Yves Mersch: Banks, SMEs and securitisation
Speech by Mr Yves Mersch, Member of the Executive Board of the European Central Bank,
at the Deutsche Börse - Clearstream "Exchange of ideas" event, London, 7 April 2014.
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Overcoming the current challenges faced by small firms
Ladies and gentlemen,
It is a pleasure to speak at this conference today. In my remarks I would like to address what
I see as the key challenge in the euro area today: how to fix the flow of credit to the real
economy.
During the crisis the credit transmission channel has become impaired in three
mutuallyreinforcing ways. First, as regards quantity, aggregate loan growth continues its steady
deceleration and remains very heterogeneous across the euro area. Second, as regards
price, low Eurosystem policy rates are simply not being passed on in certain countries.
Third, as regards distribution, smaller firms appear to be suffering more from price and
quantity effects, especially in weaker economies. Certainly, the reasons for these
blockages relate in part to demand-side factors, but the supply-side - banks' capital levels
and risk assessments - remains an important part of the story.
A malfunctioning credit channel has several unwelcome consequences for the real economy.
It impairs the transmission of monetary policy throughout the euro area. For borrowers in
weaker economies that are undergoing a relative price adjustment, tight credit means that
real interest rates are rising while relative prices are falling, thus pushing up the real cost of
servicing debt. And it also impairs the allocative efficiency of the real economy, as credit is
allocated away from the smaller and younger firms that are by nature more risky yet create
the most net jobs. As 99.7% of firms in the EU are SMEs, this is a crucial issue to be solved.
The fortunes of the euro area economy are intertwined with the financial health of SMEs.
One solution to this problem could be for firms to bypass the bank lending channel and
replace bank finance with capital market finance. This trend has already been observed for
larger corporates, with European corporate bond issuance expanding rapidly in the last few
years. However, for SMEs accessing non-bank finance is often simply not an option. Indeed,
non-specialised investors and lenders are often wary of firms facing high degrees of
competition and limited growth prospects, particularly if those firms have only existed for a
short while. That is why SME lending is currently highly concentrated among a handful of
large banks that have the scale and capacity to diversify idiosyncratic risks by investing or
lending to a broad enough range of SMEs.
In other words, SMEs will remain largely dependent on a subset of banks for the foreseeable
future. The key question then becomes, in the context of an already-accommodative
monetary policy stance, how the role of banks in providing SME finance be structurally
improved?
I believe there are two channels. First, through the Asset Quality Review transparency will be
increased and investors' confidence can be restored. Removing the blockages created by
non-performing legacy assets can unclog banks' balance sheets. Once banks' balance
sheets are cleansed and strengthened and the market is reassured about the stability of
European banks, they should be able to begin lending again. Second, connecting SME
financing needs with the funds of bank and non-bank investors via securitisation of SME
loans can assist banks' ability to fund and distribute risk. Both channels have the advantage
of not interfering with the allocation mechanism of a market economy.
As the Asset Quality Review is already receiving much attention, thus I will focus the
remainder of my talk on the second channel.
The benefits of SME loan securitisation
Let's pull together what we know right now. First, we know that SME lending in weak
economies is risky. Second, we know that many banks are reluctant to take on additional risk
on their balance sheets and indeed are trying to deleverage and reduce their balance sheet
risks. Third, we know that non-bank investors in many parts of Europe and abroad are
seeking investment assets with maturities and returns that match their liability profiles. I am
thinking both of insurers and pension funds, but also alternative investors such as hedge
funds. There are also many banks willing to hold ABSs1, but are reluctant to do so, for
reasons that I will address later.
So we have a situation where certain banks own assets with risks and capital charges that
they do not wish to bear. On the other side, there are investors who are willing to bear those
risks. In my view, this is a match that should happen in an efficient financial system, and
securitisation of SME loans is the way to achieve it. What is more, the funds received by
banks from transferring bundled SME loans to outside investors can help support new
lending, also to SMEs, and in turn support further securitisation.
One might rightly ask whether SME ABSs are too risky to deserve a comeback. After all,
memories of the US sub-prime mortgage crisis are still fresh in the minds of many market
participants. As a result, the conventional wisdom is that securitisations pose financial
stability risks and should be largely discouraged by regulators. Thus we have seen a general
drive to tighten the framework based on prudential grounds, both at the EU and international
level. Let us break down the possible sources of securitisation risk and see what the facts
are and whether the conventional wisdom is justified.
First, there is the risk that underlying assets are of poor credit quality. This indeed is a very
real possibility, as demonstrated by the actions of many mortgage lenders in the US during
the mid-2000s. Even in the EU, where loan underwriting standards are generally higher, loan
delinquencies in certain weak economies have reached double-digit levels. Subject to certain
legal conditions, securitisation allows originators to remove securitised assets from their
balance sheets, which may give an incentive to move off the riskiest loans and package
these for unsuspecting investors.
Yet we must also remember that important and sensible counter-measures have been put in
place since the 2007 US sub-prime crisis. For example, since 2011 EU lenders are required
to retain a share of the resulting ABS, which motivates them to securitise better quality
assets. Furthermore, the Capital Requirement Regulation requires that originators apply the
same underwriting criteria to loans which are securitised as those applied to loans that
remain on the balance sheet. In addition, measures such as the recently-adopted Mortgage
Credit Directive will improve underwriting standards across the EU.
But crucially as well, unprecedented levels of transparency have been brought to the EU
ABS market thanks to the establishment of loan-by-loan reporting requirements in the
Eurosystem and elsewhere. Transparency not only helps expose risks, but also acts as a
disciplining device. It reduces information asymmetries between originators and investors. It
is now possible for investors to independently analyse the credit quality of the loans and to
assess correlation risk across the portfolio - for instance, the concentration of loans to, say,
construction firms that are collateralised by real estate. This scrutiny discourages banks to
package many of these loans in an ABS. And let me add that transparency requirements are
doubly-effective because it is investors who are tasked to perform the due diligence on ABSs
and verify that lenders comply with risk retention requirements.
So we see that the worry about underlying asset quality is likely to be confined to a number
of increasingly-verifiable cases.
The second source of ABS risk is at the level of the structure itself. It is true that ABSs are
complex instruments, involving many parties to a transaction and a range of possible
constructions. Many in this room will be well aware of terms such as re-securitisations,
synthetic transactions, and revolving structures. These arrangements indeed add complexity,
but I must emphasise that the majority of current EU ABSs are static pool, true sale
structures, especially the SME ABSs we are interested in. Let me also add that senior
European SME ABSs generally have consistently greater credit enhancements than nearly
all other senior EU ABSs, certainly so in relation to the delinquencies in their asset pools.
In addition to credit enhancement, I cannot avoid mentioning the role played by the
Eurosystem collateral eligibility criteria in influencing the ABS structures we see today. The
criteria impose strict conditions, for example requiring a proper legal true sale, allowing only
publicly listed senior bonds with a minimum rating, and collateralised by granular
homogeneous asset pools. Obtaining Eurosystem eligibility, and thus the prospect of access
to funding in an emergency, acts as a powerful incentive for ABS issuers to structure
relatively high-quality deals.
Given these asset pool and structural safeguards, it is not surprising that there have been
very few European ABSs' defaults. Depending on the study and starting date, since the
start of the 2007/08 financial crisis defaults range between 0.6-1.5% on average, against
9.3-18.4% on average for US securitisations. What is more, European SME ABSs are far
below both broader EU and US securitisation default rates, with defaults occurring on
about 0.1% of instruments. And, even more convincingly, our internal analysis suggests that
ABSs eligible for Eurosystem operations have historically had impairment rates even lower
than non-eligible ABSs. This suggests again that sensible asset and structural safeguards
can go a long way to mitigating the risks of investing in ABSs.
Strengthening the SME securitisation market - looking forward
I have already discussed the potential role that SME ABSs could play in unlocking additional
affordable credit for European SMEs. Many SME ABSs, in particular those eligible for
Eurosystem operations, are on the lower end of the risk spectrum. The final piece however is
to discuss how we can revive EU securitisation markets, including SME ABS markets. As
has been widely discussed, both publicly placed issuance and secondary market activity has
lagged in recent years.
What can be done to stimulate these markets? First and foremost, I believe it is important to
recognise that ABSs come in many shapes and colours, and therefore ABSs can be
structurally different in terms of risk profile. From the various statements made by myself and
also the ECB-President in recent months, I think it is clear to everyone that the ECB feels
that EU ABSs are being treated inappropriately by present regulations and proposals.
What is the issue here? The securitisation capital framework is currently being overhauled at
the international level, with proposals being calibrated largely on a single pool of data that
does not reflect differences in standards across the world, does not reflect the structural
differences across ABS deals, and does not reflect the vastly-different default performance of
SME ABSs at the European and global level. Nor can the proposed calibration fully reflect
the future benefits of recently-adopted regulatory enhancements. For example, how does
one capture the benefit of having loan-level data and more standardised investor reports in a
numerical calibration? The resulting strict risk weights in the current discussions may, I fear,
not only curtail any growth in EU SME securitisation markets, but further damage the market
from its current state.
The revised securitisation framework should reflect the risk-mitigating features of high quality
securitisation. It is therefore important that the EU moves ahead swiftly in addressing
inconsistencies in the treatment of high quality securitisation.
The EU has already innovated in certain areas, for example introducing preferential risk
weights for certain covered bonds. I do not wish to claim that ABSs present as low risks as
covered bonds, but it is odd that certain covered bonds can earn preferential risk weights
even though they are not subject to the same tight standards regarding transparency and
harmonised regulatory frameworks at the EU level, such as ABS risk retention requirements.
It is also odd that proposals for insurer securitisation capital requirements would require far
more capital than if an insurer held the underlying asset pool directly. These are level-playing
field issues that are specific to the EU and, in my view, should be kept in mind when
reflecting on the EU-specific securitisation framework. In any event it reasonable to (re-)
establish the consistency in the regulatory treatment across asset classes without prejudice
to prudential principles.
What would I propose then? This of course needs to be carefully studied but I can already
tell you that I favour distinguishing securitisation instruments into several categories, and
assigning preferential treatment only to instruments meeting the strictest requirements. The
key question of course is what criteria to use, and here I believe that, in order to avoid too
much regulatory complexity, a principles-based approach makes sense. Yes, one can also
go down the route of detailed calibrations, however from our own experiences with the
Eurosystem collateral framework, we have found it is simpler to set out broad eligibility
criteria, and then conduct detailed numeric analysis on those counterparties and assets that
'get through the gates'. In fact, I would propose that central bank ABS eligibility criteria could
form a useful starting point for identifying 'qualified' ABSs. This is because these criteria are
determined using a common risk-tolerance threshold, are widely-accepted by market
participants, and are set without conflicts of interest. Of course, we should not entirely rely on
central bank eligibility criteria. In this regard I believe the approach recently developed by
EIOPA, and partly inspired by the Eurosystem eligibility framework, has many merits, not
least being relatively simple while managing to exclude many particularly-risky ABSs.
Having defined criteria for so-called "high-quality securitisation", the next step is deciding
what treatment to grant. There is more room to manoeuvre than is generally recognised. For
example, supervisory parameters can be adjusted in the current securitisation proposals. Or,
there is always the option of adopting straightforward preferential risk weights in a similar
manner to covered bonds in the Capital Requirements Regulation. These arrangements
could then be reviewed should the Basel Committee reach an agreement on a similar
framework. What is key however is that action is taken soon: let us not forget that the
investors I mentioned above will not simply grin and bear higher risk weights - they will
simply put their money elsewhere, and fund growth in other asset classes that are not being
treated so strictly but where investment may not be, from a macroeconomic perspective, as
desirable.
There are of course other barriers to the securitisation market not addressed in my remarks,
for example the somewhat-arbitrary imposition of caps on ABS ratings by certain credit rating
agencies, which are becoming increasing untenable, not only view of asset performance but
also because of structural reforms in the euro area institutional structure, not least banking
union and the single resolution mechanism. In addition, the Liquidity Coverage Ratio also
leaves out some ABS types that could have been included in my view, however taking a step
back it seems that an appropriate capital treatment is more important to achieve right now,
because with too-high capital requirements European ABSs are unlikely to be created in the
first place, much less traded.
Conclusion
Let me conclude.
We have seen that SME ABSs can play a key role in bridging the gap between deleveraging
banks and investors seeking to diversify their portfolio. There is growing recognition that,
first, European securitisation instruments had a far better performance than their US
counterparts and, second, significant policy improvements have been made which deem the
regulatory calibration based on the worst performing global transactions and assets as
inappropriate. Yet the potential for SME ABSs to provide some funding relief for SMEs is
limited in part by the current proposals to overhaul the securitisation credit risk framework,
and is also limited by level playing field issues within EU regulations and proposals.
It is not too late to change course: not all EU securitisations deserve the stigma attached to
them for the past few years. There is a need to restore coherence across financial sectors in
particular amid the unfavourable regulatory treatment of (high quality) securitisation
instruments without violating prudential principles.
By doing so we must act fast and in a manner that is sensitive to our own European reality. If
the Bank of England and the ECB were to put forward a joint statement on this issue at the
forthcoming IMF Spring Meetings, it would underline the European determination to
decisively move forward.