EU's Asset-Backed Debt Revival May Stumble on Competing Aims

  • Risk-Retention Rules May Deter Non-Bank Buy-In, Analysts Say
  • Pool of Eligible Products Seen as Too Narrow in Hill's Plan

The European Union’s plan to deliver as much as 150 billion euros ($167 billion) of new lending and “diversify funding sources” for companies traditionally reliant on banks by kick-starting the asset-backed securities market is at risk of getting tangled up in its own competing goals.

The proposal presented on Sept. 30 by Jonathan Hill, the EU’s financial-services chief, seeks to boost the ABS market by creating a new class of “simple, transparent and standardized” products eligible for preferential regulatory treatment. By bundling assets and selling them on as securities, banks can free up balance-sheet capacity to offer new loans to companies, which “support job creation and a return to sustainable growth,” according to the plan.

While banks will probably issue more asset-backed debt under the new rules, the promised reduction of capital charges may be insufficient and the category of simple products too narrow to spur a market revival, analysts and lawyers said. And since banks themselves will be buyers of many of top-rated portions of the transactions, the balance-sheet room may not be as ample as foreseen.

‘Capital Constraints’

“It’s difficult to see how these new rules will help the ABS market to grow significantly and rapidly,” said Jean-David Cirotteau, senior ABS analyst at Societe Generale SA in Paris. “Regulators understand that securitization is a good tool for banks in terms of managing their balance sheets, yet they impose regulatory capital constraints that are too high in holding ABS. And today the real money investor base is not large enough.”

The European ABS market has shrunk almost 50 percent since 2010 amid stiffer capital requirements for holders and investors’ reluctance to buy the securities blamed for the financial crisis. While sales have rallied to 67 billion euros this year from 58 billion euros in the year-earlier period, they remain far short of the 308 billion euros raised by this point in 2006, the busiest year for issuance, according to data compiled by JPMorganChase & Co.

If the market returned to pre-crisis average issuance levels, and banks used new issuance to provide loans, the result would be a 1.6 percent increase in credit to companies and households, according to Hill’s plan, which is part of a broader project to strengthen Europe’s capital markets.

‘Efficient Packaging’

Given the role of ABS in fueling the financial crisis, the commission loaded its proposal with safety features, starting with its focus on the simplest products. Hill shrank the pool of securitizations eligible for lower capital charges by excluding synthetic products, in which the credit risk related to the underlying assets is transferred by means of a guarantee or derivative contract.

Hill could have been “bolder” in his proposal, according to the German Banking Industry Committee. “Certain types of securitization shouldn’t be excluded ex ante from the planned framework,” the group said. “In fact, synthetic securitizations can be particularly useful for efficient packaging of real economy assets.”

The commission also refused to extend preferential treatment to sellers of bonds that have no other business than securitization, even though an earlier draft of the rules seen by investors in August had stalled sales in Europe’s growing collateralized loan obligations market. 

‘Narrow View’

Tweaks to the final proposal give investors cause for some comfort. Having previously said originators will be deemed non-compliant if their “primary purpose” is securitization, the rules now say originators will not meet the requirements if their “sole purpose” is to securitize assets.

“They’ve adopted a ridiculously narrow view of what amounts to a ‘good’ securitization,” said David Shearer, a capital markets partner at Norton Rose Fulbright. “And for all the talk about moving away from banks as sources of finance, they go on to talk about securitization being used by banks to free up capital for more lending. The real prize would be bringing in everyone else out there.”

In its proposal, the commission said that in addition to increasing banks’ lending capacity by allowing them to transfer risk to non-credit institutions, securitization can “channel non-credit-institution financing toward the working capital of companies.” Yet in the interests of safety, it requires sellers to retain at least 5 percent of any transaction -- and the risk it entails -- to ensure their interests are aligned with those of their investors.

‘Smoking Gun’

Simon Gleeson, a financial regulation partner at Clifford Chance LLP in London, said there’s “a strong feeling of smoking gun and bleeding foot about this combination of policy positions.”

“Banks are the only people capable of holding risk-retention pieces on a commercial basis,” Gleeson said. “If your aim is to encourage non-bank capital market finance, you need to permit non-risk-retention securitization, which is the very thing they seem to have refused to do.”

The risk-retention rules in Hill’s proposal are tougher than provisions in existing laws for banks, insurers and asset managers in that the originators of ABS are required to hold a “material net economic interest” of at least 5 percent in the products they issue. This interest can’t be hedged or split among different types of retainers.

For all the safety features built into Hill’s plan, some critics say he hasn’t gone far enough to tame the risks posed by securitization. Some of Hill’s main proposals “raise serious concerns,” according to Finance Watch, a watchdog group based in Brussels.

The EU should exclude tranching of debt products in its new simple and transparent category, “address comprehensively the conflicts of interests created by the ‘originate-to-distribute’ model and rule out synthetic ABS once and for all, Finance Watch said.

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