The moribund CMU is not worth the tears

A framework for simple, transparent and standardized securitization was supposed to be the flagship of the European Commission’s Capital Markets Union plan. However, so far, it has only brought more complexity, regulatory uncertainty and internal disagreements within the European Parliament.

In 2015 Jonathan Hill, former European Commissioner of financial markets, proudly launched the plan for a European Capital Markets Union (CMU). The first, and so far only, concrete CMU-initiative is the proposal to revive securitization – the repackaging, cutting up and selling off of debt as investment products. Despite partly causing the global financial crisis of 2008, the Commission nonetheless believes that securitization still has a role to play in Europe’s economic development, provided it is kept simple, transparent and standardised – or STS in short.

The European Parliament’s Committee on Economic and Monetary Affairs (ECON), headed by rapporteur Paul Tang, spent a year studying and debating the securitization proposal, finally approving an amended version in December 2016. Unfortunately the negotiations ended in a half-hearted, confusing and complex piece of financial legislation, typical of the kind the EU has been smothered in since the end of the financial crisis: a mix of industry arguments, internal disagreement in the Parliament, and indecisiveness among the different political fractions. The result pleases neither proponents nor opponents of securitization, increases the burden on the already underfunded European Supervisory Authorities (ESAs) and, in the end, benefits only financial intermediaries.

So much for STS

First of all, little is to be expected of the initial vow of ‘simplicity’, as the STS framework still allows ‘tranching’ – the process of slicing up a pool of mortgages in several tranches with different risk profiles. This increasingly complicates the calculation of risk. It might also allow for specific types of synthetic securitizations. Here, instead of selling the securitized assets to investors, the originating bank keeps them on its balance sheet and sells only the credit risk through a derivative instrument. So much for keeping it simple.

ECON also heavily debated the risk retention rate, or ‘skin in the game’. What percentage of a securitization should an originating bank keep on its balance sheet? The original proposal said 5%, which critics felt to be too low and banks felt to be the absolute maximum. The amended proposal kept the rate at 5%, with exceptions of up to 10% or 20% if any of the ESAs deem it necessary. By reverting to this type of regulatory discretion, ECON merely exposes its internal disagreement. In practice, most institutional investors (like pension funds and insurers) require the originating bank to retain at least 20% as a sign of good faith.

Another big change ECON made to the STS framework is the setup of private trade repositories in which all securitizations, originating banks and end investors have to be registered, allowing for better supervision by the ESAs. The question arises as to whether or not the underfunded and over-inquired ESAs will be able to fulfil this supervisory task. The real beneficiaries will be the intermediating repositories, which will undertake this new reporting task.

Meanwhile, opponents and proponents of the proposal largely agree, although not all on equally-explicit terms, that the Commission’s argument that STS securitization will finance ‘the real economy’ is a fallacy. The European Central Bank’s (ECB’s) biannual SME survey states that access to finance is the least important worry of European SMEs. Finding customers is the most pressing issue. So, no matter how fiercely the banks open up the securitization taps to free up their balance sheets, there will be no finance-hungry enterprises waiting.

The real beneficiaries

We can, therefore, only guess what the real motivation for promoting securitization might be. One plausible reason is that banks need it to clean up their balance sheets and improve their leverage ratios. Banks are increasingly complaining about all the different ratios they have to comply with (liquidity ratio, net stable funding ratio, leverage ratio, CET1-ratio). Therefore, some balance sheet flexibility in the form of newly-designed securitization might be welcome.

Another possible reason for encouraging the new STS framework is to support the ECB’s purchasing programme of asset-backed securities (ABS) as part of its Quantitative Easing policy. The ECB holds a little over 23 billion in securitized assets. As it will extend its purchase programmes to the end of 2017, it needs more assets to hoover up.

Also, since the global financial crisis, European regulatory and monetary policies have created an endogenous demand for high-quality liquid assets. The ECB’s asset purchase programmes, its Securities Financing Transactions Regulation (SFTR) on interbank funding, and its European Market Infrastructure Regulation (EMIR) on Over the Counter (OTC) derivatives all require high-quality collateral to function properly. Yet this collateral is increasingly in short supply. A new type of safe collateral would be more than welcome.

Now that ECON has amended and voted for the initial STS proposal, the European Parliament will do a first reading in which amendments can still be negotiated. Given the success with which the industry has already sanded off the sharpest edges, and considering the internal disagreement within ECON, Mr Tang runs the risk of ending up with a dead report, similar to that of another initially-promising proposal: the Banking Structural Reform. This initiative to separate trading from retail activities within big banks has been blocked in the European Parliament since May 2015. We may forever regret this long-needed separation of banking activities not coming through, however, the moribund European securitization market is not worth the tears.