There are few types of debt as internationally issued and traded as the debt securities issued in securitisation (in the United States, spelled securitization) transactions. European investors commonly invest in securities issued in U.S. securitisation transactions, and vice versa.
It is generally agreed that securitisation’s abuses contributed to the global financial crisis. Repayment of securities issued in certain highly leveraged securitisation transactions was so sensitive to cash-flow variations that, when the cash-flow assumptions turned out to be wrong, many of these highly rated securities defaulted or were downgraded. That, in turn, sparked a loss of confidence in the value of credit ratings and highly rated debt securities generally.
The regulatory responses to securitisation in the United States and Europe are, at least in part, political reactions to the financial crisis. As such, these responses tend to be ad hoc. My forthcoming article, “Securitisation and Post-Crisis Financial Regulation”, explains, compares, and critiques these responses. It also examines how existing regulation could be made more systematic by identifying the market failures that apply distinctively to securitisation and analyzing how those market failures could be corrected.
The U.S. regulatory responses to securitisation are primarily embodied in the Dodd-Frank Act and the U.S. implementation of the Basel III capital requirements. These responses conceptually fall into four categories: increasing disclosure, requiring risk-retention, reforming rating agencies, and imposing capital requirements. The European regulatory responses to securitisation are set forth in a plan unveiled in late September 2015, in which the European Parliament and Council proposed regulations laying down common rules on securitisation. Except for adding a fifth category of due diligence requirements, the European responses conceptually fall into the same categories as the U.S. responses. These parallels at least partly reflect that securitisation is a relatively new approach to financing, and that regulators throughout the world are attempting to learn from each other—the ultimate “transnationalisation” of the law regarding debt.
I next critique the U.S. and European regulatory responses to securitisation. Consider increasing disclosure, the first category. Increased disclosure in securitisation transactions is unlikely by itself to be meaningful. Prior to the financial crisis, the risks associated with complex securitisation transactions and their underlying financial assets, including subprime mortgage loans, were fully disclosed; but that failed to prevent the catastrophic collapse of the securitisation markets. The problem is that disclosure alone can be ineffective for highly complex securitisation products. I later observe, however, that the European proposal to incentivize simple, transparent, and standardized securitisations is likely to facilitate effective disclosure.
Risk-retention is also unlikely to be sufficient as a regulatory response to securitisation. Its intended purpose is to reduce moral hazard resulting from securitisation’s so-called originate-to-distribute model of loan origination, thereby improving the quality of the financial assets underlying securitisation transactions. It is unclear, however, whether a legal risk-retention requirement will improve financial asset quality. The market itself has always mandated risk-retention; prior to the financial crisis, originators and sponsors of securitisations usually retained risk on the financial assets (typically mortgage loans) included in those transactions. The real problem was that the housing bubble caused originators and sponsors as well as investors to overvalue mortgage loans.
Rating-agency reform is similarly unlikely to be an effective regulatory response to securitisation. U.S. rating-agency reform, for example, has not addressed the conflicts of interest inherent in the issuer-pays model, a model that some believe played an important role in the inflated investment-grade ratings awarded to complex securitisations prior to the financial crisis. In contrast, the EU-proposed regulations require the disclosure of those fees. While that does not totally relieve the conflict of interest in the issuer-pays model, it may serve to mitigate the conflict or at least reduce the appearance of impropriety.
Next consider capital requirements. Both U.S. and European regulation require investors in securitisation transactions to hold more capital than they would be required to hold for investments in other types of securities. This requirement is highly controversial, some criticizing it as “punitive,” others contending it’s illogical because securitisation investors will have to hold more regulatory capital than if they invested directly in the underlying financial assets. Industry representatives support “capital-neutrality,” requiring securitisation investors to hold capital based on those underlying assets.
As mentioned, the European proposed regulations additionally require investors in securitisation transactions to perform certain due diligence. That required due diligence is similar, however, to what investors and other parties (such as trustees) normally perform in securitisation transactions. To that extent, this requirement could be viewed as paternalistic and unnecessary. Nonetheless, it could have value to help assure adequate due diligence during another investor “feeding frenzy” for securitisation products, as occurred prior to the financial crisis.
For these reasons, the U.S. and (except for incentivizing simple, transparent, and standardized securitisations) European regulatory responses to securitisation may be insufficient. This should not be surprising; the post-crisis “macroprudential” regulation of finance to reduce systemic risk is itself insufficient. The European Central Bank Director General for Research summarized the consensus reached at a recent Federal Reserve-sponsored conference: both monetary policy and macroprudential regulatory policy are not really very effective. Part of the reason for this insufficiency, my article contends, is that the regulatory responses have been somewhat ad hoc, focusing on assembling a “toolbox” of regulatory “tools.” The article therefore attempts to supplement these tools with a more systematic regulatory framework.
In a macroprudential context, I have argued that finance has at least five fundamental market failures that need regulation to correct: complexity, conflicts, complacency, change, and a type of tragedy of the commons. Two of these market failures—change and complexity—can have distinctive application to securitisation. The others apply to securitisation, but in no way that is substantively different from how they apply to finance more generally.
Consider complexity. As mentioned, disclosure alone can be ineffective for highly complex securitisation products. U.S. regulation does not adequately address securitisation’s complexity. The European regulatory response, in contrast, establishes a framework for simple, transparent, and standardised (“STS”) securitisation transactions, including incentives such as reduced capital requirements. Disclosure is much more likely to be effective for these transactions than for more complex securitisation transactions.
Although standardization can stifle innovation, the European STS proposal is optional and does not prohibit experimentation or financial innovation. Furthermore, STS securitisations encompass the basic types of securitisation transactions that became economically significant during the 1990s, when the U.S. Securities and Exchange Commission described them as “becoming one of the dominant means of capital formation in the United States.” My article argues that U.S. regulation should incentivize an STS option.
The preceding post comes to us from Steven L. Schwarcz, the Stanley A. Star Professor of Law & Business at Duke Law. The post is based on his article, which is entitled “Securitisation and Post-Crisis Financial Regulation” and available here.