The European Commission will consider reducing how much capital banks must hold against risk for a new class of asset-backed securities, a process of packaging and selling loans blamed for the financial crisis.
EURACTIV understands the most likely route to achieve that would be through new legislation proposed by the executive, which would have to be scrutinised by the European Parliament and EU Council before entering into force.
Brussels wants to create a new market for safe, simpler, more transparent and high quality securitisation products, it said today (18 February), as it launched a three month consultation paper on its plans for a Capital Markets Union.
Capital Markets Union is the Commission’s flagship project to unlock funding for Europe’s businesses by creating a single market for capital. It is designed to create alternative sources of finance to bank lending, which is the dominant form of European company credit. Since the crisis, bank lending has dropped significantly.
The plan is to unify markets by 2019 and make it easier for companies to raise cash on stock and bond markets.
Securitisation is when a lender pools and repackages a set of loans or other assets. The lender will sometimes organise those assets into tranches of products tailored to the risk and reward appetite of different kinds of investors.
The US subprime crisis was caused by bad mortgage debts underpinning such tranches. The lower quality of the credit, obscured by the complex layers of tranches, ultimately caused massive defaults, which in turn hit the financial institution that invested in the securities.
The subsequent loss of confidence contributed to a global credit crunch and taxpayer bank bailouts on both sides of the Atlantic, with ongoing ramifications for European growth today.
The stigma of the crash has stultified the securitisation of loans to small and medium sized firms. The Commission said such securitisation was still at half pre-crisis levels and could generate €20 billion of funding for businesses.
Securitisation can help free up banks’ balance sheets, allowing them to increase their lending to businesses and households, the Commission said.
How will it work?
Banks would issue the new securitisation instruments, pooling and repackaging their loans to households and businesses, which would then be sold in tranches to institutional investors such as pension funds.
The quality of the underlying debt would be guaranteed by a standardised set of rules. How this new framework would work and its form has been put out for consultation.
A standardised system would create the conditions to encourage the new products and guarantee their quality. EU sources said they would be “extremely prudent” because of the role securitisation played in the crisis.
“This is not a return to the bad old days of the subprime market,” Financial Stability, Financial Services and Capital Markets Union Commissioner Jonathan Hill told reporters at a Brussels press conference.
Experts told EURACTIV that investors would be interested in such a product, if it offered attractive rates of return.
Hill, who is British, said that the Bank of England, the European Banking Authority (EBA), the European Central Bank and global standard-setter the International Organisation of Securities Commissions (IOSCO), had looked at safe securitisation.
“This is not some kind of maverick solo run the Commission is making,” he said, “”It is part of a broader conversation.”
“Lots of brainy people, who think about securitisation a lot of the time, think it is possible to come up with a framework that will be more transparent, and more stable and enable people to see more clearly where the risk is,” he added.
The Commission, through its work on the Solvency II capital law for insurers, IOSCO and the EBA, currently have differing definitions of “high quality” securitisation. Although they have much in common, they will need ironing out before the new framework becomes a reality.
The Capital Requirements Directive sets the levels of capital that banks must hold against risk. The rules were part of the response to the crisis and designed to shore up the EU’s banking system’s ability to withstand financial shocks.
But critics blame the CRD for disincentivising banks’ lending to business. A lack of access to finance for businesses is one of the reasons for the EU’s sluggish return to growth.
To support that, EU sources said they would consider reducing the risk calibration for the new safer, simpler and more transparent securitisation instruments.
Currently there is no distinction in the treatment of securitised products. That distinction for products within the new framework would be introduced.
EURACTIV has learnt this would be achieved most simply with a new legislative proposal for transparent securitised products that would apply for all financial institutions, including banks, pension funds, and other institutional investors.
Hill hinted at some regulatory flexibility in his Brussels press conference. During the crisis, policymakers were forced to legislate at speed “with the flames lapping at their feet”, he said.
“It makes sense to look at the effect of that regulation over time,” he added.
British Banking Association deputy chief executive Sally Scutt said, “EU policymakers have worked to make Europe’s banks safer in recent years but now is the time to focus on measures that will help boost growth for citizens across Europe. A fully functioning Capital Markets Union, with banks playing a central role, could be an important part of that programme.”
Concerns and support
Sony Kapoor, managing director of the think tank Re-Define, warned the challenges of integrating fragmented capital markets run on different legal principles should not be underestimated.
“Some ideas, such as encouraging securitisation for SME loans, make a lot of financial sense but the proof will lie in the pudding,” he said.
Kapoor, a former Lehmann Brothers trader, added, “This is very different from the kind of dodgy securitisation that contributed to the crisis and should have an overall beneficial impact.”
Finance Watch is an organisation that campaigns to make “finance serve society”. It wants tranching banned from any future framework.
Frédéric Hache, head of policy analysis at Finance Watch, said, “”Recent initiatives to define transparent and simple securitisation go in the right direction but are not tight enough to make securitisation become again truly simple and robust.
“This practice [tranching] generates model uncertainty, additional complexity and conflicts of interests,” he added.
The City of London would play a fundamental role in the creation of the new market, with much of the product design originating from the EU’s leading financial centre, EU sources said.
If UK Prime Minister David Cameron wins May’s general election, he has promised to hold a referendum on Britain’s membership of the EU before 2017.
Quizzed over whether the plan could help encourage the UK to stay in the EU, Hill said the Capital Markets Union would be drafted with all 28 member states in mind.
Pressed further, he said, “The UK is traditionally a champion of the single market and this is a classic single market initiative.”
Britain is the EU’s biggest capital market and could benefit from such initiatives to increase trading turnover.
Hill did not mention a new “super-regulator” to hold sway over the City of London financial centre.
Capital Markets Union
In the United States stock and bond markets generate most of the cash for the economy but Europe’s fragmented capital market has a stock market capitalisation that is only half that of the US.
In the eyes of the EU executive, the CMU should be seen as “the first structural initiative” adopted under the €315 billion investment plan put forward by Jean-Claude Juncker last year.
“If EU venture capital markets were as deep as the US, as much as 90 billion euro more in funds would have been available to companies between 2008 and 2013,” the Commission said in a statement, explaining that the current environment was “tough for businesses that remain heavily reliant on banks and relatively less on capital markets”.
Hill’s CMU plan includes making it easier and cheaper for smaller companies to list on stock markets and tap money directly from investors. He wants fast progress involving as little new legislation as possible and instead to tweak existing EU rules and rely on industry initiatives.
“I don’t think there are any quick wins,” said Lachlan Burn, a financial services lawyer at Linklaters, saying the key would be to rework some existing EU rules, but it will not be easy.
Hill said the CMU was not a threat to banks but would widen choice for companies who need cash to grow.
Andy Baldwin of EY consultancy said Hill’s plans do not address cultural and historical barriers to CMU and it could take a generation to stimulate demand for more funds from markets.