If manufacturing and commerce are the engine of global economic development and growth, then finance provides the lubricant that enables that engine to function effectively. Without an effective finance market the engine will splutter forward or at worst grind to a shuddering halt.
The Bank of England (BOE) and European Central Bank (ECB) issued a Joint Discussion Paper in May 2014 on re-establishing a framework in which securitisation (and arguably banking markets generally) can function properly through the principal of adopting the concept of “Qualifying Securitisations”. This paper provided some long awaited relief that central bankers, regulators and policy makers are finally looking at the numbers rather than following a populist agenda in respect of complex or not easily understood financial structures.
The steps taken to address weaknesses in the structures and regulation of complex products are already extensive and arguably more than enough to address the issues that were faced in certain products leading up to the financial crisis in 2007 onwards. The effect of these changes and a better understanding of what these products actually do from a risk perspective is essential in establishing appropriate calibration of capital to structuring, issuing and holding complex financial products. Over-regulation and punitive costs can lead to market failure just as much as under-regulation. Inappropriate pricing of capital leads to long term changes in market activity which could be difficult to remedy (we are already seeing a large number of finance providers move out of certain types of activity and large volumes of financial asset selling) which may undermine in the long term significant sources of funding and liquidity essential to certain consumer and commercial activities and the on-going health of the economy.
An effective and efficient global capital market is key to funding the needs of modern society ranging from loans to buy homes, finance cars, pay for credit items, fund education, provide infrastructure, finance commercial businesses and properties, as well as to enable our insurance companies and pension funds to model and diversify appropriate asset portfolios that will fund our retirement and healthcare. It is important that genuine efforts to make the financial system safer should not undermine the system that provides the means for effective long term economic growth and improved stability.
Securitisation has for several years provided an efficient mechanism for accessing funding by banks and others for a wide range of consumer and commercial assets. Securitisation assisted in the expansion of the global economy and efficient matching of asset and liability profiles for borrowers and investors and for the most part credit performance has been good (e.g. according to data from Standard & Poor’s default rates on European RMBS outstanding in mid 2007 were only 0.12% and other asset classes had similarly low default levels compared with general corporate credit). Banks act as intermediaries between households and businesses and the financial markets that provide funding necessary for the expansion of the global economy. As with any powerful tool however, the success and flexibility of structured products enabled misuse in certain circumstances (most noticeably US sub-prime assets) and misapplication by users who were unaware of, or had sold on, the downside risks (securitisation does not remove risks in respect of assets but structures a risk/return profile in a more efficient manner). As a result losses in certain segments (e.g. sub-prime and complex CDOs) resulted in a media and regulatory backlash across all asset classes, often unfairly and for reasons based on a lack of understanding of the underlying product. Steps that are already in place to require a minimum retention of 5% of the underlying risks and increased disclosure and transparency arguably address these main structural weaknesses that effected segments of the market.
Securitisation is essentially a form of secured funding with varying degrees of credit enhancement to achieve segmented credit profiles based on statistical default and loss experience drawn on historical data. This tranching of the credit profile drives efficiency of the product as it aims to more closely match the cost of funding with structured credit profiles, and therefore risk, across a given pool of exposures. This allows a wider range of funders and users of funds to come to the market. The transfer of assets to an insolvency remote vehicle isolates the risks to the underlying exposure or pool of exposures and takes out the uncertainty of general corporate risk to enable cleaner risk analysis. The historic data may prove to be ultimately not representative but the alternative is to simply aggregate risk and take a less informed view on risk and pricing. The process does not mean that the risk disappears or even that it is necessarily accurately priced but simply that based on historic data and as analysed (typically supported by analysis from a third party rating agency) the credit profile is expected to display certain characteristics within estimated parameters.
Requiring organisations to hold more capital than is justified by the risk profile means that the efficiencies (lower pricing for the level of risk) are lost as a higher return is required to justify the capital employed. This results in funders having to look for more uncertain products (higher risk) to justify the application of capital. This is particularly problematic at a time when capital is constrained (i.e. expensive, because banks are facing higher costs, less efficiency and therefore having to pay out more to attract capital). The real cost however is borne by everyone as the cost of consumer and commercial funding is more expensive, the price mechanism is not able to work effectively, the distribution of financial assets is restricted and capital is constrained. The result is a squeeze in capital in the economy resulting in restricted growth and productivity. If banks continue to exit and capital providers such as pension funds and insurance companies cannot afford to hold securitised assets the availability of lower cost funding to consumers and companies could disappear entirely with detrimental consequences for the European and Global economy.
Recent statements by policymakers and central banks suggest a more balanced recognition of the risks and benefits of the product and importantly the significance of a well-functioning capital market including securitisation in the regeneration of an active and efficient global economy. A key element of restablishing an efficient and well functioning market however will be an appropriate callabration of risk capital that is applied to banks and other holders of securitised assets. The table on pages 6 & 7 looks at the current status and taking in the reasoning and proposals expressed in the BOE and ECB joint paper provides a road map to a better functioning securitisation market capable of assisting the smooth flow of global liquidity and acting as a catalyst for real economy growth.
IMPORTANCE OF SECURITISATION
- Facilitates an effective mechanism for funding and risk transfer through international capital markets enabling more effective functioning of bank lending, consumer finance, commercial finance, monetary policy and financial stability.
- Leads to well diversified funding (maturity, investor type, currency).
- Facilitates asset-liability maturity matching.
- Tailored to investors’ risk appetite and preferences.
- Banks need it as it helps avoid build-up of systemic risk and diversifies sources of funding.
- Helps non-bank lenders raise funding for real economy lending.
- Risk transfer
- Subject to minimum retention requirements credit risk transfer away from the banking sector can be beneficial to the real economy, the banking sector and monetary and fiscal stability.
- Can free up bank capital (which may support the transmission of accommodative monetary policy).
- Reduces dependency on banks’ lending decisions and on business cycle conditions and lowers exposure of real economy businesses to refinancing or liquidity risk thereby helping to contain systemic risk.
- May reduce concerns around banks’ balance sheets reducing the extent to which funding sources are withdrawn from banks’ balance sheets in times of stress.
- Contributes to issuer risk management culture through the discipline that the process of securitising assets imposes.
- Provides insurance companies, pension funds and typically long term investors with a broader pool of assets that are genuinely low risk.
- More low risk Asset Backed Securities (ABS) may increase the supply of high quality collateral which is timely given the increased focus on collateralised structures.
- Reliable secondary market liquidity enables use of ABS for effective risk management.
DETERRENTS TO FUNCTIONING MARKETS
- Regulatory capital charges for holding higher quality ABS perceived as punative/conservative compared with similar asset types.
- Solvency II proposals affecting insurance companies apply conservative treatment (even though less than previously).
- Capital charges applied by securitisation framework of Basel Committee on Banking Supervision (BCBS) have been revised downwards in recent proposals but still high.
- Investors more cautious in risk assessment due to (i) underlying assets may not have sufficient yield, (ii) complexity of product, (iii) managing risk or analysis onerous and/or (iv) regulatory compliance costs.
- A lack of standardisation across EU and between EU and US.
- Deterrents to issuing as banks constrained by uncertainty around capital relief.
- Retention requirements may act as a deterrent to non-bank issuers funding retained portions. Inconsistency of retention globally may result in unequal treatment and uncertainty.
- Certain types of asset may be difficult to securitise due to lack of data, value of cashflows or investor preferences or spreads.
- Hard sovereign rating caps undermine transparency around credit quality and negatively impact transaction structures in certain jurisdictions.
- Concerns around infrastructure required e.g. Credit Rating Agency (CRA) view on rating of swap counterparty, account bank and servicers.
- Actual or perceived illiquidity of securitisation product makes funding more expensive to issuers and less appealing to investors.
SUGGESTIONS FOR IMPROVING THE MARKET
- High level principles for qualified securitisations applied to the entire securitisation not just tranches.
- Identify securitisations that are simple, structurally robust and transparent, enabling investors to model risk with confidence and incentivising originators to behave responsibly.
- Investors still need to conduct due diligence and aim to create structures where the risks and pay offs can be consistently and predictably understood.
- Qualifying securitisations could benefit from improved secondary market liquidity and warrant regulatory capital treatment (favourable) e.g. decrease in haircuts for central bank liquidity operations.
- Benefits from harmonisation across EU and improvements in data availability.
- ECB and BOE loan level transparency requirements for ABS and SME securitisations are already a step forward. Further steps are envisaged by ESMA.
- Credit registers detailing loan performance could help. Indices could be published.
- Consideration of accounts at account banks that fall outside account banks’ insolvency to avoid rating caps detriment e.g. implied ratings.
DOES SECURITISATION MEET THE FOLLOWING STANDARDS
- Regulatory requirements for an effective Market
Risks spread across financial systems in a transparent and diverse manner to investors that are not excessively leveraged or dependent on short term funding.
Securitised assets should embody features that improve the ability of investors to predict performance in different economic environments e.g. assets backed by real economy loans rather than re-securitisations:
- Transparent structures involving credit claims rather than derivatives (synthetic structures).
- Well understood and controlled relationships between the SPV and the Issuer.
- Authorities aware of interconnections between financial institutions.
- Regulatory requirements for an effective transactional product
- Underlying assets relate to credit claims or receivables with defined terms.
- Verifiable loan loss performance available for sufficient period.
- Recourse to the ultimate obligors.
- Homogenous claims consistently originated in ordinary course of business.
- Current and self-liquidating receivables.
- Security transferred with claims first ranking or all prior ranking security also transferred as part of the securitisation.
- True Sale of underlying receivables.
- Enforceable against third parties.
- Beyond reach of seller, its creditors or liquidators.
- Not effected through credit default swaps or derivatives.
STEPS ALREADY TAKEN
- Requirements for originators, sponsors or managers to retain a minimum net economic interest of 5% in securitised assets.
- An obligation on investors to have available sufficient information, and to have in place systems to carry out appropriate due diligence.
- Increased standards and requirements of good practice for banks initiating underlying business.
- Clarifying standards required to achieve significant risk transfer.
- Requirements on CRAs to be regulated.
- Requirements on CRAs to publish information relating to their rating process.
- Ability of alternative CRAs to offer unsolicited ratings.
- Requirements to obtain two rating agencies for securitisations.
- Requirements on rotation of rating agencies in relation to certain types of securitisation.
- Higher capital weightings on resecuritisation.
- Requirements on insurance companies and alternative investment funds to apply regulatory capital requirements.
- Requirements to report positions in derivatives.
- Template forms for mortgage and auto securitisation.
- Template forms to comply with industry quality standards such as PCS.
- Limits on eligibility of securitisation assets in context of liquidity requirements and money market operations.
- Changes to treatment of liquidity facilities in securitisation structures.
- Increase in capital requirement for certain securitised assets.
- Significant steps have already been taken to improve the workings of securitisation structures (most particularly skin in the game and transparency). This needs to be reflected in reduced NOT increased risk weightings.
- A failure to calibrate risk weightings appropriately is damaging to the ongoing effectiveness of the ABS market and could therefore undermine the future competitiveness of European businesses and harms growth in the European economy.
- Existing commentary fails to recognise that actual loss data in respect of different asset classes has been better than perceived throughout the financial crisis. Urgent action needs to be taken to:
- Reduce proposed capital requirement for holding ABS assets under the Basel capital framework in-line with risk calibration of similar assets;
- Reduce proposed capital requirements for holding ABS assets under Solvency II in-line with risk calibration of similar assets.
- Announcements need to be made to clarify:
- The position with regard to holding a broader range of ABS in eligible assets under the liquidity coverage ratio;
- Including ABS assets as eligible assets for purchase under ECB asset purchase regime.
- Regulators need to improve coordination of regulation, understand that there is regulatory overload and exclude regulatory overlap all of which are damaging markets.
- Policymakers need a better understanding of the role of derivatives and how they can assist the market without necessarily increasing systemic risk.
- Policymakers need to improve understanding of underlying structures and remove negative bias amongst politicians, regulators and media.
- It is all well and good to say that structures need to be simple but just like a complex piece of machinery, it is not that the machine has to be simple, it is that it needs to be properly put together and work as intended. Rules should establish that the technology works properly rather than prevent it operating at all. History has shown that the failure to utilise any significant technology presents a risk that the relevant economy will dramatically underperform.