Question

Explain any FOUR of the following, and, where appropriate, use examples to demonstrate key points:

(each part is worth 12.5 marks)

(a) Shadow Banking

(b) True Sale Securitisation

(c) Synthetic Securitisation

(d) Credit enhancements

(e) Tranching

(f) Special Purpose Vehicle

Answer 1

Answer(a)- Shadow banking- It is a banking system where group of financial intermediaries are facilitating credit creation in the whole financial system without much regulatory oversight. It is not under regulation of banking system because this system does not accept deposits and lend money. This system has escaped many limits and laws that are imposed to traditional banking system in the world. This system facilitates the creation of credit by serving as mediator. It takes place among non banking financial institutions (NBFIs)

Examples:

1. Hedge funds
2. Unrealistic derivatives
3. Investment banks

Answer(d): Credit enhancements- These are the methods through which a company increases its creditworthiness and improves its debt. It is also a technique of reduction of risk so that credit profile can be increased. It increases the credit rating for a company by reducing the default risk.

Example: A bond issuer can enhance its credit by purchasing some insurance on the payments so as to guarantee that repayment of loan and regular interest payment will be made. That insurance can be "Third party guarantee and additional collateral insurance.

Answer(e): Tranching- It is a process of dividing the debt into pieces so that risk can be minimized. Tranches are the securities with different level of risk that are offered at the same time.

Example:

Mortgage backed securities- These securities are made of multiple mortgage pools, it has different and wide range of mortgage with different maturities and risk level. It has one year, two year, five years and twenty years maturity.

Answer(f): Special Purpose Vehicle- As the name suggests, Special purpose vehicle is an entity that is created for a special purpose or task. It is a separate legal entity. It has assets and liabilities and own legal structure. This can be partnership or join venture that is created for a particular task or sometimes for taking advantage of other company's resources. It is also called "Bankruptcy remote entity". If parent company goes bankrupt, special purpose entity's obligations get secured.

Examples:

1. Partnership
2. Join venture
3. Limited partnership.