Securitization enters the ring in the fight for Europe’s soul

Europe is facing an “existential” threat.

So said Mario Draghi in his September 2024 report: The Future of European Competitiveness. According to Draghi, a former governor of the ECB and Italian prime minister, the EU needs to grow and become more productive, or its “fundamental values [of] prosperity, equity, freedom, peace and democracy in a sustainable environment” are at risk.

Most agree that the bloc is in a malaise, but opinion differs starkly on why and on how to chart a way out.

What does this have to do with securitization?

The industry may appear to only have a walk-on part in the debate, but questions around its role represent — in some ways — a microcosm of the fight for Europe’s soul.

Draghi is clear: “the EU should aim to revive securitization”, backing lobbyists who for over a decade have pressed the case that economic potential is being wasted because disproportionate regulation holds back the market.

In that time, a few tweaks have aimed to help the market grow but have largely failed. Any efforts to effect more radical change had been to little avail — until, in a stroke, the Draghi report galvanised the European Commission into action.

It has since held two consultations on securitization regulation and is expected to publish a draft proposal for a new regulatory framework on June 17.

GlobalCapital understands the proposal is likely to address the major issues the market has raised, but it is unknown how far the Commission will go.

The Association for Financial Markets in Europe (Afme), a trade body, laid out a proposal in paper published at the Global ABS 2024 conference, addressing five key areas. The proposed reforms aimed to boost demand with more proportionate due diligence requirements, recalibrating capital requirements for insurance investors and improving liquidity treatment for banks. To lift supply, Afme also proposed reforms of capital treatment for banks and another look at disclosure requirements.

From within the bubble of the Global ABS event in Barcelona, a relaxation of the rules along these lines can feel like the inevitable end to a long arc of history. At some point, somebody was bound to listen to years of experts pointing out how the regulations are miscalibrated versus other capital markets products.

That is not what has happened. In reality, EU leaders are feeling isolated in the world and are reaching for solutions. Securitization has become almost the low hanging fruit of a plan to make Europeans’ savings part of the €750bn-€800bn that Draghi estimates is needed to boost productivity.

In February, when explaining to CNN his plans to put Europe’s savings to use, French president Emmanuel Macron mentioned securitization. Such an intervention would have been unimaginable a few years ago.

Yet, many of the market’s newfound supporters in the political class have been diminished by recent election results — Macron included.

In September 2023, the French and German finance ministers — Bruno Le Maire and Christian Lindner — published a column in the Financial Times that called for “[revitalising] the EU’s sluggish market for securitizations” and was heralded by market participants as a breakthrough moment. Nearly two years on, however, little tangible change has been made to regulations and both Le Maire and Lindner are out of their jobs and out of politics.

As that class of politicians exits, some of those who have reptlaced them have different ideas about the future of Europe and how it should be funded.

The far right appears more focused on cultural issues and immigration than economics. The far left, however, has well developed ideas that run deeply opposed to loosening the rules on securitization. Although the left has had mixed results in recent elections, it has made gains in places and those new representatives may get opportunities to advance their point of view.

A few months before Global ABS takes place in Barcelona and 1,000 miles away, the Festival of Scotonomics took place in Dundee. The number of attendees ran into the low hundreds, making it Scotland’s largest economics festival, the organisers said.

The venue was The Little Theatre, an old jute warehouse converted into a bar and an intimate theatre. As your correspondent stepped into the bar that served as an entrance hall and social space, there was one similarity to Global ABS. A confident-looking crowd were catching up and sharing ideas convivially, while a more nervous looking group of first timers milled around the edges of the room.

Otherwise, it was a world away. The only free swag was a badge on arrival. There was no complementary sushi, but self-service soup was available for £2.50, taken apologetically.

The £50 ticket price included a full schedule of panels featuring academics, politicians and campaigners. The programme ran from Friday evening to Saturday night and included panels titled “Ending Austerity” and “Financialisaton”.

Securitization was not popular, with the critiques essentially split into two parts: one doubting its usefulness in achieving Europe’s ambitions, the second regarding the risk of financial crises.

The market’s case for securitization is that if Europe needs to find up to €800bn in investment, the securitization market could facilitate at least some of it.

“Securitization makes banks’ balance sheets more flexible by allowing them to transfer some risk to investors, release capital and unlock additional lending,” Draghi argues. “In the EU context, it could also act as a substitute for lack of capital market integration by allowing banks to package loans originating in different Member States into standardised and tradeable assets that can be purchased also by non-bank investors.”

Despite the obstacles that reforming securitization regulation has faced so far, it is in fact a much easier place to start than other more ambitious plans for capital markets integration.

That argument has the ear of key politicians. The Commission, under Ursula von der Leyen, is providing much of the impetus for reform, while other European leaders remain supportive. Macron told CNN in the February interview that key figures were “totally aligned” on what needed to be done.

“We have to focus on killing some crazy regulations, simplification of the current environment,” he added. “Europe has to simplify its rules, make it much more business friendly and synchronise with the United States.”

Outside the industry, however, there is pushback on every facet of that plan.

Draghi emphasises growth and boosting productivity. The UK government under Keir Starmer has been pushing a similar agenda, despite open criticism from some in his own ranks about these fundamental aims.

“What kind of growth do we want? No one is answering that question,” said Labour MP Clive Lewis in a speech in January in the House of Commons. “Do we want sustainable growth? What is growth about? What are we growing? Are we growing pollution in our rivers? Are we growing roads that go through ancient woodlands? Yes, that is growth, but is it the growth we want?”

Many on the left also dispute the idea that securitization financing really will boost productivity.

“The financial sector is separate from the real economy,” says William Thomson, founder of Scotonomics. “Growing the financial sector above a certain point is detrimental to the goals that we’re trying to achieve. By pushing an increase in securitization and financialisation, we’re actually likely to reduce the productivity of the real economy.”

Some research backs Thomson’s argument, including a 2014 working paper published by the Bank for International Settlements titled ‘Why does financial sector growth crowd out real economic growth?’ written by Stephen Cecchetti and Enisse Kharroubi.

The paper argues that “financial sector growth benefits disproportionately high collateral/low productivity projects […] like construction, where returns on projects are relatively easy to pledge as collateral, but productivity (growth) is relatively low”.

If “skilled labour works in finance, the financial sector grows more quickly at the expense of the real economy”, the paper says. Hence, “financial growth disproportionately harms financially dependent and R&D-intensive industries”.

Of course, plenty of research finds completely the opposite.

“The bulk of the historical evidence suggests that financial development affects economic growth in a positive, monotonic way,” said a 2017 ECB working paper called ‘Evidence on finance and economic growth’. “Yet recent research endeavours have provided useful and important qualifications of this conventional wisdom.”

Another important note is that Cecchetti and Kharroubi do not consider exporting financial services.

Proponents of securitization may argue that, for exporters of financial services, the distinction blurs between the financial sector and the real economy. Those who disagree contend that exporting financial services often means importing risk and still means that the financial sector competes with other sectors for talent.

In any case, the upshot is that some on the left argue that any shortfall in investment is down to self-imposed limits on government spending. These constraints, they say, are political choices. By relaxing them, governments could directly fund their priorities.

“We don’t think there’s a lot of demand for securitization,” says German MEP Fabio De Masi. “There’s not enough demand for loans.

“From our perspective, it’s clear why that is. Government spending has been reduced. If you cut government spending, you’re directly cutting private sector income. If that falls, why would companies invest?”

Securitization market participants may disagree, but the arguments are an alternative vision for how to run an economy at a time when European politicians are casting around for answers.

In this view of the economy, one of the lessons of the Covid pandemic was just how impactful government intervention can be. Such arguments also have support among some parties that have gained momentum in recent elections, even if they have cut through only a little to those in power.

Draghi himself acknowledges the need for public spending, saying “the private sector will not be able to bear the lion’s share of financing investment without public sector support”, though he argues that increase in productivity will create more “fiscal space” for such an intervention.

There are also more technical criticisms of securitization. One that has traction among European governments is that expanding securitization may come at the expense of covered bonds, meaning it would contribute little to overall levels of financing.

That is salient for countries with large covered bond markets, such as Denmark, which is due to take on the presidency of the European Council at the end of June.

“An increased role for securitizations should not come at the expense of already well-functioning funding instruments such as covered bonds, as little real value would be gained in terms of an increase in total funding supply,” the Danish government said in response to the Commission’s consultation. “It is important to add that Denmark has a very well-functioning covered bonds market.”

Even if securitization has supporters in the right places in the debate over its usefulness in funding the real economy, any attempt to make a case for the reform of regulation also has to reckon with the legacy of the 2008 financial crisis.

Indeed, the events of that crisis — and their retelling in Michael Lewis’ The Big Short — still largely shape the public perception of the market.

The industry has been carefully trying to rebuild its reputation, arguing that what happened in 2008 was mostly linked to US subprime mortgage lending and some limited subsectors of the market of that era.

Securitization does not create risk itself, just transfers it. At least part of the story, then, is that if underwriting of subprime loans had not been so lax, a financial crisis would not have happened.

But the creation of resecuritizations, which obscured risks investors were taking, amplified the subprime defaults. It also would have been difficult to write such volumes of loans if there had not been ready buyers.

For those problems, there were two key mitigants introduced after the crisis. First, a ban on resecuritization, which limits the ability to create products that obscure risks. Second, the introduction of risk retention, which makes originate-to-distribute models uneconomic unless the loans perform.

Other changes to the market have also taken place around disclosure, due diligence and the introduction of the ‘simple, transparent and standardised’ stamp aimed at mitigating risks.

The market’s supporters argue that putting these regulations in place tames the risks of securitization. The US, where the crisis originated, has dusted itself down, taken the pain and got on with it. Europe has thrown the baby out with the bath water.

In fact, many would argue that securitization — as it exists now — actually strengthens financial stability by allowing the allocation of risk to the most appropriate holder. To take the example of SRT, it makes much more sense to transfer illiquid credit risk to a long lock up fund, than it does for a primarily deposit-funded bank to hold on to it.

But for critics, like De Masi and Thomson, what happened in 2008 was something much more fundamental. They say what happened in 2008 was a ‘Minsky moment’, as theorised by 20th century American economist Hyman Minsky.

“A fundamental characteristic of the economy is that the financial system swings between robustness and fragility,” Minsky argued in an op-ed published by the Ocala StarBanner in 1974.

His financial instability theory posited that long periods of stability result in overconfidence, which leads to bubbles then sharp asset price slumps. In 2008, the US housing bubble would appear to be one such example.

In this paradigm, relying heavily on financial services to fund the real economy is heading inevitably for crisis. Securitization is a particular risk because it is complex and features considerable informational asymmetry.

Ultimately, each side makes points that might appeal to European policymakers. The swing constituency in the debate might well be sympathetic to Draghi’s aim of using securitization to channel European savings into boosting productivity, but worried about whether relaxing regulation poses a risk to financial stability.

The dilemma harks back to the keynote speech at Global ABS 2023 given by Jonathan Hill. The former EU commissioner called for “a proper discussion about risk”, adding the 2008 crash “still seems to dominate our thinking”.

“For me, the biggest risk we face today is lack of growth, but we pursue regulatory approaches that make growth more difficult,” Hill said at the time. “We need to be honest about the trade-offs involved and ask ourselves whether we have struck the right balance, particularly when our international competitors are striking that balance in a different, more growth-friendly place.”

Economies can recover from corrections and crashes. In Hill’s framing, you can accept Minsky’s argument about the inevitability of periodic crashes but decide that is a risk worth taking if the benefits are sufficient.

The Financial Stability Board set the problem up similarly in its July 2024 evaluation of the global regulatory framework.

A review of prudential requirements “involves an assessment of social benefits and costs”, it said. Such an analysis would typically weight expected benefits of tighter regulation “in terms of reducing the likelihood and severity of financial crises”, against “[increased] funding costs of financial institutions that are in turn passed on to borrowers through higher lending spreads”.

In its response to the consultation in December 2024, European non-profit Finance Watch was sceptical that such an assessment had been done.

“We are not currently aware that such a cost-benefit analysis, which would demonstrate and justify the proposed unilateral amendments to the securitization prudential framework, had been carried out in the EU,” it said.

If politicians decide they want to take more risk, it introduces another element to the ‘proper discussion’ about who it is that actually bears that risk.

Economists and others regularly complain that Europeans are not taking enough risk with their investments. In April 2024, Christian Noyer, former governor of the Bank of France, published a report commissioned by French finance minister Bruno Le Maire on ‘Developing European capital markets to finance the future’.

Noyer said European household savings are mostly “allocated to fixed income products, especially sovereign bonds”, which “alone cannot finance the long-term investments necessitated by the green and digital transition”.

“Most tellingly, Europe exports a significant share of its savings through the acquisition of foreign fixed income products and imports equity financing necessary for the long-term development of its companies,” Noyer’s report adds. “Beyond its collective cost, the misallocation of savings carries individual costs borne by European savers through lower returns.

“Allocating savings to liquid, low-risk products carries a cost, depriving European savers of the returns that long-term investors can achieve on the financial markets.”

Governments could act to incentivise more risk taking, but past schemes to encourage private investment have been accused of privatising profits and socialising risk. Critics invoked that concept in dismissing the idea of a securitization platform for Europe, perhaps with Fannie Mae and Freddie Mac as models — an idea that Draghi proposes.

“Setting up a dedicated securitization platform, as other economies have done, would help to deepen the securitization market, especially if backed by targeted public support (for example, well-designed public guarantees for the first-loss tranche),” Draghi’s report says.

The Commission’s consultation asks for feedback on the idea of such a platform, floating the possibility of pursuing a route “inspired by the US model”. But the plan appears to be on ice after meeting resistance.

“Nearly all the respondents agree that creation of a securitization platform is not the main issue in the market, and it should be addressed at a later stage, following comprehensive feasibility studies and consultations,” the Commission’s summary of feedback says.

Notably in Denmark’s response to the Commission, it declared itself “fundamentally against the use of public guarantees to support a securitization platform, as we firmly believe that the transfer of credit risk should be conducted on market terms”.

The questions about social risk apply more broadly as well, if public money is to be used to reinvigorate the economy after another ‘Minsky moment’ or if institutions deemed ‘too big to fail’ need bailing out.

Securitization’s advocates would argue that it can mitigate that risk, by allowing such institutions to offload risk into more suitable hands.

If most risk, however, is to be taken by those most able to bear it, they will make greater returns. Hence, the rate of returns to capital will increase with the amount of capital available. Any attempts to redistribute would have to well designed or they may again discourage risk taking.

How that fits with Draghi’s European value of equity and whether the wider benefits brought by the extra financing are worthwhile is a question that will require soul searching, particularly since greater inequality itself is widely considered detrimental to growth.

“If Europe cannot become more productive, we will be forced to choose,” Draghi says. “We will not be able to become, at once, a leader in new technologies, a beacon of climate responsibility and an independent player on the world stage. We will not be able to finance our social model. We will have to scale back some, if not all, of our ambitions.”

Even if the Commission proposes changes along the lines the market is hoping for, they face a bumpy road to become law.

The Commission’s draft statute will go to the Council, comprising the governments of the 27 member states, and the European Parliament. Both the council and parliament’s Econ committee will propose amendments.

If the Parliament and Council cannot agree amendments, as sources thought was likely, the proposal will likely end up in trilogue between the Commission, the Council and the Parliament. That is an informal negotiating process, normally held behind closed doors.

Rising geopolitical uncertainty — be that through US tariffs, the war in Ukraine, or challenges from China — adds further urgency to the EU’s need to boost investment. That gives securitization’s advocates their moment of opportunity, but that they will prevail is no foregone conclusion.