Carlos da Silva Costa: Reviving markets in high quality securitisation in
Europe
Address by Mr Carlos da Silva Costa, Governor of Banco de Portugal, at the European
Investment Bank/International Monetary Fund Meeting, Brussels, 23 October 2014.
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Let me start by congratulating the EIB and the IMF for this initiative. It is very important to
assure that the topics chosen for this workshop (SME Securitization and Distressed assets)
be at the forefront of policy makers' and regulators' concerns. A more healthy European
financial system requires progress in these areas.
Six years since the onset of the financial crisis in 2008, output levels in the EU are below
those observed before the crisis. The same is true for employment and investment. Some
countries have fared much worse than this average while adjusting their balance sheets and
external accounts; that has been accompanied by deleveraging in all sectors, along with
changes in relative prices vis-à-vis the rest of Europe in a low inflation environment. All this is
taking place at the zero lower bound on the nominal interest rate, where active monetary
policy can only be unconventional.
The role of financial markets is crucial in this story. But the distinction of the direction of
causality is difficult: is the economy weak because of financial markets or are financial
markets weak because of the economy? The question is often put as: is the problem
supply or demand for, say, credit? If the problem is supply we know for sure one thing:
fewer firms will have access to credit, some will be in trouble and will fail due to this fact; after
many of these firms fail one can naturally state that there is no demand for credit. That is why
it is so important to take care of supply problems. In doing so, policy mistakes should be
avoided. It would be a mistake to simply state that a major policy target is to restart
funding. That would be relatively easy to achieve, by the way: by funding expensive projects
with public funds, independently of their quality. It would also be a mistake to try to boost
artificially any specific financial instrument.
Instead, the route towards a better financial system is one characterized by a level
playing field for all types of finance, with specific choices left to borrowers and savers.
The tax system should also not discriminate, i.e., it should treat symmetrically equity and
debt, so that firms decide on the funding source regardless of the tax advantage of one over
the other. Creating this level playing field will most likely lead to a more balanced and
diversified financial system, i.e., with more options for savers and borrowers. This
competitive environment is key to maintaining financial markets in constant improvement,
characterized by innovation that responds to the insufficiencies of the existing instruments.
Ideally, restrictions to the development of any type of finance should always be clearly
justified on efficiency grounds.
Along the way, the problems faced by the main source of funding in Europe (i.e., banks)
should not be forgotten. Banks do not seem to have liquidity problems; enough steps have
already been taken by the Eurosystem to provide liquidity, in such a way that a typical
balance of payment crisis was avoided in several countries. But investors are suspicious
about the reported balance sheet of banks. Thus, the steps towards the banking union,
the major leap Europe has given to deepen financial integration, including the
underway comprehensive assessment, must be credible. Losses should be recognized
so as to definitely resolve the uncertainty and bring back investors. Once this is done overly
cautious capital requirements ought to be relaxed.
In Europe, banks' assets account for the bulk of financial wealth. And it is expected
that banks will continue for a long time to be the most important intermediaries
between borrowers and savers. In fact, it is not easy to change from a bank-based
economy to a capital market-based economy nor it is clear that this is the best thing to do.
For instance, European firms will have to go through several changes before such shift (if
any) occurs, namely in terms of size, access to information, transparency; in general a
different corporate culture will be necessary. Forcing a shift may be counterproductive. At
the same time, more prudent transformation ratios (say, loans to deposits), coupled with a
lower capacity of banks to attract savings would imply, at least in some countries, that the
ability of banks to lend would decrease; but their willingness would not necessarily decrease,
since they keep the advantaged standpoint to screen and monitor loans. This means that the
implied gap might be filled by actors (insurance companies, pension funds) with greater
capacity to attract savings although with limited capacity to lend directly. Securitisation of
bank loans can be the privileged vehicle through which the gap is filled.
Securitisation is also key when one thinks at impediments to capital relief and at tools
to decrease the perilous geographical concentration of assets in banks' balance
sheets. In fact, if the right incentives are given, securitisation markets are the best way to
more rapidly guarantee that loans are available for capital markets to invest while decreasing
the home bias in banks' balance sheets and ensure that credit is channeled to the best
projects at the minimum cost. That is, securitisation could also have a decisive role in the
integration and deepening of European financial markets, by allowing the transfer of risk from
the originator to investors of any type located in other jurisdictions, in the context of a still
very fragmented banking sector, lacking for instance relevant pan-European banks.
Securitisation is not the silver bullet but it can thus be seen as a seed instrument to
reshape the European economy funding, whereby long-term investors such as insurance
companies, pension funds among other real money investors are given a more important role
in the funding of the economy, while preserving the clients/banks relationship. These real
money investors are natural investors in securitization also because they have long-term
liabilities that ought to be matched by long-term investments.
However, it seems now clear that the changes in the regulatory treatment of ABS in the
aftermath of the crisis, which were to a great extent a response to events in the US,
may arguably have hindered the development of the European ABS market. These
postcrises regulatory proposed reforms (CRD IV and Solvency II) lead to a substantial increase
of the capital charges for investments in securitisations. It is worth mentioning that risk
weighted assets calculated on ABS tranches can be several times the risk weighted
assets of the constituting pool. Further, the due diligence process that must be put in
place to invest in ABS represents a considerable burden. The common practice in the
US of full derecognition of assets also led to regulatory changes with impact on the supply
side, and may have been a main cause of depression in the European ABS market, which in
many cases already had provisions against lack of "skin in the game". The new
regulatory framework also made it harder for originators to get capital relief insofar as the
conditions that must be met in order to qualify for a significant transfer of risk (a necessary
condition to free-up capital) are now much more stringent.
This was unfortunate in the sense that the contribution of this class of securities in
alleviating systemic effects, which should warrant a more reasonable regulatory treatment,
was overlooked; in at least two ways. First, ABS sales are, from an aggregate perspective,
a better way for banks to deleverage vis-à-vis credit supply restrictions. In fact, if many banks
deleverage simultaneously by restricting credit, this will have an aggregate impact on the
total supply of credit, which might end up in a credit crunch. In contrast, deleveraging through
securitisation does not mechanically induce a credit supply restriction, even if many banks do
it simultaneously. In fact, deleveraging through securitisation could provide banks with
enough funding and capital to enable them to increase lending, or, it could help transforming
zombie banks into active players in the economic recovery. Second, there is considerable
home bias in the loan portfolio of banks whereas diversification of assets and reserves
across the euro area, something which is achievable through cross-border purchases of
ABS, could act as an absorber of asymmetric shocks.
All this suggests that the next regulatory steps could justifiably give a more favourable
treatment to ABS. There seems to be a consensus among European authorities and market
participants that simple, standard and transparent securitisations should have a beneficial
regulatory treatment. Speed is now warranted, also given the recent ECB announcement of
an ABS purchase programme, so as to decisively eradicate regulatory uncertainty.
This recent ECB announcement on the launch of an ABS purchase programme, although
decided taking into account monetary policy considerations, is also a game changer in the
reactivation of the ABS market. It reduces the stigma carried from the aftermath of the
financial crisis and it contributes decisively to put securitisation in the policy agenda. The
inclusion of mezzanine tranches in the programme can effectively result in capital relief for
originators. Also, the existence of a European guarantee scheme (possibly using European
funds and with involvement of a supranational institution like the EIB/EIF group) to help
originators achieve a significant risk transfer at an affordable price can be justified under the
current adverse market conditions. It is also important to stress that the focus on ABS based
on SME loans may be counterproductive. ABS based on residential mortgages represent
the bulk of ABS issuance while capital relief associated with sales of these ABS has
also the potential to generate new SME loans.
The above steps depend on us as policy-makers. But one should not forget what
depends less on us but can have a great impact on the securitisation market. I am
talking about rating agencies. It is now clear that rating agencies' models failed in the
recent past as a result of wrongly basing their ratings on the correlations observed during
good times. In my opinion, the recent methodological changes, imposing stricter rating
caps (above the rating of the sovereign), in particular for EMU countries, amount to
treating crisis times as structural changes making the new methodologies based
again on extreme assumptions. Thus, the error is the same, this time in the opposite
direction.
Policy-makers timely acknowledged the fragilities in the design of the EMU, identifying the
most crucial reforms needed. These will increase the robustness of the euro area economies
against adverse shocks. Rating agencies do not fully recognize the ongoing process.
Instead, they decide to change their procedures exactly at the moment in which the
institutional framework of the EMU is responding to the very same conditions that
motivated such move. In this regard, it is important to emphasize that EMU countries are
about to be equipped with a banking union, which will contribute towards breaking the link
between sovereigns and the banking/financial system. Further relevant institutional changes
include the creation of the European stability mechanism, the Fiscal Compact, the new role
of the ECB in eliminating runs on sovereign debt (through the Outright Monetary
Transactions programme) and a comprehensive set of EU regulations aimed at avoiding
fiscal and macroeconomic imbalances. Therefore, rating agencies are moving
countercyclically with the EU institutional advances and risk becoming irrelevant.
On the methodological side, it is quite obvious that imposing caps in ratings based on the
sovereign is equivalent to constraining the results of whatever quantitative models rating
agencies use. This is arbitrary and reduces the information conveyed by the ratings while
leading to severe pricing distortions in assets across countries. Investors in capped securities
will require a premium over similar but higher-rated securities while other investors are
limited by regulation in their incentives to buy poorly rated securities. Additionally, it should
be mentioned that ABS originated in countries under stress have performed
considerably well even during the crisis. Indeed, ABS default rates have remained low in
these countries and at levels comparable to non-stressed jurisdictions (including the US).
Thus, unless clients and regulators have (also) access to ratings without the cap, there
should be minimal regulatory reliance on the ratings. In any case, additional
transparency on loans, the existence of reliable credit registers or credit score systems
should be mentioned as instruments to help market participants understanding better the
European ABS risk profile. Additionally, such information could even support entrants into the
business of assessing credit risk, which currently lacks competition.
Whereas the policy conclusions are often hard to come about, one thing seems clear:
Europe must avoid ending up with zombie banks as well as with zombie firms. Zombie banks
and zombie firms have never been a characterization of a well-functioning financial system
and economy. This is to say that Europe must avoid a lost decade; this is to say that
European policy-makers must be intelligent and fight causes instead of consequences. This
is to say that Europe will be able to maintain its geo-economic and geopolitical influence.
Thank you.