Date: 3rd November 2017
In September 2015, the European Commission (EC) proposed a Regulation on Securitisation, along with the Regulation on Capital Requirements, as part of the Capital Markets Union (CMU) action plan.
Under the objective of increasing banks’ lending capacity, the regulation for simple, transparent and standardised (STS) securitisation is meant to ensure that the trade of credit-instruments takes place in a more transparent manner, allowing for a better assessment of risks for subprime securities.
Securitisation explained
Under the Regulation on prudential requirements for credit institutions (such as banks), a minimum capital reserve of 8% must be kept in order to release new loans. However, if a bank sells the debt it has from borrowers, it escapes the 8% requirement, unblocking both its own capital and the capital received from selling the debt. This is a securitisation process, where – for example – a loan is sold to investors, thus transforming the loan into a security.
Initial STS proposal
In September 2015, the EC’s proposal concerning STS securitisation focused on three ‘strongholds’ for risk management. First, banks would be required to retain 25% of the risk associated to a debt instrument. This was meant to encourage prudency in credit-issuing processes by credit institutions. Second, a steep increase in the risk retaining ratio was introduced for when securities were traded between banks, i.e. 50% of the debt instrument. This was meant to limit banks’ exposure to defaults. Lastly, the proposal ‘promoted a ban’ (as Sven Giegold calls it in his article) on re-securitisation by imposing a limit of 3 tranches for securitisation. The purpose of this provision was to limit potential chain-reactions in securitisations.
Approved STS proposal
The EC’s proposal passed through the European Parliament on 26 October 2017 on to the approval of the Council, with two out of the three abovementioned proposals removed. The simple securitisation tranche-limitation was removed, as well as the 50% risk-retention rate for inter-bank securitisations. Moreover, the general risk-retention ratio for securitisations was reduced from 25% to 5%.
Disadvantages for financial services users
Sven Giegold explains that the Regulation, in this form, invites to ‘loading off bad risks’, and does not put the brakes on ‘the uncontrolled spreading of poorly understood risks throughout the financial system’. He deems that the legislative act will not benefit ‘the real economy nor ordinary citizens’, in that allowing the development of complex securitisations, risks ‘market panics and deep financial crises’.
BETTER FINANCE also advocated for a higher retention rate, which would have given credit institutions the incentive to limit risk-taking. In addition, the proposal is also very opposed to banks using securitization to fund other banks instead of real economy businesses and households (since one of the purposes of the STS securitisation Regulation, as well of its pillar’s focus was to create new funding opportunities and redirect funds of investors to the economy).