Has the European Commission taken a big step forward with EU securitisation?

The European Commission (EC) recently announced a highly anticipated package of measures intended to simplify the EU securitisation framework, revitalising the market, while continuing to safeguard financial stability. The view is that existing regulations can be improved and simplified, helping to channel more investments into the real economy.

The original EU Securitisation Regulation (SECR) framework in 2019 introduced a set of rules that were designed to improve safeguards for investors, ensuring transparency and stability in the market for securitised debt, which groups individual assets, such as credit card debt, mortgages or other forms of borrowing into collective assets that can be traded.

But while a strong regulatory framework is arguably necessary, the constraints that came with those regulations have been pinpointed within the industry as an impediment to growth, ultimately contributing to a significant contraction in Europe’s market for securitised debt, in stark contrast to the growth seen in the US.

Financial industry voices have long advocated for reform, and after review, the EU Commission has identified some aspects of the existing rules that they believe are hindering market developments and imposing unnecessary operational costs. The package includes a reduction to the Liquidity Coverage Ratio (LCR) that determines the volume of liquid assets originating banks must have to meet its short-term needs[i].

The targeted regulatory changes aim to address these shortcomings and ultimately boost the EU securitisation market, helping to stimulate economic growth, encourage technological and corporate innovation and, ultimately, create more jobs across the EU.

These proposed changes have ramifications across Europe, for both stock markets and the market for securitised debt, with some thoughts outlined here from our Portfolio Managers:

European equities (Robert Schramm-Fuchs)

The announced (planned) regulatory reforms represent a potentially meaningful turning point for the EU’s securitisation market.

In addition, the Joint Committee, a forum designed to strengthen co-operation between the various European Supervisory Authorities (ESAs) for the financial sector, has published its own evaluation to unlock the use of securitisations to help stimulate economic growth (with due attention to safeguarding financial stability).

The revival of the EU securitisation market has been highlighted as critical to achieve the objective of the Saving and Investment Union (SIU), a European Commission initiative aimed at improving the integration and efficiency of the region’s financial ecosystem for EU citizens and households. The report focuses on recommendations to enhance the functioning of the SECR, improving clarity over its jurisdictional scope.

What does this all mean for European equities?

Europe is still ‘savings-rich’, but for a long time has been ‘investment-poor’. Several initiatives are underway to change that, to unleash the huge volume of ‘trapped’ existing savings and channel them into productive uses. This is entirely under Europe’s own control, and the huge external (and internal) political pressures are finally leading to positive policy action, which is just not priced into European stocks.

As we have noted before, bank lending is responsible for c.80% of all European funding needs, yet the second-hand market (securitisations) that helps to recycle capital, or sell on collectivised loans, has shrunk in Europe. In 2010, when European Union GDP was €13.1tn, the European securitisation market was c.€2.0tn in size. In 2023, when European Union GDP was €17.1tn, the securitisation market had shrunk to €1.2tn, albeit with about half of that retained by originating banks for repo funding with central banks, so was not distributed to investors.

Just to get back to the nominal (not inflation-adjusted) 2010 market size would represent a €800bn stimulus to European GDP (which we estimate at approximately 4% of GDP). This is significantly larger than Germany’s recently announced infrastructure package, with potential to feed through to growth considerably quicker than Germany’s stimulus package, given the 10-year schedule for the latter to be fully deployed.

European securitisation (Ian Bettney)

From the perspective of the securitisation investment community, the European Commission’s proposed measures offer a promising direction for the market. They strike a balance between maintaining regulatory oversight and fostering growth, which many industry stakeholders have welcomed. However, while the proposals do address some existing limitations, they ultimately fall short of delivering the comprehensive changes that some have anticipated.

The Commission emphasises the broader benefits of securitisation, not just for banks but for investors seeking high-quality opportunities. This aligns with the goals of the SIU, showcasing a focus on economic growth rather than solely banking interests. The package reflects an understanding of the market as an ecosystem, aiming for recalibration rather than deregulation, though its reliance on enhanced supervisory oversight might be overly optimistic.

Key positives:

• Simplified due diligence: The proposals reduce mandatory due diligence requirements, adopting a principle-based approach that lowers standards for senior tranches and repeat transactions. Specific obligations for EU-supervised issuers are removed, easing processes for market participants.
• Simplified reporting: By making 35% of existing reporting templates voluntary, the need for new IT expenditures for originators is reduced, and the elimination of loan-by-loan disclosure requirements for certain highly granular pools is a welcome change.

Key concerns:

• Complexity in risk sensitivity: The introduction of risk-sensitive categories, such as ‘resilient’ senior tranches, adds complexity to the existing framework, potentially complicating prudential requirements.
• Cost implications for reporting: Expanding the definition of public securitisations and requiring comprehensive reporting may increase costs and create disparities with other market sectors, possibly shifting activity away from public securitisation.
• Expanded sanctions: Concerns arise with the broader scope and increased severity of sanctions related to due diligence compliance, particularly given the removal of the ability to delegate that liability.

Awaiting clarification:

• European insurers: Associated amendments have yet to be announced to Solvency II but are expected to follow. This large European investor base currently has negligible exposure to securitised assets due to the excessively penal capital charges, in comparison to US insurers where securitised assets are treated less harshly and so comprise a material exposure.

In summary, the timeline for the proposals to become law is likely extended, potentially not before mid-2027 following a lengthy consultation and negotiation period.  While the amendments are a positive step toward revitalising the European securitisation market, they may not be ambitious enough in their current form to drive significant market recovery or advance the SIU’s objectives decisively.

[i]  The package includes a reduction to the Liquidity Coverage Ratio (LCR) that determines the volume of liquid assets banks must have to meet its short-term needs.

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Glossary:

Originator banks: The entity that initiates or creates the underlying assets that are packaged and sold as securities, such as a bank issuing mortgages, or a financial company offering loans for car purchases.  

Public securitisation: Refers to a securitization transaction that involves issuing securities that are offered to the public and typically traded on a regulated market or exchange. This type of securitisation is characterized by the issuance of securities that are available to a wide range of investors, including institutional and retail investors.

Repo: A short-term loan, using collateral, where one party sells securities to another with the agreement to buy them back at a later point, at a pre-determined price. The difference between the sale and repurchase price represents the interest (or repo rate) paid for the loan.

Repo funding: Lenders need to manage their cash positions to cover their repo funding obligations, to ensure they have sufficient funding to repurchase the securities at the agreed price and time.

Tranches: In securitisation, tranches refer to the different layers or classes of securities that are issued, each with distinct characteristics, primarily varying by their risk level, priority in the payment structure, and interest rates.  Senior Tranches are the highest-rated tranches, typically receiving AAA ratings. They have the first claim on the cash flows from the underlying assets, making them the least risky. Because of their lower risk, they usually offer lower yields compared to other tranches.