Wednesday, May 6, 2009

Regulating ABS: cage the sell-side or tie down the buy-side?

Posted in Euroweek:

Politicians and regulators around the world are beginning to set out their visions for how securitisation markets will be regulated in future. International coordination is vital to prevent distortions, but will be hard to achieve given widely varying philosophies.

The European Parliament is on Wednesday set to vote on amendments to the Capital Requirements Directive, which will impose strict requirements on bank buyers and sellers of securitisations. Meanwhile on Tuesday the International Organisation of Securities Commissions (IOSCO) published its interim recommendations on the regulation of securitisation and credit default swaps.

The CRD amendments contain two main elements — the much debated “skin in the game” proposal for originator/sponsor banks to retain 5% of securitised exposures for the life of any deal, and less discussed credit analysis requirements for bank investors. While the former rule has been the subject of the most heated arguments and active lobbying, the latter has the potential to change the marketplace far more dramatically.

After all, European banks tended to retain the first loss of securitisations they issued, although the same did not always apply to non-bank issuers or structured credit. However, the new rule that in future investors will have to prove that they can perform detailed credit analysis — evaluating and monitoring specified information such as delinquencies of 30, 60 and 90 days, loan to value ratios and diversification — makes genuinely new demands on investors. This requirement is balanced by an obligation on originator/sponsor banks to provide sufficient disclosure for the investors to perform this analysis.

IOSCO, by contrast, focuses its recommendations on the sell-side. It too calls for regulators to “consider” requiring retention by originators/sponsors and for disclosure of any due diligence performed, but does not suggest sanctions for firms investing in non-compliant issues.

Similarly, the report accompanying the IOSCO recommendations acknowledges the role played in the crisis by investors over-relying on credit ratings and failing to perform their own analysis, but proposes to solve the problem by improving the definition of a “sophisticated investor” and requiring dealers to “ensure the product being sold is suitable for the financial requirements and risk profile of the investor”.

Thus while there is considerable overlap between the two proposals, there remains a wide gap too. The EU has been far keener — since the crisis, anyway — to strictly regulate the investment process than have other jurisdictions, particularly the US, which prefer to control the sell side. Investors such as pension funds have a powerful voice in US politics and the Treasury needs them on board for programmes such as the Term Asset Backed Lending Facility and Public Private Investment Funds.

The EU’s approach has some strong attractions from a politician’s point of view, given the seemingly intractable problem of entrenched use of credit ratings. But it has high costs as well — smaller banks which are unable or unwilling to bring their internal systems and staffing up to scratch, or to outsource them to a reliable but expensive third party, may well pull out of the ABS market altogether.

With the investor base for securitisation already vastly diminished, the proposals threaten to delay the market’s recovery even longer and reduce Europe’s competitiveness.

As with so many initiatives arising from the ruins of the global financial system, international coordination will go a long way to improving the odds of success and reducing the potential for harm. In this case, however, it seems unlikely.

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