The idea behind the European Union’s ‘simple, transparent and standardised’ (STS) framework for securitization was simple. With Europe lagging far behind the US in transferring risk to the capital markets, the framework was developed to encourage securitization as a means of funding the economy under a set of guidelines that also promoted stability and predictability in underwriting. It was believed that this would also lead to less stringent capital requirements for investors holding the bonds.
As it turns out, it was never that simple.
Political sparring
The European Commission proposed to simplify the origination process and to make securitizations more transparent. The plan passed through the Commission in December 2015, but promptly hit a roadblock in the European Parliament.
Dutch MEP Paul Tang, rapporteur for the European Parliament’s Committee on Economic and Monetary Affairs (ECON), led calls to more heavily police securitization in Europe, with more regulation, more supervision and more risk retained by issuers, measures he believed would protect against the crisis-era abuses in the US that plunged the world into the recession that followed the global financial crisis.
Looking to block the originate to distribute securitization model, Tang proposed raising the risk retention requirement in the STS proposal to 20%. While that has since been reduced to 10% for vertical retention and 5% for horizontal, market participants are annoyed at having to alter their businesses to make up for the excesses seen in US securitization.
Efforts have been made by ABS market advocates to shed the political stigma of securitization and to educate legislators on the differences between the US and European markets.
“It’s perfectly reasonable for parliament to check what is going on and to make sure that we are not going back to the bad old days, it is a legitimate question to ask,” says Richard Hopkin, head of fixed income and managing director in the securitization division at the Association for Financial Markets in Europe (AFME). “Our job at AFME is to answer that question. We clarified that is not the case and that in fact most European securitization performed really well. We have never had the originate to distribute model which caused the subprime problems in the US.”
While risk retention requirements have come down from the proposed 20% level, many in the market
feel the European Parliament’s attitude towards risk retention contradicts the message of making securitization easier.
“The risk retention provisions in these STS proposals are simply not rational and will inhibit market issuance in itself,” says Mark Hale, CIO at Prytania Group in London.
“What should have been done in Brussels is a proper study which looks at all the impact of all these different regulations together and then turns it into a counter-factual exercise… however, what appears to be the case is that people are reacting to a problem that essentially happened elsewhere and have politically imposed a solution for a problem that did not exist in this part of the European market.”
Closing up the market
Another problematic part of the regulation is that it restricts participation in the market to only EU regulated financial institutions. This is a potentially big problem for US companies and unregulated entities looking to issue into the EU.
“One of the proposals says that originators, sponsors and lenders need to be EU regulated institutions,” says David Quirolo, partner in the capital markets group at Cadwalader in London.
“That would only allow EU regulated institutions to act as retention holders and the problem is not only that that would exclude US securitization parties from issuing into Europe, it would also stop a European corporate from securitizing trade receivables as they are not EU regulated entities. It really limits any companies which are not EU-regulated financial institutions from accessing securitization as a form
of funding.”
According to Hale, the discussions about market access and who can participate in securitizations are a huge problem.
“You can understand why they say that you have to be a regulated entity, but the market is much more diverse than that,” Hale says. “The reality is if you want to succeed and fulfil all the ambitions set out in the Capital Markets Union, there should be a paradigm shift away from banks and towards other market participants, especially corporates.”
What does the EU really want?
According to data from AFME, total issuance of European ABS was €419.2bn in 2007. In 2016, that figure had shrunk to €96.4bn.
Total issuance in Europe, both retained and placed, has always lagged behind the US. However, many in the market feel that the figures should be much closer given the comparative sizes and GDP of the two geographies — a criticism that could be levelled at most sub-sets of the capital market.
The European system has never operated in the same way as the US, with central bank funding and the covered bond market playing a larger role since the crisis.
This has led to speculation that some MEPs see no need for securitization, and would advocate instead for shrinking the industry given its association with the financial crisis.
Still, the compromise around risk retention levels shows that there is at least some willingness in parliament to adapt their thinking on the market.
“The view that Europe doesn’t need securitization is very much a minority view, even in the parliament,” says Hopkin.
“The Commission is completely supportive of the need for securitization because of the big picture requirement to make Europe less dependent on banks and to have more access to capital markets funding. There is a big difference between Europe and the US on that point and securitization is the perfect tool for building a bridge between bank balance sheets and capital markets.”
However, Brexit has thrown another wrench in the wheels. Negotiations to remove the UK from the EU will see the most capital markets-friendly country in Europe taken out of the equation.
This could dampen support for STS in the Commission, and the fact that the UK is Europe’s largest securitization market means an important voice will be absent from future discussions.
“One of the unfortunate consequences of Brexit was to remove one of these most powerful advocates for more sensible regulation from the policy equation in Europe, especially Lord Hill and the Capital Markets Union initiative,” adds Hale.
“The momentum for that has been reduced and, you can argue, has been permanently impaired.”
Examples of compromise
Fortunately, the European Parliament has shown an ability to compromise already on STS, and according to AFME has come to a more sensible conclusion on the issue of capital requirements regulation (CRR).
Many banks have struggled with some of the modelling requirements originally laid out in the provisions, but the European Parliament has moved to pass measures to make the rules less onerous. This development bodes well for STS.
“The CRR is the more technical part of this package. Less political discussions were ongoing and therefore the process was slightly faster,” says Anna Bak, manager in the securitization division at AFME. “There were fewer things to cause so much of an issue. You hear from a number of people in the industry that the capital charges are still quite conservative and definitely higher than anything for similar products. But to be a little bit more optimistic, we have seen an intention to include provisions in the text for banks to be able to use proxy data in their internal model calculations, which is very important.”
Headaches to come
Compromise on CRR and some pieces of STS point to EU legislators being able to put aside politics in order to achieve desired results.
There are still concerns in the market about the proposals, but the regulatory discussions will likely be concluded by the end of June, at which time the market must adapt to the new regime. At that point, the market then faces another challenge in the months following implementation.
Cadwalader’s Quirolo says that while the current rules do provide for grandfathering, following the effective date of the new regulation, the market will need to wait at least six months following the effective date for regulatory technical standards to be published by regulators.
This will potentially lead to a period of uncertainty where
markets are operating in a state
of limbo.
“During those six plus months, we can continue to use the old regulatory technical standards (RTS), but once the new ones come into effect, they will apply retroactively to any transaction that closed since the new regulation came into effect,” Quirolo says.
“A lot of the provisions relied upon by the market, such as the ability to enter into risk retention financing, are laid out in the RTS, so it’s going to be very difficult to do a deal where those standards may change and then apply retrospectively.” s