Definition
Structured finance is a financial service that offers highly complex, fixed-income products. These products are usually designed for large financial institutions or companies that require a unique funding or risk management solution, not typically provided by standard financial instruments. This often involves pooling various financial assets and converting them into securities that are then sold to investors.
Phonetic
The phonetics of the keyword “Structured Finance” is: ‘strʌk.tʃərd ‘fɪn.æns
Key Takeaways
- Complex Financial Tool: Structured finance is a highly complex financial tool used by large financial institutions or companies. These tools, which often include securitization of various financial assets, can allow firms to mitigate risk or navigate regulatory and tax regimes efficiently.
- Risk and Return Management: It presents unique ways to manage risk and return. This sector of finance permits investors with a greater risk appetite to invest in higher-risk tranches, likely yielding a higher return. In contrast, more conservative investors might target the safer tranches, which have a higher likelihood of repayment but offer a lower return.
- Role in Financial Crises: Unregulated use of structured finance, particularly with subprime mortgages, has been cited as a significant contributing factor to the global financial crisis of 2008. This points towards the potential dangers and downfalls of structured finance when not used responsibly.
Importance
Structured finance is crucial in the business/finance field because it facilitates complex financial transactions, often involving large amounts of money, that might not otherwise be possible. It offers institutions and companies multiple avenues to secure funding, efficiently manage risks, and maximize returns. The flexibility, customization, and potential capital relief provided by structured finance can greatly enhance the liquidity, efficiency, and financial stability of corporations, banks, and financial markets. Consequently, structured finance can play a significant role in promoting economic growth and financial innovation.
Explanation
Structured finance is a complex financial instrument offered to companies with unique financing needs that aren’t usually fulfilled by conventional financial products. Its purpose is to provide funding solutions to businesses which otherwise would find it hard to obtain capital. These needs could be the result of intricate business models, regulatory issues, or challenges associated with standard forms of capital. This methodology contributes significantly to the optimization of risk-reward trade-off, enabling companies to achieve funding at a lower cost than traditional sources, as well as the potential for tax benefits.Structured financing products can be beneficial in several financial scenarios. For instance, companies that are looking to pool assets and convert them into tradable securities use this form of financing. This conversion to tradable securities allows these firms to minimize the risk associated with direct ownership of underlying assets, reduce the cost of funding, and improve access to liquidity. Also, it allows investors to acquire a broader variety of assets and to customize the amount of risk they are exposed to. Structured finance models can be seen in areas such as project finance, securitization, and leveraged leasing.
Examples
1. Mortgage-backed Securities: This is probably the most common example of structured finance. In this scenario, financial institutions issue securities which are backed by a pool of mortgages. Investors buy these securities and receive payments derived from interest and principal of the pooled mortgages. This strategy helps banks to offload the risk of default to the investors and also create liquidity by turning long-term loans into short-term assets.2. Collateralized Debt Obligations (CDOs): Another example of structured finance are CDOs. A CDO is a type of structured asset-backed security (ABS). Essentially, CDO’s pool together riskier assets such as mortgages, corporate debt, and other types of loans, and then selling them off to investors. This helps financial institutions to spread the risk of default, and also to free up their balance sheets to issue more loans.3. Asset-backed Securities (ABS): Apart from mortgages, structured finance can also deal with other types of loans, like credit card debts, auto loans, and student loans etc. Similar to MBS and CDOs, these loans are also pooled, and turned into securities for sale to investors. The interest and principal payments of the underlying loans again act as a source of cash flows. This is particularly beneficial for companies in the lending business, as it allows for recycling of capital and continued lending.
Frequently Asked Questions(FAQ)
What is structured finance?
Structured finance is a highly involved financial instrument presented to large financial institutions or companies that have complex financing needs that don’t match with conventional financial products.
Why is structured finance used?
Structured finance is used when simple financing instruments are not able to meet the specific needs of the borrower. This type of financing is used by organizations for leveraging, risk management, or for funding large investments.
Who typically uses structured finance?
Larger corporations, financial institutions, or entities involved in complicated financial structures tend to use structured finance.
Can you provide an example of structured finance?
Sure, one common type of structured finance is securitization. This is when assets that generate cash flow are packaged together and sold as securities.
Are there risks associated with structured finance?
Yes, due to the complex nature of structured finance, there may be higher risk endured due to financial, operational, regulatory, or specific project risks.
What is the role of credit rating agencies in structured finance?
Credit rating agencies assess the risk level of the structured product to provide potential investors with information about the likelihood of receiving returns on their investment.
How can structured finance affect the economy?
Structured finance can have a significant impact on the economy. It can provide companies with needed capital for investments and operations, but it can also contribute to financial instability if not managed properly. For example, structured finance practices played a role in the 2008 financial crisis.
What professionals are typically involved in creating a structured finance deal?
The creation of a structured finance deal typically involves various financial specialists, such as financial analysts, accountants, investment bankers, and lawyers, to create, evaluate, and execute these types of agreements. These professionals work together to ensure the financial instrument meets the client’s needs while also considering legal, tax, and accounting implications.
What types of assets are used in structured finance?
A wide range of assets can be used in structured finance, including mortgages, credit card debt, auto loans, and corporate debt. These assets are combined into a pool, which is then used to back the financial instrument.
Related Finance Terms
- Collateralized Debt Obligations (CDOs)
- Mortgage-Backed Securities (MBS)
- Asset-Backed Securities (ABS)
- Credit Default Swaps (CDS)
- Special Purpose Vehicles (SPVs)
