Make Europe (securitisation) great again

Europe pioneered mortgage-backed bonds before the US was even born, but today its securitised bond market is a runt compared to America’s. Mario Draghi thinks that should change.

MainFT has already written up the main gist of Draghi’s The Future of European Competitiveness report, but FTAV couldn’t resist a deeper look at it to see if it was all the usual guff that has been said many many times before. Luckily, several sections caught our eye.

First of all, Draghi argues that Europe should get over its hangups and actively nurture much more securitisation.

This report recommends that the Commission makes a proposal to adjust prudential requirements for securitised assets. Capital charges must be reduced for certain simple, transparent and standardised categories for which charges do not reflect actual risks. In parallel, the EU should review transparency and due diligence rules for securitised assets, which are relatively high compared to other asset classes and reduce their attractiveness. Setting up a dedicated securitisation platform, as other economies have done, would help to deepen the securitisation market, especially if backed by targeted public support (for example, well-designed public guarantees for the first-loss tranche).

Intrigued, we downloaded the separate “in-depth analysis and recommendations” report, hoping for more meat on the bone. Sadly, there weren’t tons, but here are the concrete steps that Draghi thinks the European Commission should pursue.

— The Commission should make a proposal to adjust prudential requirements for securitised assets First, capital charges must be reduced for certain STS categories for which the capital charge is not reflecting the actual risk

— Second, a targeted and appropriate reduction of the p-factor should be considered (which increases capital requirements for securitised assets and under the current rules is criticised for being excessive and discouraging securitisation, in particular, for corporate and SME portfolios)

— The Commission should review transparency and due diligence rules to facilitate issuance and acquisition of securitised assets Currently, the transparency requirements for these assets are relatively high compared to other asset classes and reduce the attractiveness of securitised assets for financial parties

— The EU should set up a securitisation platform to deepen the securitisation market, like other economies also have done This would reduce costs for banks (especially smaller ones) and could foster standardisation in securitised products More standardisation would make investing in securitised products also more attractive

— The EU has to consider targeted public support (for example, well-designed public guarantees for the first-loss tranche) This could encourage issuance and increase lending in certain sectors that are particularly relevant for competitiveness, while ensuring adequate incentives for risk management

This all makes a lot of sense. Draghi makes the point that annual securitisation volumes in Europe run at a rate of about 0.3 per cent of GDP a year, compared to 4 per cent in the US. Narrowing that gap would be a huge boon.

The king of online brain rot also seems to agree, however, which does give us pause.

Of course, Europe also has a ca €3tn covered bond market – this is the market that dates back to Frederick the Great rebuilding Prussia after the Seven Years’ War – and there are lots of people who think this is a superior structure.

These are bank bonds collateralised with a pool of underlying mortgages. Thanks to the double recourse (investors have security both in the bank and the hived-off assets) and over-collateralisation (banks usually stuff mortgages worth far more than the covered bond into the collateral pool), no covered bond has ever defaulted. Which, well, is not a boast that US MBS can make.

However, there are some downsides to covered bonds — mainly the fact that it’s basically just a form of cheap bank funding. A covered bond doesn’t actually move any assets off a bank’s balance sheet, so they don’t free up capital for new loans.

As Draghi points out:

Securitisation makes banks’ balance sheets more flexible by allowing them to transfer some risk to investors, release capital and unlock additional lending. In the EU context, it could also act as a substitute for lack of capital market integration by allowing banks to package loans originating in different Member States into standardised and tradeable assets that can be purchased also by non-bank investors.

The other main bit that jumped out for FTAV was Draghi urging Europe to move forward with “capital markets union” project that Jean-Claude Juncker launched over a decade ago.

To do so, Draghi says Europe should introduce a harmonised insolvency regime to replace the current hodgepodge of messy, opaque and often unpredictable national systems, and transform the European Securities and Markets Authority into a true, supranational and independent European SEC.

This isn’t a new idea, but intriguingly it echoes precisely what Christine Lagarde, Draghi’s successor at the ECB, has also been arguing lately. Draghi and Lagarde are heavyweights, and we assume they wouldn’t be making the case so forcefully if there wasn’t something to it.

The recommendations report also goes into far more depth on this topic. Here are its main bullet points, which we’ll quote in full because the details matter (it even included a rough suggested phasing of supervision to overcome resistance from national regulators and the finance industry).

— As a key pillar of the CMU, ESMA should transition from a body that coordinates national regulators into the single common regulator for all EU security markets. To this purpose, ESMA should be entrusted with exclusive supervision over: (i) large multinational issuers (i e those with subsidiaries in various EU Member State jurisdictions and revenue, and/or total assets above a certain threshold, a natural identifying criteria would be issuers belonging to major indices such as the CAC40, DAX, Euro Stoxx 50, FTSE MIB, IBEX 35, or else — if one wants to be more encompassing — the STOXX Europe 600); (ii) major regulated markets with trading platforms in various jurisdictions, such as EuroNext (where ongoing supervision would be done by ESMA, while sight visits might be done by joint supervisory teams with national competent authorities (NCAs, such as Consob, AMF, BaFin, CNMV, CONSOB, etc ); and (iii) central counterparty platforms (CCPs)

— An essential step to transform ESMA into a regulatory and supervisory agency similar to the SEC is to modify its governance and decision-making processes along similar lines as those of the ECB Governing Council, so as to detach them as much as possible from the national interests of EU Member States. Currently, ESMA’s governing bodies are composed of national competent authorities, plus the Chairman and some non-voting members. To enable ESMA to take swift and decisive action in sensitive areas, it would be important to add six independent and highly-qualified individuals, including the Chair, to ESMA’s Management Board, as proposed by the Letta report. Another all-important step in this transition is to shift EU security market legislation to a principles-based approach, outlining the key strategic policy choices of co-legislators, while delegating technical work to ESMA, and enhancing its powers to develop and change technical rules and streamline their adoption; and increasing its funding to enable it to efficiently carry out its regulatory and supervisory tasks.

— To overcome likely opposition, the EU regulator will have to share supervision with national regulators and elicit their cooperation along lines similar to what the ESM does with national central banks in euro area bank supervision. Turning national security market regulators into subsidiaries of a single, EU-wide one will face fierce resistance, not only by the national bureaucracies that will feel directly displaced, but also by trading platforms and market participants who draw sizeable rents from the status-quo fragmentation, as suggested by both theory and evidence. Therefore, tactically wise steps would be to: (i) leave the supervision of purely local issuers to national regulators, as done for the prudential supervision of smaller banks within the Eurosystem; (ii) start from the supervision of issuers and market structures, and subsequently turn to that of mutual funds, which is likely to be more controversial; (iii) create Joint Supervisory Teams between ESMA and national supervisors to supervise significant issuers and market structures, and mechanisms to ensure a constant and timely information flow among them.

If Trump wins the presidency and ousts Gary Gensler, maybe he could come over here and do a job?

Further reading:

– A Kantian shift for the capital markets union (ECB)