Thursday, 24 January 2019

The prodigal’s return

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  • The prodigal's return

A new eurozone SME loan securitisation strategy is taking shape in the effort to boost the real economy.

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They may not yet be draping a fine cloak across his shoulders, but there is no doubt European banking authorities are trying their best to welcome the prodigal son of the capital markets – the asset-backed security – back into the fold.

Recent overtures by the European Central Bank to a troubled offspring sent a clear signal that securitisation – described by the Bank’s president Mario Draghi in May as “long-dead” – could play a key role in reviving the SME credit market to oil the wider recovery.

But with the recession officially over (for now), the prodigal might be forgiven for feeling confused – blamed for being a catalyst for the global liquidity crisis, yet also seen as part of the solution.

Prior to the crisis, benign conditions generated a global explosion in securitisation issuance, peaking at what Credit Suisse put at around US$4trn in 2006, which was at the epicentre of the profligate lending in the US housing market in 2005–07.

Not all structured finance securitisation was unsound, yet the backlash in the US tarnished by association a legitimate funding tool in Europe – and issuance slumped.

Seeking protection from risk

“I think if you look at what happened since 2007–08, ABS has been seen by some as one of the many contributors to the credit crisis, or certainly a trigger – mainly in terms of US subprime and certain CDOs – and in Europe in particular some stakeholders have a negative view on ABS, meaning that there was and still is the attitude that you need to protect institutional investors from taking too much ABS risk,” said Christian Aufsatz, director of Barclays European ABS research team.  

European regulators are now reassessing ABS as they reconsider the role capital markets can play in boosting the real economy – and in particular the SME sector, which contributes a substantial portion to European GDP and hence is key to wider recovery.

“The capital markets, particularly the fixed-income markets, are crucial to the real economy, and while austerity has been a main theme of government policies over the past four years, this is now being supplanted with policies driving growth, particularly in the SME sector,” said Sean Taor, head of European DCM at Royal Bank of Canada.

Prohibitive costs, the sovereign debt crisis and CRD IV are still forcing banks to ration capital, stifling access to finance for SMEs, especially in peripheral European countries. Securitisation allows banks to redistribute credit risk while potentially slashing the cost of capital associated with SME lending.

It has been a default position to blame a shortage of credit on the banks, but ECB lending surveys suggest that demand remains weak.

Moreover, the Basel capital methodology is punitive on SME lending – by definition an unrated credit that is both capital-inefficient and economically inefficient for banks to process.

Easing financing conditions has duly risen up the agenda of the ECB as it has grown more worried about limited credit flows to SMEs, which hinder the transmission of its ultra-low interest rates to the real economy, and as the obstacles to securing bank loans faced by Spanish, Portuguese and Italian SMEs have become clearer.

Overly harsh attitude

Accordingly, a new eurozone SME loan securitisation strategy has been taking shape, which may reflect recognition that attitudes have hitherto been too harsh towards ABS.

“The securitisation market was in many respects at the epicentre of the crisis, but it plays a pivotal role in credit creation. After two or three years of general frustration at economic growth and credit demand, there’s been a greater willingness to embrace securitisation again and a recognition that it can be an effective contributor to SME lending,” said Chris Whitman, global head of risk syndicate at Deutsche Bank.

But what can the ECB do? Central banks traditionally leave SME financing to development banks, but can boost lending by accepting ABS as collateral in liquidity operations. Predictably, the use of ABS as collateral in Europe has fallen dramatically from 28% of the total put forward to the ECB in 2008 to 14% (€347bn) in Q2 this year. (See table.)

The ECB already accepts securities backed by SME loans as collateral, but lowering its eligibility requirements is seen as a fast way of freeing banks of securitised assets for which there is still little demand, thereby giving them more leeway to lend to firms.

For some observers, accepting SME loans as collateral does not go far enough and there have been suggestions it could purchase ABS – something most analysts regard as unrealistic.

There are finite limits to what the ECB can do to stimulate demand, not least because of the complexity of the market: there is no single definition for SMEs across jurisdictions. Some observers have talked of the need for a well-defined valuation framework or the creation of a securitisation platform, but given the heterogeneity of SMEs much greater harmonisation would be needed.

Promotional role

The wider role that the ECB now appears to be taking is promotional ­– the first signs of this approach came in July when it changed its collateral rules, lowering the required credit rating on the plain vanilla brand of ABS for which it requires information on underlying assets, and reducing haircuts from 16% to 10% for the best quality ABS. It also said it was looking at possibly accepting as collateral SME-linked ABS mezzanine tranches guaranteed by European institutions.

The latest moves, while not expected until at least next year after a period of observation, have been welcomed.

“The ECB has made it very clear that they want to do what they can to promote the market for ABS linked to a basket of SMEs, and to provide the mechanism for its funding, said RBC’s Taor.

“It’s too early to know by what process the SMEs can use ABS – whether it’s via an institution like the EIB who could bundle different SME loans and package them into an ABS, or through individual banks – but it’s clearly more than a signal because they have taken specific steps.”

Aufsatz at Barclays said: “It is only recently that regulators become more comfortable that there is a need for the securitisation technique to reduce the reliance on banks, and so you need to promote the right securitisation market in Europe.

“At the margin these initiatives promoted by the ECB will help SMEs in Europe. I think the intention is very good and, depending on the details, they could free up between €50bn and €100bn of lending to SMEs.”

Infrastructure injection

Of course the ABS market is only one of the tools that European authorities can use to boost the real economy, and other instruments include an infrastructure injection (see box).

The ECB and its peers are clearly moving in the right direction – but if these measures are to support recovery they will have to confront some home truths.

Investors remain nervous so demand for securitised assets is still weak, arguably not helped by the exclusion of securitisation from the list of eligible assets under Basel III and proposals to increase the risk weight in bank regulation for ABS. Some observers also want a rethink of how Solvency II treats ABS investment by insurers.

So a well-functioning European SME-backed ABS market does not appear to be imminent, and many observers remain convinced that the master key to recovery – especially in Europe – will still have to be fixing the banking system and pursuing pro-growth policies.

“It’s been assumed that some day-to-day activity has the potential to be more subject to scrutiny than it would have five or 10 years ago, but the activity in capital intermediation between issuers and investors in the unsecured space hasn’t fundamentally changed that much,” said Deutsche Bank’s Whitman.

“It probably shouldn’t be a surprise: it hasn’t changed that much because it didn’t need to because it wasn’t the source of problems.”

So if recovery ultimately depends on finding the right policies to nurture healthy markets, it begs the question as to why securitisation in Europe came to be viewed with such suspicion.

The prodigal son may have returned – but there are some who cannot figure out why he left in the first place.

Unpacking the toolbox

The economies of Germany and France, which grew faster than expected in Q2, may be leading an otherwise fragile eurozone out of its 18-month recession but the peripherals, notably Spain and Italy, are still struggling.

Revisiting the securitisation market to boost the flow of SME credit is aimed primarily at these peripheral countries, but the ECB’s overtures towards the ABS market are just one of the measures that can be taken to encourage recovery.

Europe’s central bank is assuming a much broader, proactive role as a co-ordinator between private and public institutions in an effort to incentivise the SME ABS market. In May, Mario Draghi began to sketch out a new eurozone initiative, saying the ECB’s governing council would start consultations with the European Investment Bank and European Commission on how to promote a functioning market for ABS backed by loans to enterprises and households. He hinted at a greater role for national governments, the Commission and the EIB in defining, regulating, packaging, certifying and guaranteeing ABS.

There has also been talk of the use of a negative interest rate on the ECB’s deposit facility, now being experimented with in Denmark. The EIB and European Investment Fund have also increased their support to SMEs through debt guarantees and securitised portfolios of loans.

Turning heads

One instrument that seems to impress is the Europe 2020 Project Bond Initiative, a joint effort by the Commission and the EIB to stimulate financing for large infrastructure projects that made its debut in July with an issue backing a Spanish gas project. The €1.4bn bond was supported by a €200m liquidity line and the EIB also committed to buy €300m of the bonds as an investor.

“The crisis was arguably more challenging in the US as it was so acute, but the US did for the most part put the so-called elephant on the table and cauterised the infected tissue. The general market view is that the US, which led the way into crisis has also led the way out of crisis…”

Sean Taor, head of European DCM at Royal Bank of Canada, believes this sends a valuable signal: “The Project Bond Initiative is a significant undertaking but it will take time. It clearly opens up a specific market and investors will be very open to more of the same. I think it will also give investors comfort around other infrastructure projects which they find attractive and more closely match their assets and their liabilities. The EIB provides effective credit enhancement, and given its success on the Spanish transaction I think we’ll see many more going forward.”

Others stress that the initiative needs to be seen in context.

Limited impact>

James Martin, director of European Securitisation Research at Barclays, said: “I think the EIB Project Bond Initiative will have limited impact on the recovery of the real economy in the short term – over the next two to three years. Annual issuance is expected to be about €4bn per year for 2013 and 2014 and might rise to €10bn to €20bn if the current pilot phase is deemed a success.

“To put it into context, current euro area GDP plus the UK is about €3.5trn – so expect the Project Bond Initiative to have limited impact in the short term. It is also worth bearing in mind is that this is a gross figure of €4bn for the next couple of years and not a net increase in overall lending to the sector, which may come under pressure from bank capital requirements and concerns over implementation of Solvency 2.”

Although August’s positive figures for the main eurozone economies compared favourably with Q2 in the US, Europe is still lagging. The IMF has forecast US economic growth next year of 2.6% against the eurozone’s 1%, and has urged Europe to move faster towards a unified budget and banking union.

“The crisis was arguably more challenging in the US as it was so acute, but the US did for the most part put the so-called elephant on the table and cauterised the infected tissue. The general market view is that the US, which led the way into crisis has also led the way out of crisis, and is farther along in dealing with crisis-related issues than Europe is at this point,” said Chris Whitman, global head of risk syndicate at Deutsche Bank.

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