After nearly two years of negotiations, new legislation to revive securitisation markets in a sustainable way has been agreed between the European Parliament and the Council. This represents a major step towards the creation of a Capital Markets Union. The legislation draws lessons from the past, building in particular on the characteristics of those securitisations that did well during the global financial crisis. Such simple, transparent and standardised securitisations will offer an effective funding channel to the economy.
Securitisation in a nutshell
There are three stages to securitisation. First, a lender – frequently a bank – pools a set of loans, assets or other receivables (such as mortgages, car loans, consumer loans, credit card receivables). Next, this pool is converted into tradable securities by selling it to a separate legal entity which in turn issues the tradable, interest-bearing securities. These securities are grouped into different priorities of payment (or "tranches"). During the maturity period of the security investors are then repaid by the cash-flows generated by the underlying loans. Buyers of different tranches face different levels of risk that their investment will not be repaid. However, higher risk normally also carries higher reward.
The three steps to creating a securitisation of mortgages
Source: European Commission
Recognising the potential benefits of better-developed securitisation markets to the EU economy, the Commission proposed comprehensive new rules for EU securitisation markets in September 2015. The proposal was based on extensive work of EU supervisory authorities as well as central banks, supervisors, trade bodies, academics and institutions from across the EU and beyond. Its aim was to revive the EU securitisation markets while protecting investors and containing potential systemic risks.
The final text agreed between the European Parliament and the Council at the end of May closely reflects the Commission's initial proposal. It includes a set of minimum requirements for all securitisations and an additional set of criteria to identify simple, transparent and standardised (STS) securitisations. So the regulation requires that, for all securitisations, at least 5% of the securitised loans or assets must be retained by the originator ('skin in the game'). But in order to qualify for the new STS label, securitisations have to comply with a catalogue of further requirements, such as increased transparency on the securitised loans or assets. On the flip side, the new prudential treatment for banks and insurances as investors favours STS securitisations, recognising the strong performance of simple, transparent and standardised securitisation structures that generated only minimal losses during the financial crisis.
The new legislation will facilitate efficient and effective risk transfers to a broad set of institutional investors and help securitisation to work as an effective funding mechanism for banks as well as some non-banks, such as car manufacturers. It will also help relevant parties, particularly investors, evaluate the risks of a particular securitisation and across similar products.
The new rules will become EU law by the end of this year and the Commission believes the implementation of the securitisation package could help unlock significant amounts of additional funding to the real economy.
Learning from the past
Securitisation is a vital funding tool that can help free up banks’ balance sheets so they can lend to households and businesses. But the experience in the Unites States during the 2008 financial crisis showed that securitisation can only be beneficial to the economy if it is sound and well-structured. Indeed an important lesson from the financial crisis was that, whatever the underlying assets packaged in a securitisation, the securitisation structure itself can represent a source of risk: complex and opaque structures may render it hard for some investors to understand the cash flow-generating mechanism and where disruptions may arise in the future. So the Commission has put great emphasis on the need for high-quality, transparent structures and processes to ensure that the flawed products that were the catalyst for the financial crisis in the US are not allowed to return.
The overall goal is for Europe to benefit from a deep, liquid and robust market for securitisation, one that is able to attract a broader and more stable investor base to help channel funding where it is most needed in the economy. For this reason, the securitisation initiative has been a central part of the Capital Markets Union initiative, which aims to develop financial markets that can complement and support the traditional channel of financing of the EU economy – banks.
For more information on securitisation rules