nations may interfere with cross-border cash flows through taxes, exchange controls or other measures.

This risk can be mitigated by using an offshore SPV and a foreign guarantor, by capturing foreign-source cash flows, or by specifying an independent jurisdiction to govern the agreements. However, the most effective way to protect investors against sovereign risk is to ensure that the transaction accords fully with all laws and regulations and with the national economic interest.

Servicer performance risk

Servicer performance risk arises from the possibility that the servicer will fail in these tasks, must be reduced by proper screening and monitoring of the servicer. The ability to choose an alternate servicer can play an important role in mitigating this risk.

Interest-rate risk Frequently, the payment characteristics of the underlying assets do not match the needs of investors. This may give rise to interest-rate risk. For example, if the assets are leases, which are essentially fixed-rate loans, the cash flows may be unsuited to banks that prefer floatingrate assets. One way to bridge this gap is to have the SPV enter into a fixed/floating interestrate swap, which allows investors to receive a market-based interest rate. This is particularly valuable for those many investors whose cost of funds is also based on short term rates.

Currency risk Currency risk the risk of devaluation arises when the assets underlying an issue are denominated in a currency that investors do not wish to hold. Some ABS contracts provide for an increase in the local currency payments to offset any decrease in the currency’s value.

Alternatively, a currency swap can be employed to transform the local currency cash flows into known payments in, say, US dollars or Japanese yen.

Prepayment risk Payments made in excess of the scheduled principal payments on a loan are called prepayments. Individuals and businesses normally pay early either because of a change in their circumstances or because they can refinance on better terms. When borrowers can refinance at cheaper cost, it generally means that investors must reinvest at lower rates. That is why prepayment risk often implies interest-rate risk. Although prepayments are a factor in many ABS, they have the greatest impact on securities backed by long-term, fixed-rate home mortgage because it is here that they may produce the largest change in the present value of foregone cash flows. To mitigate prepayment risk for investors who prefer long-term instruments, prepayments from the underlying mortgages are often redirected to different classes of investors.

Legal Risk Devising a legal structure in a securitization is a great challenge, particularly in countries where the legal/regulatory framework is evolving. The major issue is “bankruptcyremoteness�: the SPV must be insulated against bankruptcy of the originator, and vice-versa.

Should the originator experience financial difficulties, the SPV must still be able to perfect its security interest in the assets and obtain full control over cash collections. Other legal issues include the legal, accounting and fiscal status of the asset transfer and the form of the SPV Liquidity risk Liquidity risk is the possibility of a cash shortfall at times when interest or principal payments are due. If the individual obligors behind the underlying loans are late with their payments, cash flow to the SPV may be insufficient for it to make interest and principal payments in full and on time to investors. The cash flow from the underlying assets to the investors should be structured and, if necessary, supplemented in such a way that no such shortfall will occur.

Various techniques we can employ to eliminate or mitigate the risks affecting the underlying assets. Four major categories of risk-reduction are illustrated the next diagram.

Recommendations and Conclusion 8.1 Recommendation The economy of Bangladesh is growing and so is its financial industry. So the financial industry need plan to create new and innovative products to cater to the needs of the marketplace. Technology will play a key role in the process of upgrading our platform for efficient delivery of financial services. New areas such as retail deposit mobilization, SME financing, leasing and perhaps securitization and other such instruments may be explored in due course. Following the discussion of the overall paper some recommendation has given in terms of prospective benefit financial industry can achieve:  So far no banking financial institutions of Bangladesh have issued asset backed securities, though it is highly prospective in terms of low cost and efficient sources of funds. So bank should issue asset backed security by utilizing their idle and illiquid asset from the balance sheet.  Asset securitization can be done by the banks to cope with the challenge of maintaining the capital requirement under Basel II.  Basel III is coming ahead from 2013, so bank have to face huge challenges to maintain capital requirement. Asset securitization can showed an impotent avenue in this perspective.  NPL is a huge problem for the banking sector basically that are for the state owned commercial banks. Asset securitization can be a probable solution for overcoming the problem of asset securitization.  It can be low cost sources of fund which we find that average cost of fund for financial institution is much lower for asset securitization.  Financial Institution can achieve tax advantages from the asset securitization in terms of its earning and sell off the non performing loans from the banks books of accounts.  Bank expose to capital market of collect fund without flotation of capital which is the most costly sources of funds.  We know that efficient bond market is needed for the capital market stability of a country. It can help to develop bond market that can be a prospect for the capital market of our country. Zero coupon bonds will help to float security with lower cost.

8.2 Conclusion Asset securitization is nothing but separation of illiquid assets from a company or financial institution and floating high quality security instrument to the investors that is backed by that pool of assets. The motives behind the asset securitization include benefit to the originator, investors and to overall economy. With the development of securitization market, more and more financial institutions realize that securitization is not only an economic way to raises new funding, but also as an useful tool for risk management. This paper basically analyzes the theoretical background, prospects and challenges of asset securitization. From the analysis we find that asset securitization can be used by the banking industry. We find that securitization acts as a substitute for banks’ on-balance-sheet liquidity as it provides deposit institutions with an effective channel to convert illiquid loans into liquid securities. It alleviates the advantages of large banks in terms of liquidity management allowing the liquidity levels of small and large banks to converge. Banks’ ability to securitize has become

an integral part of their liquidity-risk management. Securitization increases credit availability across sectors as it reduces the sensitivity of bank loan portfolios towards availability of the traditional sources of financing (e.g., deposits). So securitization can benefited the financial sector of Bangladesh in respect of i) low cost sources of funds, ii) better balance sheet management, iii) to cope with maturity mismatch of asset and liability ie liquidity management, iv) to cope with the problem of non performing loans.

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