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A Vote of Confidence

31 May 2017 by Rob Ford

The European ABS market has had incredibly strong fundamental performance even throughout the last decade of economic turbulence, and yet it has been re-regulated and re-rated more than once, with harsh implications for market participants.

Last night following several years of development and months of negotiations between policymakers, the final terms were agreed for the new securitisation regulatory framework, crucially including a successful resolution of the “risk retention” proposals which sit at the heart of the rulebook.

Understandably perhaps, albeit arguably somewhat unfounded, regulators made knee-jerk changes to securitisation regulation in the fallout of the financial crisis. However, having subsequently recognised the value of revitalising securitisation as an important funding tool for promoting growth in the real economy, European regulators, policymakers and politicians have been aiming to create and finalise a new regulatory framework for securitisation markets based around standards of best practice and embracing the principles of quality, transparency and simplicity.

This concept goes back a long way to the Prime Collateralised Securities (PCS) initiative, a best practice standard developed by the industry itself through 2011 and 2012, and a process that TwentyFour was an integral part of.

This was followed by numerous consultations from the likes of the Bank of England and the ECB amongst others and finally the development throughout 2015 of a number of proposed criteria.  Whilst not perfectly aligned, the European Commission and the European Council’s respective proposals laid the groundwork for a practicable regulatory framework, designed to encourage new investors and issuers to engage with the market.

Then.….enter the politicians!

Few of you will be surprised to hear that they wanted to make their own mark on the asset class – merely approving what had been suggested by the experts would not do – and one area of focus was the “risk retention requirement” and a significant increase to the original proposal.

No one denies that a lack of alignment of interest (or “skin in the game”) was a major part of why the US Sub-Prime RMBS market collapsed in 2007.  By selling all of the risk, issuers were not incentivised to look after their transactions when things got tough.  For the most part, this was never the case in Europe – most banks actually wanted to retain the first loss risk of their deals as this was their running profit margin on each transaction.  Nevertheless, there followed an introduction of global risk retention rules requiring originators/sponsors of all securitisations to retain a minimum 5% exposure to each transaction to ensure their interests were aligned.  Issuers and investors alike were happy with this rule as it was considered an appropriate but not overly onerous incentive. The European Parliament then suddenly proposed increasing that to 20% for all European deals!

Forcing such a significant amount of capital to be put into each deal not only showed a complete disregard for strong historic performance, but also made the issuance of ABS as a funding tool much less efficient and therefore materially less likely as other forms of funding such as covered bonds and even unsecured debt have no such requirement.

Needless to say, negotiations have been fractious over the past year with various sets of compromise proposals leading to a watered down version being put before the Trilogue discussions (essentially a series of bargaining meetings between the three authorities) which began at the start of this year and the last of which took place last night.

As the meetings have progressed throughout the year, the Commission and the Council have remained firm on this point, their rationale being that 5% is enough and that deviating from the global standard would be disastrous for the future development of the European market.  This view was bolstered by comments from Mario Draghi in the last few days who told the Trilogue delegates:

“We … suggest special care about raising the risk retention ratios, because, if you want to re-introduce this instrument [securitisation] for the financing of the real economy, we think that the features of the instruments being discussed are safe enough as they are”.

He went on to say “too high risk retention shares threaten to hamper the spread and the success of the instrument itself”.

Central bankers are not known for hyperbole, and we would view this as being as strong a vote of confidence in an asset class as could be expected.

Whilst there were also a number of other no-less important but more technical issues being tabled in the meeting, a successful outcome for this point was crucial to the future development of the market.

Late last night we heard from the corridors of Brussels that the issue has been resolved successfully, and this will certainly go a long way to removing the uncertainty that has been overshadowing the ABS market and the full suite of regulations, once implemented (which may of course still take some time, given the speed that the policymaking machines work at) should be beneficial for all concerned.

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