The resignation of EU Financial Services Commissioner, Jonathan Hill, has dealt a serious blow to the prospects of restarting the European securitisation markets. His well-informed, moderate, pragmatic and common-sense approach offered a refreshing antidote to European pressures for ever-greater regulation and bureaucracy.
Meanwhile, Paul Tang, the European Parliament Rapporteur that is responsible for taking Jonathan Hill's proposal for Simple, Transparent and Standardised (STS) securitisations through the European Parliament, is considering making some rather draconian amendments to the text, including an increase in the risk retention requirement from 5% to 20%.
When introducing severe post-crisis capital charges on securitisation positions held by banks and institutional investors, European regulators did not attach sufficient weight to the fact that legacy European securitisations performed exceptionally well during the crisis. Default rates remained at a fraction of 1% . The idea is that STS securitisations should benefit from reduced capital charges.
The sub-prime securitisation debacle was an American problem that resulted in global contagion. The root of the problem was not the technique of securitisation per se (while acknowledging that the complexity and opacity of some structures was an exacerbating factor) but rather fraud, negligence and other criminal behaviours across the US banking system on an alarming scale. Major US banks have been fined more than $200 billion for misleading investors, including JP Morgan Chase $13bn, Bank of America $17bn, Citigroup $7bn, Goldman Sachs $5.1bn, Morgan Stanley $3.2bn, Wells Fargo $1.2bn. The SEC brought charges against more than 195 entities and individuals, including 89 CEOs, CFOs and other senior managers, that also resulted in billions of dollars of fines. In too many cases, the representations and warranties provided by US banks in relation to securitised sub-prime mortgages proved to be false and worthless. We should not punish European securitisations or the securitisation market as a whole for these outrageous US sub-prime excesses. The remarks made by Jonathan Hill in his recent (and last) presentation on securitisation to the European Parliament sum up the situation well. The text is reproduced below:
Remarks of Commissioner Jonathan Hill at the European Parliament's Public Hearing on Securitisation
Brussels, 13 June 2016
Thank you for the chance to come and talk about our proposals to restart securitisation markets. To explain why that's important if we want to help increase funding to the wider economy and to manage risk more effectively in our financial system. And to set out how we want to proceed in a way that's measured, prudent, and learns from the past.
The Committee has of course given a lot of thought to this issue and I’m grateful for the recent reports of Paul Tang and Pablo Zalba, and for all their work on the Securitisation Regulation proposal and the CRR amending regulation.
If we go back to the crisis, it's worth remembering that EU securitisations performed well. It was American ones that didn't. In response, we took action to strengthen our governance framework and ensured all securitisations in Europe are properly regulated. We've increased capital requirements; introduced rules on risk retention to make sure issuers have the right incentives; increased transparency; established due diligence requirements before investments are made; set clear standards and strengthened oversight. None of this is in question.
But now, as we work to support investment, it's sensible to ask some questions. To make sure that we're not tarring an entire market with the same brush. And to look carefully at the body of analysis that points to the positive role securitisation can play in a modern economy.
Why is securitisation important? Well, in their simplest form, securitisations can be straightforward and benefit the whole economy. By converting pools of individual loans into tradable bonds, they open up investment into households and businesses from a much wider market than just banks.
In the financial sector, securitisation allows banks that receive monthly mortgage repayments to combine loans and offer them to investors who want a share of those repayments in return for their investment. It means banks can then raise further financing, reduce borrowing costs for consumers or support more lending to the wider economy. It gives investors access to investments that they might not be able to make directly themselves.
But the importance of securitisation goes well beyond the financial sector. A car manufacturer receiving monthly payments from customers that have taken out car loans can sell its claim on those payments to finance research and development, and remain competitive. A department store with an in-house store-card might use securitisation to sell its claim on card repayments to support product development and improve its service. Or a company leasing specialised equipment could use securitisation to sell its claim on lease repayments to grow and expand into other markets.
Securitisation helps companies diversify their funding sources across the board. And it's also an important way for banks to manage some of the risks they have to take to provide many of the services their customers depend on in their daily lives, like loans to buy a house or a car.
How does this work? Well a securitisation is a transfer of assets – like mortgages or SME loans - to a vehicle which issues securities backed by these assets. Institutional investors can invest in these securities and the bank keeps some of them – a minimum of 5% – to ensure everyone’s got skin in the game. This shares risk more widely between the different parties in the financial system; it reduces the risk of shocks; and helps strengthen financial stability.
Securitisation also provides more opportunities for investors, particularly institutional investors, like insurance or pension funds. Securitised assets are an attractive way for them to benefit from the steady return delivered by well-regulated consumer and corporate loans. The institutions which extend the loans often have specialist knowledge of the sector where the loans are granted. The institutional investors can benefit from this expertise and use securitisations to diversify their portfolio of assets for the benefit of their clients.
At macro-level, securitisation can also support financial stability. The ECB and the Bank of England have argued in a joint paper that transferring some credit risk away from the banking sector can be beneficial to the wider economy, to the banking sector, and both monetary and financial stability.
They're not alone. Today, there's a broad consensus among regulators, supervisors, and the companies that need the financial markets, that building stronger securitisation markets would be beneficial for the European economy. I agree with them.
At the moment, issuance of securitised products in Europe is low. Issuance has dropped from nearly 600 billion euros in 2007 to under 220 billion in 2014. SME securitisations are half of the pre-crisis level. This means that risk is more concentrated, that there are fewer funding options, and fewer options for investors.
That's why we came forward with a proposal to restart securitisation markets by defining Simple, Transparent and Standardised securitisations. These criteria build on work done by the Basel Committee and IOSCO. We've used the work and analysis by the ECB, the Bank of England, the ESAs' Joint Committee, and we've sought and received valuable advice from the EBA. Our proposals flow from the solid analysis and cautious recommendations of these independent and respected institutions. They are based on the products that performed well during the crisis and exclude those that have failed.
Our goal is to free up more lending for investment in the wider economy by creating a new category of securitisations, securitisations that fulfil very specific criteria of simplicity, transparency and standardisation, with appropriately calibrated capital requirements for those who invest in securitisations.
So what do we mean by Simple, Transparent and Standardised?
By Simple, we mean only securitisations that bring together loans that are comparable. So mixing mortgages with car loans is out. We mean securitisations that don't repackage other securitisations. And we mean securitisations where the securitised assets cannot be cherry picked to the advantage of the issuer. So repackaging non-performing loans is definitely out.
To ensure these securitisations are Transparent, those selling securitised products will need to make the right information available to investors and regulators, so that they can undertake an assessment of risk and return, and developments in European securitisation markets can be monitored.
Our proposals would make it compulsory for relevant information to be made available electronically to all investors free of charge, in a way that was clear and comparable. And to ensure proper oversight, we're proposing a framework to improve cooperation and coordination between the different national supervisors and the ESAs, to make sure the information flows, and everyone abides by the rules. I know that Verena Ross, from ESMA, will be speaking to you in a moment. ESMA will play a key role in ensuring the integrity of the overall framework.
By focusing on Standardised securitisations, our intention is to identify securitisations that use consistent and well understood structures, where the issuer retains some of the assets that are being securitised, and where the obligations for all the parties involved are clear up front. Any assets in STS securitisations would have to be credit worthy according to the rules of the Mortgage Credit Directive and the Consumer Credit Directive.
Put simply, the criteria for simple, transparent and standardised securitisation would help investors to understand what they're investing in. It would make the risk of the underlying assets easier to assess for professional investors. And it would empower investors by making them less reliant on the assessment of rating agencies, enabling them to make their own judgements based on reliable information.
The criteria for STS have been set to make sure that we learn from the mistakes that led to the American sub-prime mortgage boom, and ensure they are not repeated in Europe. We’re right to keep the lessons of the crisis in our mind’s eye. But that should lead to caution, not inertia. Prudence, not paralysis. And it's worth remembering that European securitisations fared much better than American ones. The EU's worst performing AAA securitisation products’ default rate was 0.1% at the height of the crisis. In America, it was 16%, with the consequences we all know.
So the case I'm making today is cautious but forward looking. It's for us to build on the post-crisis reforms. It's for an intelligent solution - based on the advice of independent international and European bodies – that will help us make the most of Europe’s well-managed securitisation markets. One that channels funding to the wider economy.
My proposals for Simple, Transparent and Standardised securitisation do just that. They’ve been welcomed by Mario Draghi, who’s said “they achieve the balance between the need to revive Europe’s securitisation markets and the need to preserve a prudential regulatory framework.” They contain a robust supervision and sanctioning regime so that market participants live up to their responsibilities, and are held accountable through strong oversight. And at the same time, they deliver a more risk sensitive treatment and more straightforward legal framework, to make it easier to issue and invest in securitised assets.
We know there's an investment gap in the European economy. And we know our businesses need more funding to grow and compete internationally. Simple, Transparent and Standardised securitisation can make a difference. It's an opportunity to combat the biggest macro threat to financial stability: the lack of growth itself. That's an opportunity I hope we can work together to seize, to move these proposals forward, to get them agreed, and by increasing funding sources and bank lending, to support growth in Europe.
Apparently, very frequently! It’s a complex but very important issue for the European economy. The broad category of ‘non-CIVs’ highlighted below generates huge amounts of investment in Europe as well as promoting savings, economic growth and capital markets efficiency. However, there is concern that such non-CIVs may be subjected to restrictive and inappropriate anti-tax abuse measures that would greatly dampen investment activity and hurt the European economy.
The OECD is currently mulling over the definition and tax treaty entitlement of non-CIVs and the outcome will be strategically very important for Europe. We cannot assume that the right result will be achieved, as the EU has already applied onerous capital charges on securitised assets, part of a series of measures that have all-but killed a sector that is widely seen to be essential to any properly-functioning economy.
The UCITS and AIFM directives address two substantial, fairly homogenous and well-defined categories of CIV with large bodies of regulation. However there is a third category of ‘unrecognised CIVs’ or non-CIVs that includes many types of securitisations, private equity, venture capital, real estate, private debt, pension fund, infrastructure and other investment vehicles that are also widely held, are highly varied in structure and asset classes, and are regulated by diverse frameworks that are tailored on a country-by-country basis.
Like UCITS and AIFs, these non-CIV structures are created for genuine commercial reasons, and have the critical pooled-investment characteristics of a CIV. Investment activity in these structures is dominated by institutional investors such as pension funds, private equity, insurance, sovereign funds, local authorities and charitable endowments.
It is important that these non-CIVs enjoy tax neutrality in the country in which they are established in order to avoid double taxation and maintain the same tax situation for investors as if they had invested directly in the underlying assets. Our view is that this should not be confused with ‘treaty shopping’ and any tax deferment issues should be dealt with by the investor’s home country.
It is difficult to defend the potential application of special anti-abuse measures - such as Limitation of Benefits (LOB) and the Principal Purpose Test (PPT) - to these non-CIVs when they are almost identical to AIF CIVs. Rather than focusing at the investor level, it is hoped that a well-defined list of eligible types of non-CIVs will be developed by the OECD, that can be self-certified as ‘deemed compliant CIVs’ and, like AIFs and UCITS, will not be subject to harsh anti-abuse measures. We suggest that in-country supervisory bodies be asked to provide rulings on the eligibility of particularly complex or non-standard structures. The results of the OECD’s work are awaited with a more than a little trepidation..