Securitization industry players are questioning the necessity of yet more proposed regulations in Europe, under which securitization activities would be policed as a component of shadow banking.
The addition of such regulation, which would overlap with already existing rules, would restrict the activities of nonbank entities in Europe and could stymie funding to the real economy, market participants say.
In an interview with ASR, Raines & Co. lawyer Marke Raines, said that if there is too much regulation, "investors will not return and you will not see a recovery because it cannot be funded."
He said that the market can probably live with the 5% risk retention requirement implemented through amendments to the Basel II framework and the European Union Capital Requirements Directive (CRD). But the "cumulative effect of various regulations" is stalling the return of the European investor base.
He cited as an example the European Union's (EU) Solvency II Directive that changes the amount of capital that EU insurance and reinsurance companies must hold to reduce the risk of insolvency and that will impose a significantly higher capital cost on ABS investments.
Shadow Banking Overview
In an April 2012 occasional paper on the subject, the European Central Bank (ECB) defined shadow banking as covering activities related to credit intermediation (where lending is not made directly to the borrower but involves at least one intermediary), liquidity and maturity transformation that are outside the regulated banking system.
According to the ECB, the broad definition that defines shadow banking by function and activities instead of entities will allow the monitoring of developments over time and might aid in lessening the extent of regulatory arbitrage.
In terms of securitization, the ECB said this funding mechanism allows for the credit intermediation process to be broken down and aids in maturity transformation by funding long-term assets through short-term liabilities. It also helps liquidity transformation by financing illiquid assets acquired via more liquid liabilities.
The ECB enumerated securitization activities that are considered part of shadow banking - pooling and structuring of ABS and CDOs by broker-dealers; ABS warehousing through trading books and repurchase agreements; ABS intermediation via limited-purpose finance companies; structured investment vehicles (SIVs); conduits and credit hedge funds funded through repo; ABCP; and medium-term notes and bonds.
The bank said that, in Europe, lending activity is seldom moved outside the regulated financial system, although this is true to a lesser extent in the U.K. However, the specter of shadow banking does occur when the original lender sells his claims to an entity that might not be a regulated bank. The bank might also acquire a portfolio of loans to issue ABCP, among other asset-backeds.
Many market participants have taken objection to the term "shadow banking," specifically as it applies to securitization.
Richard Hopkin, a managing director in the securitization division of Association for Financial Markets in Europe (AFME), said that "from the securitization side, first and foremost we don't really like the term 'shadow banking' since it sounds vaguely sinister." Hopkin pointed out that the Financial Stability Board (FSB) had noted this and had said that use of the term was "not intended to cast a pejorative tone on this system of credit intermediation."
However, despite the objections, the phrase is still commonly used.
In its response to the European Commission (EC) green paper on shadow banking, the AFME noted that traditional securitizations are structured as a fund, where a pool is credit-tranched. These include passthroughs where the investors' repayment rights rely on the securitized assets producing cash and how this is timed. As such, this involves no maturity transformation and does not entail any leverage issues.
"Traditional securitizations that fund the real economy - we don't think they should be classified as 'shadow banking,'" he said. "These are almost exclusively done by regulated banks that are already subject to detailed regulation."
The AFME said that regulators need to be mindful of which kind of securitizations can be considered part of shadow banking and what should not fall under this umbrella. In the case of ABCP conduits, for instance, maturity transformation can clearly happen, and there might be a maturity mismatch between conduit assets and liabilities. But, in most instances, this mismatch is absorbed by the liquidity lines offered by banks.
"There are traditional term securitizations that do not create maturity transformation or leverage issues, which are issues of concern with shadow banking," Hopkin explained. "ABCP is slightly different since there can be a maturity transformation if long-term assets are financed by short-term commercial paper." In this case, he said, the sponsoring bank that provides the liquidity line is already regulated.
Evolution of Shadow Banking Regulation
Increasing concerns about shadow banking prompted a request by G20 leaders at the November 2010 Seoul Summit that the FSB, together with other international standard-setting bodies, come up with suggestions on how to strengthen the oversight and regulation of the shadow banking system.
In an October 2011 report, the FSB listed initial recommendations to monitor shadow banking that the G20 leaders endorsed when they agreed to strengthen the oversight and regulation of the system at the Cannes Summit in November 2011.
In its progress report on the issue addressed to the G20 ministers and governors and published in April 2012, the FSB reported that the International Organization of Securities Commission (IOSCO) and the Basel Committee on Banking Supervision had examined retention requirements and measures to enhance transparency and standardization related to securitization.
The IOSCO structured the work into two phases where the EC and the U.S. Securities and Exchange Commission (SEC) made an initial comparison of securitization rules in the EU and the U.S. It then published a consultation in June based on findings from a survey conducted by IOSCO's Task Force on Unregulated Markets and Products (TFUMP).
The paper was open for public comment until Aug. 6 (see story on page 28). The IOSCO asked industry participants to comment on the differences in approaches to risk retention requirements between the U.S. and the EU, transparency issues such as disclosure of information about stress testing and scenario analysis and standardization of disclosure.
A spokesperson from the IOSCO said once the comments are received the organization will draw up final recommendations, principles or guidelines. Although these guidelines are not binding, the commission usually tries to implement or adopt them because there is a general consensus that regulation should converge as much as possible to prevent regulatory arbitrage.
Antoine Chausson, who is part of the portfolio management transaction group in the fixed-income division at BNP Paribas, said banking regulators responded to the crisis with extensive rules to strengthen banks, with Europe racing to implement new regulations first. However, in the process, they may not have fully considered the immediate adverse consequence on the financing of the economy.
Since shadow banking finances a big portion of the financial economy, "any type of shrinking in this segment results in a reversal in the broader market," Chausson explained. This is further exacerbated by the financing structure of the European economy where banks provide more than 70% of the financing versus about 25% in the U.S. Therefore, regulation leading to a sharp contraction of bank financing will have a much larger impact on the European economy. This would have the unintended consequence of putting more pressure on the shadow banking system to pick up the slack and avoid a massive funding shortfall of the European economy.
AFME's Hopkin said that the challenge around the discussion on shadow banking for policy makers is to define clearly the nature of the perceived problem. To help achieve this, AFME has recommended regulating activities rather than entities, and then only in a proportional and targeted way.
"One can never be 100% sure that regulation is 'innovation-proof,' but regulation can be - and often is - revisited from time to time. Activities can undergo mutation, and of course it's fine to monitor developments and then regulate further if it becomes appropriate," Hopkin added.
One of the problems in regulating shadow banking is rules piling on top of one another.
A case in point is that regulators are basically overseeing the activities of the nonbank sector through directives such as Solvency II, which regulates insurance companies and pension funds. There are also regulations such as the Alternative Investment Fund Managers Directive and the Undertakings for Collective Investment in Transferable Securities Directives for fund activities.
Chausson said that beyond currently regulated shadow banking entities, regulators are now potentially looking at other entities that might be deemed to pose systemic risk as they review credit activities taking place outside the banking system.
Effectively "we're convinced shadow banking should be viewed as a complementary activity to acquire and fund assets originated by highly regulated European banking origination activity," he said.
He added that when they look at shadow banking or the funding provided by the nonbanks, they look at a wide range of tenors and sectors: from short-term assets - mostly receivable types, funded via short-dated corporate funding conduits - to consumer finance, such as residential mortgages, credit card and auto loans, to corporate loans (via CLOs) and onto specialized, long-dated export finance, transportation and project finance.
According to Chausson, Basel III puts constraints on these long-dated specialized finance activities through liquidity ratios that would require matched long-dated funding. "This will be the major challenge for funding infrastructure and supporting European manufacturing of heavy capital equipment for exports," Chausson said.
AFME's Hopkin cited the current discussion going on about the revisions to the Capital Requirements Directive, known as "CRD 4," which is intended to enhance the financial soundness of credit institutions such as banks, building societies and certain investment firms.
He said that if ABCP activities are regulated on the shadow banking side, this illustrates the regulatory layering effect because the sponsoring banks providing the liquidity lines are already regulated under the CRD. Two layers of regulation should prove "unnecessary," he noted. "This industry, in many respects, is being regulated over and over again, particularly in Europe."
Regulators are obviously trying to prevent what has happened in the past from reoccurring. However, market participants believe that the learning process has already started, even without increased regulation.
Raines acknowledged that there has been market misbehavior in the past, including the lowering of some rating standards and inadequate disclosure of risks.
And riskier entities, such as SIV-lites backed by questionable assets, were created and rated. However, while these entities have all but disappeared from the market, the technology behind many of the "non-lite" SIVs remains sound. "SIVs had been around for more than 18 years prior to the start of the credit crisis and were important investors in the ABS markets," he said.
Moreover, the misuse of CDOs through structuring and disclosure errors "does not invalidate many of the basic techniques."
"You cannot regulate shadow banking activities prospectively because you cannot forecast the development of new products and techniques," Raines said. He also said that regulators are developing rules on the false premise that regulatory intervention can resurrect the debt markets.
A closer integration of the rules is needed. For instance, Chausson said that in terms of the global banking regulations, harmonization has become a key issue as Europe has implemented the Basel II, Basel 2.5 and Basel III within four months through Capital Requirements Directives (CRD1/CRD3/CRD4) much earlier than the U.S. The Basel Accords are meant to regulate the capital banks by obliging them to retain part of the risk by investing a portion of their own capital in any securitized vehicle.
For instance, Basel III puts constraints on long-dated specialized finance activities through liquidity ratios that would require banks to put up matched long-dated funding.
"This will be the major challenge for funding infrastructure and supporting European manufacturing of heavy capital equipment for exports," Chausson said.
Loan origination requires an extensive expertise, he said, and replicating that would not only take a long time, but would possibly divert resources best focused on analysing and acquiring such long-dated assets originated by banks. "That's why we are looking at, a complementary set up where banks would originate credit while long-dated investors would participate in it."
For long-term funding, the natural place would be European insurance pension funds that would be regulated by Solvency II, which is currently being worked on.
Unfortunately, this piece of legislation "discriminates against securitization with capital charges widely in excess of the underlying economic risk: for instance, a five-year, 'AAA' senior tranche of a residential mortgage portfolio with LTV below 75% would require 35% of capital, while an insurer acquiring the full underlying mortgage portfolio would have almost no capital charge, " he said.
Chausson mentioned an "interesting proposition" from the Pension Corp., a provider of risk management solutions, that advocated that instead of another round of quantitative easing, the Bank of England should basically buy long-dated infrastructure loans from banks and sell them into pension funds, "which nails a key issue of how to effectively address the mismatch highlighted by the liquidity ratio on the banks' balance sheet and at the same time match long dated liabilities of the pension fund sector. Matching a long-dated infrastructure project finance, with a long-dated investor - this will present the project bond market with a huge potential to fill the funding gap for infrastructure over the next few years," he said.
In addition, there is also the issue of harmonization between Europe and the U.S. Europe has taken the lead with regulation affecting securitization, including CRD 2 and regulations governing credit rating agency activities. Extra territoriality often penalizes European banks operating in the U.S. by imposing an overlay of European regulation over the local U.S. regulation.
"How do you level the playing field? Thankfully, IOSCO is already working on the harmonization of the securitization rules across regulatory environments," Chausson said.