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Skip to 0 minutes and 19 seconds One interesting issue, I think, is whether emerging markets should develop some of the financial innovations in their financial systems that advanced countries have previously developed in their financial systems. So, for example, advanced countries have developed products summarised as securitisation in their financial systems, in Britain and in the United States, going back to the 1970s in fact. Securitisation could be summarised as the pooling together of debt contracts of different kinds. It could be mortgages, it could be car loans, but pooling them together and, through financial engineering, turning them into a tradable security which can be sold on to third party investors.

Skip to 1 minute and 16 seconds The advantages of this securitisation from the point of view of the originator of these contracts is that they can be sold off, off the balance sheet, and that originator can then use the expertise of that institution - in mortgage granting for example or in micro finance lending - that expertise can then be used to make additional loans, without the need to raise more capital in order to do so. Third party investors in these tradable securities get the advantage of having an additional kind of financial instrument to invest in, something different to invest in, and actually the financial system might benefit from the general diversification of risk that that makes possible.

Skip to 2 minutes and 8 seconds A particularly interesting example of this securitisation is, in fact, mortgage-backed securities, partly because this was heavily implicated in the run up to the 2008 global financial crisis. In the United States, mortgage-backed securities were developed to parcel up mortgages which had been actually issued by the originators to mortgagees, to borrowers, without a good credit history who had no previous experience of taking out a mortgage at all. Mortgage-backed securities were originated and then sold off to third party investors, around the globe, in fact, thus diversifying the risk, or actually, in this case spreading risk so that it was not identifiable where that risk had landed up.

Skip to 2 minutes and 58 seconds And so, this particular kind of subprime mortgage-backed security acquired quite a bad name because of its role in the buildup to the global financial crisis. This kind of mortgage-backed security was used by some businesses - not all businesses, but some businesses who originated them - in a business model that came to be labelled the originate to distribute business model. In other words, these mortgages were originated or set up by the original lender simply so that they could be parcelled up and sold off, off the balance sheet.

Skip to 3 minutes and 35 seconds That means that the originator of these loans had no intention of retaining them on the balance sheet and therefore had no skin in the game, had no real drive to assess the riskiness of these loans properly.

Skip to 3 minutes and 57 seconds Emerging markets like India had not avoided securitisation, even before the 2008 global financial crisis. Securitisation had started to come about in India maybe from the year 2000 or so, and India had issued some guidelines from its Reserve Bank to try to regulate and give guidelines for securitised products, securitisation processes, as early as 2006. Even after the global financial crisis of 2008, the Indian Reserve Bank, and India generally, did not decide to completely abandon securitisation. After all, the international regulatory authorities around the world had developed much better ways of limiting the dangers of securitisation after the problems of 2008.

Skip to 4 minutes and 48 seconds For example, the Dodd-Frank Act in the United States, various EU directives in Europe, and so on, and the Basel 2 and 3 Regulatory Frameworks, were amended to take into account some of the problems that the global financial crisis had revealed. India’s Reserve Bank had issued revised guidelines in 2012 to reflect some of these requirements to be a bit more careful about how much securitisation was done in the market, and what kind of securitisation was permissible. And the kind of thing that India, amongst other markets, has done is to introduce requirements on a minimum holding period that originators have to hold loans for before they’re allowed to securitise them and sell them off.

Skip to 5 minutes and 39 seconds In other words, a requirement that the originator of a loan does have to retain some skin in the game, as it’s called, for a certain amount of time. It might be three months or it might be 12 months, but has to retain that loan on its books for a minimum holding period. And when it is allowed to securitise those loans, it’s only allowed to securitise a certain proportion of them. That’s the kind of limitation that India has introduced in order to really retain the advantages of having some securitisation in its financial markets, but to try to limit the dangers of that as well.

Skip to 6 minutes and 19 seconds India’s securitisation market has remained small so far, a nascent market, and some people think that it will always remain that way. But some, including some commentators from inside India’s Reserve Bank, think that there’s a good future for the market and that it will expand in future, safely.

Derivative markets in emerging economies: securitisation

What can emerging markets learn from the financial systems of advanced economies?

In this short video, Sonja Ruehl from SOAS School of Finance and Management explores how tools such as securitisation have impacted both mature and emerging financial markets, drawing particular reference to lessons learned in India.

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This video is from the free online course:

Risk Management in the Global Economy

SOAS University of London