Securitization can be part of the sustainable finance revolution if given the chance
Regulatory treatment holds back sector ripe for assisting the ESG transition
People in the securitization industry, like their counterparts across the capital markets, are eager to play their part in the financial world's push on environmental, social and governance matters.
However, they believe their asset class is considered only as an afterthought when it comes to policy makers and that this is hindering their efforts to take part in the biggest secular shift in the way financing is done in decades.
And it is not just at the policy level that they think the world of finance is missing a trick. While banks have developed large sustainability-focused teams to sit across their capital markets businesses, securitization is often seen as too niche or too complex, so much so that at best it will have its own, separate sustainability team.
Securitization is very much the outcast of the capital markets, as it perhaps has been since the 2008 financial crisis. At the very least it is the estranged relative. Within the EU’s Green Bond Standards proposals, securitization doesn’t quite fit. It needs amendments, perhaps eventually its own framework.
At the same time, progress is slow as there are only a small amount of assets in Europe that are suitable for securitization which also qualify as green. Were regulators to allow the use of proceeds from a securitization to fund green projects, as they already do for other bonds, the potential for a functioning green ABS market would dramatically increase.
Yet regulators are taking "forever", as one speaker told Afme's sustainable finance conference in Amsterdam last week.
Tech vendors that can give firms or loans a sustainability rating often don’t do so for structured products. For simple, transparent and standardised-related (STS) sustainability disclosures, the European Supervisory Authorities again made it clear that securitization needs special treatment.
The proponents of the asset class must jump through hoops and accept terms that similar, secured products like covered bonds do not have to. The treatment of the two products under the Liquidity Coverage Ratio (LCR) rules is one such example.
The LCR has three categories: Level 1, Level 2A and Level 2B, with Level 1 being considered the best quality assets. Banks are required to hold assets under the LCR so that they can meet meet short-term obligations.
Covered bonds can count towards each of the tiers of the LCR, depending on their ratings, with triple-A rated versions eligible for the top level.
But any securitization that does not meet the criteria for EU's simple, transparent and standardised (STS) label, even if the notes are rated triple-A, are automatically ineligible for the LCR.
Even within STS securitizations that are LCR eligible, only the most senior tranche, typically triple-A rated, is eligible but the weighted average life (WAL) must be less than five years. Even at this point, those eligible securitizations can only qualify for Level 2B.
This renders securitization a less appealing market from which to draw funding or invest in, and stifles its growth as a result.
Combined, it creates the sense that securitization is not welcome in the move towards sustainable capital markets.
Perhaps it was this which led Daniela Francovicchio, head of securitization at the European Investment Fund to tell delegates at Afme's conference that the asset class had been “punished” for years.
Whether securitization is cast aside intentionally, as a punishment for its role in the global financial crisis of 2008 or due to a lack of understanding, is unclear. However, it is clear that governments, legislators and regulators can help unlock the great potential that securitization has in driving the EU’s green transition.
Securitization can dive down and touch the real economy. The ECB acknowledged this in 2014 when Yves Mersch, then an executive board member, advocated for using securitization as a way to fund SMEs that lacked competitive access to bank financing — a ploy some in the market today would no doubt hold up as a shining example of ESG finance.
"... connecting SME financing needs with the funds of bank and non-bank investors via securitization of SME loans can assist banks’ ability to fund and distribute risk," he said.
Well, at least someone at the ECB got it.
Securitization can be a direct method of creating more green funding or lending for energy-efficient homes, electric vehicles, solar energy, wind power, the list goes on. Eventually, it could incentivise consumers to choose greener options through discounts and subsidies.
However, none of this is possible if, while the rest of the capital markets are being greened, securitization is left in the brown stuff.
As another speaker told the Afme conference, time is not on our side. Action is needed and quickly. If the momentum for sustainable finance can be diverted to securitization, it would only add to the methods the financial world can use to help transition to a more sustainable society.