Structured investment vehicles, known as SIVs, are structured financial products issued by banks to raise capital. SIVs issue short-term securities like commercial paper while investing in long-term assets like mortgage-backed securities. The profit comes from the spread between short-term liabilities and long-term assets. SIVs allow banks to obtain low-cost financing through high leverage. However, they also expose banks to liquidity risk and credit risk. SIVs played an important role in the 2008 financial crisis when they could not roll over their short-term funding. As an essential structured financial product, SIVs have complex structures involving various derivatives like credit default swaps to transfer risks.
SIVs function as bank-sponsored off-balance sheet vehicles
Structured investment vehicles(SIVs) are bank-sponsored structured finance entities that are kept off the sponsoring bank’s balance sheet. The purpose is to earn spread income by issuing short-term securities at lower costs while investing in higher-yielding long-term assets. A typical SIV would issue commercial paper with a maturity less than one year and use the proceeds to purchase mortgage-backed securities, collateralized debt obligations, or other asset-backed securities with maturities over 5 years. The liquidity risk and credit risk are passed on from the bank to the SIV investors through the complex structured finance arrangement.
SIVs allow banks to obtain leverage and reduce regulatory capital
By keeping SIVs off the balance sheet, banks can obtain leverage by issuing more liabilities than their assets. Banks sponsor SIVs to reduce regulatory capital requirements and free up capital for more lending. Under Basel II rules, banks must hold 4% capital against corporate loans but only 1.6% against mortgages and as little as 0.56% against super senior AAA-rated tranches of securitized products. By selling assets to SIVs, banks can reduce average capital charges and increase lending capacity.
SIVs exposed banks to runs and contagion risks
The extensive use of short-term funding makes SIVs vulnerable to runs and liquidity issues. SIVs act as shadow banks engaging in maturity transformation like traditional banks. But they lack access to central bank liquidity and public sector credit guarantees. Many SIVs got into trouble when they could not roll over their commercial paper during the 2008 financial crisis. SIV failures also created contagion where investors lost confidence in the sponsoring banks and withdrew funding even though the SIVs were off-balance sheet.
Today SIVs are rarely used due to regulatory reforms
After the financial crisis, SIVs are rarely used today due to regulatory reforms. Restrictions were placed on sponsoring banks’ support for SIVs. New accounting rules also required consolidation of formerly off-balance sheet vehicles. Basel III introduced liquidity coverage ratio and net stable funding ratio requirements, reducing the incentive to use short-term funding. Central clearing for derivatives increased costs of structured products used in SIVs. Financial reforms addressed systemic risks from bank-sponsored SIVs and limited their revival.
In conclusion, structured investment vehicles exemplify the sophisticated use of structured finance to manufacture money-like liabilities, reduce regulatory costs, and increase financial system leverage. However, the extensive reliance on short-term funding and derivatives makes the financial system prone to liquidity crises and contagion. Regulatory reforms since the 2008 crisis have curtailed the systemic risks from SIVs.