Originate to hold model

The originate to hold (OTH) model is a traditional banking and financial accounting approach where a financial institution, typically a bank, issues a loan or creates a financial asset with the explicit intention of keeping it on its balance sheet until its maturity date or until the borrower repays it in full. This model emphasizes the lender's commitment to maintaining ownership of the asset and managing the associated credit risk throughout its lifecycle. It stands in contrast to models where assets are originated with the intent to sell.

History and Origin

Historically, the originate to hold model was the predominant way banks operated. They accepted deposits and used these funds to issue loans, which then remained on their asset side of the balance sheet. This traditional approach fostered a direct relationship between the bank and the borrower, with the bank bearing the full burden of monitoring the loan's performance and managing potential defaults. This model was the cornerstone of banking for centuries, providing stability and fostering trust within local communities where lenders knew their borrowers well.

The landscape began to shift significantly in the latter half of the 20th century, particularly with the rise of securitization. This financial innovation allowed banks to package and sell loans to other investors, leading to the emergence of the "originate to distribute" model.²³ However, the global financial crisis of 2008, which was partly attributed to lax lending standards associated with the originate to distribute model, led to renewed scrutiny and a partial return to the principles of the originate to hold model by some institutions and regulators.²²,²¹ Regulators and financial institutions re-emphasized the importance of holding assets to maturity, particularly for less liquid or riskier loans, to align incentives and strengthen financial stability.²⁰ Indeed, some banks have since "reinvented" their lending practices, leaning back towards an originate to hold approach for certain types of lending.¹⁹

Key Takeaways

• The originate to hold model involves a financial institution retaining loans on its balance sheet until maturity.
• It implies that the originating institution bears the full credit risk and reaps the full interest income from the loan.
• This model contrasts sharply with the "originate to distribute" model, where loans are sold off.
• It emphasizes the long-term relationship between the lender and borrower and can foster more stringent underwriting.
• The model has seen renewed interest following financial crises, as it promotes greater accountability for loan quality.

Interpreting the Originate to Hold Model

The originate to hold model signifies a strategic decision by a financial institution to maintain exposure to the loan portfolio it creates. In this model, the bank benefits directly from the cash flows generated by the loans, primarily through interest payments, but also assumes responsibility for all associated risks, such as default. The intention to hold loans until maturity impacts how these assets are classified and measured on a bank's financial statements under various accounting standards.

For instance, under International Financial Reporting Standard (IFRS) 9, a financial asset is classified at amortized cost if it meets two criteria: the business model objective is to hold the asset to collect contractual cash flows, and the contractual terms give rise to cash flows that are solely payments of principal and interest.¹⁸,¹⁷,¹⁶ This classification differs from assets held for trading, which are typically measured at fair value through profit or loss.¹⁵ The originate to hold model is therefore central to a bank's risk management framework, influencing capital allocation and regulatory compliance, particularly regarding capital requirements and regulatory capital.

Hypothetical Example

Consider "Evergreen Bank," a commercial lender specializing in small business loans. In an originate to hold scenario, when Evergreen Bank approves a $500,000, five-year term loan for a local bakery, it intends to keep this specific loan on its books.

Here's how it would work:

1. Origination: Evergreen Bank underwrites the loan, assessing the bakery's creditworthiness and the business plan.
2. Funding: The bank uses its own capital and customer deposits to fund the loan.
3. Holding: For the next five years, the loan remains an asset on Evergreen Bank's balance sheet. The bakery makes monthly principal and interest income payments directly to Evergreen Bank.
4. Risk and Reward: Evergreen Bank is directly exposed to the bakery's ability to repay the loan. If the bakery thrives, Evergreen Bank earns the full interest income over the loan's life. If the bakery struggles, Evergreen Bank bears the credit risk, potentially incurring losses if the loan defaults. The bank's profitability is directly tied to the performance of the individual loans it originates and holds.

This example illustrates the direct linkage between origination, ongoing management, and the ultimate financial outcome for the bank in an originate to hold model.

Practical Applications

The originate to hold model is fundamentally applied across various sectors of finance, particularly where long-term relationships and direct risk retention are crucial.

• Commercial Banking: Traditional banks often utilize the originate to hold model for corporate and retail lending, including mortgages, auto loans, and business lines of credit. This allows them to foster long-term customer relationships and directly manage the credit quality of their assets.
• Relationship Banking: Institutions that prioritize deep client relationships and tailored financial solutions often adhere to this model, as it ensures continuity of service and direct oversight of the loan portfolio.
• Regulatory Frameworks: Post-financial crisis regulations, such as those emphasizing risk retention, have implicitly encouraged aspects of the originate to hold model. By requiring institutions to hold a portion of the credit risk of assets they originate, regulators aim to reduce moral hazard and align the interests of originators with the long-term performance of the loans. The Federal Reserve, for instance, has closely examined banking models in the wake of crises, often contrasting the originate to hold approach with more risky alternatives.¹⁴,¹³
• Specific Asset Classes: Certain less liquid or highly customized loans, such as project finance loans or complex structured financing arrangements, are often originated with the intent to hold due to the specialized nature of their monitoring and servicing requirements.

This model remains a core component of prudent banking, ensuring that institutions retain a vested interest in the quality and performance of the financial products they create. Many banks have been observed to "reinvent" their lending strategies to be more aligned with an originate to hold model after periods of financial instability.¹²

Limitations and Criticisms

While the originate to hold model offers stability and promotes careful underwriting, it also presents certain limitations and criticisms:

• Capital Intensity: Holding loans on the balance sheet requires significant regulatory capital to cover potential losses. This can limit a bank's capacity to originate new loans, especially for smaller institutions or during periods of high loan demand. The need to maintain sufficient capital requirements can constrain growth.
• Concentration Risk: By holding loans to maturity, a bank can accumulate a concentrated loan portfolio subject to specific sector, geographic, or borrower risks. If a particular industry or region experiences an economic downturn, the bank's entire portfolio could be adversely affected.
• Limited Liquidity: Loans held under this model are generally illiquid assets. If a bank needs to raise cash quickly, selling these loans might be difficult or require substantial discounts, impacting profitability and liquidity management.
• Lower Profitability from Fees: Unlike the originate to distribute model, the originate to hold model does not generate significant fee income from the sale of loans. Profitability is primarily derived from interest income, which can be less volatile but also potentially less lucrative than origination and distribution fees.
• Impact of Economic Cycles: Banks operating solely under an originate to hold model are more exposed to the full impact of economic cycles. During recessions, increased defaults can directly impair their asset quality and earnings, necessitating higher loan loss provisions and potentially eroding regulatory capital.

Critiques of the banking sector following the 2008 financial crisis often centered on the "originate-to-distribute" model, which highlighted the comparative benefits of the originate to hold model in aligning incentives. However, the inherent capital constraints of the originate to hold model also contribute to why institutions might seek alternative, less capital-intensive models. Research has often focused on the "moral hazard" issues that arose in the "originate-to-distribute" model, indirectly advocating for the accountability promoted by the "originate-to-hold" model.¹¹,¹⁰,⁹,⁸

Originate to Hold Model vs. Originate to Distribute Model

The originate to hold (OTH) model and the originate to distribute model (OTD) represent two fundamentally different business strategies for financial institutions, primarily banks, regarding the loans and other financial assets they create.

Historically, the originate to hold model was the standard. However, the OTD model gained prominence as banks sought to free up regulatory capital, increase fee income, and diversify their funding sources.⁷ The 2008 financial crisis highlighted significant flaws and systemic risks within the OTD model, particularly concerns about moral hazard and the origination of lower-quality loans when originators did not retain sufficient risk.⁶,⁵ This led to a re-evaluation of banking practices and a renewed appreciation for the risk retention inherent in the originate to hold model.⁴,³

FAQs

What is the main purpose of the originate to hold model?

The main purpose of the originate to hold model is for a financial institution to create a loan or financial asset and keep it on its books until maturity, intending to earn the contractual interest income over the asset's life and manage the associated risks directly. This model emphasizes long-term ownership and risk management.

How does the originate to hold model impact a bank's capital?

The originate to hold model requires banks to hold sufficient regulatory capital against the loans on their balance sheet. This can make it more capital-intensive than the originate to distribute model, as capital is tied up in the held assets rather than being freed up through sales. This adherence to capital requirements is critical for financial stability.

Is the originate to hold model safer than originate to distribute?

Generally, the originate to hold model is considered to promote safer lending practices because the originating institution retains the full credit risk of the loans. This creates a strong incentive for thorough underwriting and diligent monitoring, reducing the potential for moral hazard that can arise when loans are quickly sold off to other investors.

Why did banks shift away from the originate to hold model historically?

Banks historically shifted away from the originate to hold model towards the originate to distribute model to free up capital, generate fee income from loan sales, and transfer credit risk off their balance sheet. This allowed them to originate a higher volume of loans without increasing their capital base proportionally.

What accounting standard is relevant to the originate to hold model?

For financial institutions reporting under International Financial Reporting Standards (IFRS), IFRS 9: Financial Instruments is highly relevant. It defines a "hold to collect" business model, which aligns with the originate to hold concept, and allows for the measurement of qualifying financial assets at amortized cost rather than fair value.²,¹