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1.5.2 Funding for Real Estate Loans and Syndication

The traditional fund raising systems are the “German system” and the “French system”. The German system of fund raising is characterized by the close relationship between the fund raising activity and the lending activity which is reserved to specialist banks in certain countries. Very often this link is established upon conclusion of the loan agreement and must also be maintained for the full repayment term of the loan. The French fund raising system is characterized, by contrast, by a separation between the fund raising activity and lending.

The banks are free to choose which system of fund raising they wish to use, whether French, German, a mixture of both, or others, given that fund raising activity is essentially free from constraints. Nevertheless, the banks must adopt suitable measures in order to control and manage the risks associated with these activities, including the risks resulting from the mismatching of balance sheet asset and liability maturity dates and the risks inherent in medium to long-term lending to businesses. One of the most important and delicate activities within a bank is that carried out by the treasury department which has to keep under control the following critical issues:

• What happens if the bank uses current account deposits for granting loans (or part of them), and all of the funds are withdrawn by clients from current accounts, which are instant access accounts?

• What happens if the maturity of the funding does not match the maturity of the loans? • What is the stable level of current account deposits which may be relied on for a corresponding medium to long-term commitment?

• What happens if interest rates rise or fall? Are there sufficient guarantees to cover that risk?

• What happens if the fund raising is in Euros and lending in dollars (or vice versa)?

Under the French system banks usually resort to the interbank market in order to raise funds and buy money at a cost which depends upon the market's perception of the risk of the borrowing bank. For this reason, a bank with a high rating may offer more beneficial terms to its clients than banks with worse ratings, precisely because it can secure funding at a lower cost.

Under the German fund raising system, funds could be secured on an ad hoc basis and are referred to as covered bonds. Covered bonds (Pfandbrief), which were established more than a hundred years ago in Germany, were introduced in other countries such as the United Kingdom, the Netherlands, and Italy. Previously each issue was defined on the basis of genuine contractual agreements. They are now used in 22 European countries.

In contrast to securitization operations, covered bonds guarantee a return on capital and interest since part of the bank's assets are burdened and are earmarked exclusively for the remuneration and repayment of these instruments, which are in any case also guaranteed by the issuing bank.

For the bank issuing the covered bond, the difference compared to securitization is that their issue does not make it possible to remove the transaction from the bank's balance sheet (precisely due to the existence of the guarantee), which means that the bank will continue to bear the credit risk, and is required to make the relative capital allocations in its accounts.[1]

Covered bonds offer greater security compared to traditional bonds, and consequently greater liquidity accompanied by higher ratings and lower returns.

Covered bonds should accept a lower return compared to normal medium and longterm fund raising systems: covered bond holders may enforce their rights directly against the assets set aside which are beyond the reach of the bank's other creditors. If for example the bank's credit rating were “B” and that of the covered bond were “A”, the bank would have an undoubted advantage in issuing this instrument in order to raise funds for its own real estate lending operations. As a consequence banks issuing covered bonds can lend to their clients at lower rates because of the lower cost of funding.

Covered bonds are mainly characterized by:

• the guarantee relating to the ring-fencing of the receivables assigned to the vehicle which ensures that they will be dedicated, along with the cash flows generated by them, exclusively to satisfying the subscribers of the covered bonds;

• certain guarantees of the issuing bank relating to its assets and a self-standing commitment by the vehicle in the event of default by the issuer.

  • [1] On capital requirements please see Chapter 8. Basel Accords and effects on real estate financing.
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