Basel Pushes Risk Realism as Draghi Prepares to Buy ABS

As Mario Draghi and Mark Carney campaign to revive the asset-backed securities market, Wayne Byres wants to make sure banks keep their feet on the ground.

For Byres, secretary general of the Basel Committee on Banking Supervision, the bottom line is that banks’ risks must be covered by capital. That’s proving a challenging line to toe as the committee comes under pressure from banks including Deutsche Bank AG and Barclays Plc that say its latest proposals are so strict they may hamper their participation in the market.

Regulators must take bank warnings “that the sky is going to fall in with a degree of skepticism,” Byres said in an interview in his Basel office. “But equally there’s no desire in the committee to do anything that unduly impairs the securitization market. The objective is always to get the balance right.”

The push to develop Europe’s ABS market gained momentum on June 5, when Draghi, president of the European Central Bank, said the ECB would “intensify preparatory work related to outright purchases” of asset-backed debt. The ECB and the Bank of England, led by Carney, said in a paper published last month that the new Basel rules will be a factor in the future growth of the market.

“There has to be a revisitation of the regulation that had been introduced in the past few years about ABS to eliminate some of the undue discriminations toward this specific product when this product is simple, real and transparent,” Draghi said.

Real Loans

The ECB seeks asset-backed securities with three key characteristics, Draghi said. They should be simple, “so no complex CDOs, cubes or squares,” based on real loans and transparent, he said.

Securitization is a process where a bank pools assets, such as debt arising from mortgages or other loans it has offered to customers, and re-sells all or part of the risk to investors.

About 181 billion euros ($245 billion) of bonds backed by everything from auto loans to credit-card payments were issued in Europe in 2013 compared with a peak of 711 billion euros in 2008, according to data from the Association for Financial Markets in Europe. U.S. issuance totaled 1.5 trillion euros, down from a 2003 peak of 2.9 trillion euros, the data show.

‘Second Chance’

“The European securitization market is being given a second chance to make a positive contribution to real-economy lending and to the development of monetary and financial stability,” said Ashley Kibblewhite, a manager in the structured finance department at the Bank of England’s Prudential Regulation Authority. “It’s extremely important the industry doesn’t squander this opportunity by reverting to the most questionable practices of the past.”

The Basel committee, a group of regulators from 27 nations including the U.S., France, the U.K. and China, is overhauling capital requirements for holdings of securitized debt. Byres, who steps down on June 13, said the priority for the committee is to produce measures that are robust and reflect real risks.

“What we need to do is make sure that there’s the right balance, that the risks are covered by capital, no more, no less,” Byres said. “It’s about reflecting on what we learned in the financial crisis, and I think one of the things we learned was the previous policy settings, notwithstanding banks’ complaints when they were introduced, were quite inadequate. So there’s a need to respond to that.”

Mortgage Debt

Basel regulators have been grappling with how to set capital rules for asset-backed debt since the market collapsed in the wake of the 2008 bankruptcy of Lehman Brothers Holdings Inc. Authorities identified the pre-crisis boom in securitizations as one of the prime causes of the turmoil that followed, as banks struggled with a drop in the value of previously highly-rated instruments based on residential mortgage debt.

Lenders made dire predictions during a previous round of rule-making in 2003, Byres said.

“There were claims then that the sky was going to fall in, there would be no securitization market, banks wouldn’t be able to do the business,” he said. “We all know what actually happened. The industry went absolutely gung-ho and a lot of people lost very large amounts of money. There was no hindering of the securitization market whatsoever.”

Now policy makers, notably in Europe, are increasingly looking for ways to encourage development of the market in a bid to expand bank lending and to boost the role of other institutional investors in financing businesses.

‘Legitimate Criticism’

“There was legitimate criticism of our first set of proposals, which were issued in 2012, that the pendulum potentially went too far in the sense of tightening things up” Byres said.

“The latest proposals have produced a more realistic set of outcomes. There’s still some more work to do, and we acknowledge that, to get this right,” he said. “What we want to try and do is make sure there’s appropriate capital and sensible structures.”

In their paper, the ECB and the Bank of England said the Basel committee’s draft rules “for higher-quality ABS may still be perceived by investors as conservative, particularly when compared with similar asset types.”

Byres said there’s “a lot more” to restoring securitization markets that just bank capital requirements.

“You could have very low bank capital requirements; it still doesn’t mean that end investors are going to want to buy the product, and if that is the case it doesn’t bring any new credit into the system,” he said.

‘Bits of Paper’

“I don’t think we want to design a system where all we do is encourage banks to hold one another’s bits of paper,” he said. “If we really want to encourage a securitization market as an alternative form of financing, and bring additional credit into the system, then it’s also about the incentives for other investors, non-bank investors.”

Byres, previously an executive general manager of the Australian Prudential Regulation Authority, took over as the Basel group’s secretary general in early 2012. He leaves this month to become APRA’s chairman, handing over the Basel post to William Coen, currently the committee’s deputy secretary general.

The biggest surprise for Byres from his time as secretary general is that he still finds himself “defending the need for reform, and the fact that it does not make sense for things to go back to the way they were,” he said.

“Despite the mess that was made of the financial system, there are still people arguing that the pre-crisis world is what we should aspire to,” he said. “We should obviously aspire to healthy economic growth and prosperity, but not if they are built on dangerous levels of leverage and mispriced risks.”

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