Since the Lehman crisis, asset-backed securities (ABS) have struggled to regain their status as a key funding instrument for European banks.
Historically, ABS emerged in 2000 as an important funding instrument in Europe, particularly among banks. The pooling of assets into financial instruments, known as securitization, enabled capital market participants to invest in new asset classes through granular pools of assets that are typically too small and illiquid for individual investments. Between 2000 and 2006, the volume of ABS issuances in Europe alone rose to more than €500 billion.
However, as the U.S. subprime mortgage crisis escalated into a global credit crisis, ABS products were criticized for transferring credit risk to unsophisticated investors in a complex and nontransparent fashion. Consequently, policymakers identified ABS as a key driver of the credit crisis, which peaked with the collapse of Lehman Brothers in 2008. Despite the fact that European ABS did not suffer losses anywhere close to what had been realized in parts of the U.S. market, European ABS were nevertheless indiscriminately discredited in the same manner. In response, European regulators started to treat ABS more harshly, imposing higher capital charges and other restrictions for investors. Trading and placement levels of ABS fell significantly after 2007 as many market participants withdrew from the asset class completely (see Figure 1).
However, bolstered by renewed interest, ABS markets in Europe have slowly recovered since 2010 and placed issuances have increased, though to much lower levels than before the crisis. Are ABS once more gaining favour as an important capital market instrument among Europe’s banking institutions? We think so.
Banks in Europe are on a deleveraging path
In the aftermath of the global credit crisis, developments in Spain, and more recently in Cyprus, continue to highlight the substantial challenges that Europe’s banking system is facing. Although Ireland, Malta and Cyprus were extreme examples of banks’ balance sheets reaching multiples of their respective country’s GDP, Europe simply remains overbanked. More stringent capital requirements set out by the Basel Accords have placed demands on banks to deleverage. The trend to shrink balance sheets has been in place for several years now and is targeted through a combination of both asset sales and a reduction of the lending business. Banks not only face increased capital costs, but their debt funding costs have moved up as well. While U.S. banks can rely to a large extent on relatively attractive deposit funding, European banks, on the other hand, are much more dependent on funding through the capital markets.
Lessons from Cyprus should lead to increasing funding costs for banks….
The decision in Cyprus to have bank depositors participate in the restructuring of the country’s insolvent banks couldn’t have come at a more inopportune time, while political commentary from European policymakers who saw Cyprus as a potential model for the rest of Europe only added fuel to the fire. Although the inclusion of bank creditors in the costs of a bank restructuring has become more frequent – as highlighted by the recent nationalization of SNS Bank in the Netherlands, where subordinated debt was written off entirely – the involvement of senior note holders or bank depositors has been avoided in the past. With Cyprus, however, the taboo has been broken. While politicians openly debated whether Cyprus’ bank restructuring could and should serve as a blueprint for other European banks, the message was clear: Bank deposits are no longer a safe investment as future bail-ins of depositors can no longer be ruled out. This conclusion should eventually result in higher risk premiums and funding costs for European banks.
With the decisions for a bail-in in Cyprus, European policymakers aimed to send a signal that the costs of Europe’s debt/banking crisis should not be paid by taxpayers alone. Unfortunately, the same decision foils the ambition of European policymakers to spur lending and, ultimately, growth. The consequences of higher funding costs for banks could ultimately dampen Europe’s efforts to grow slowly out of its debt misery.
…though central banks currently ensure ample liquidity
At this stage, it is important to note that funding is not a hot topic for European banking institutions as central banks continue to provide cheap liquidity to the system. The European Central Bank’s (ECB) long-term refinancing operation (LTRO) facilities and access to other central bank funding operations have substantially reduced the issuance of traditional capital market funding instruments from banks.
The issuance of prime residential mortgage-backed securities (RMBS) in the UK can be seen as a good example. Starting in 2009, UK banks managed to regain market access for this product. Although challenged by relatively high funding costs of prime RMBS with issuance spreads of about +135 to +150 basis points (bps) from 2010 – 2011, UK banks increased the issuance of RMBS to almost €40 billion in 2011.
Yet despite the improvement of funding conditions since mid-2012 and current issuance spreads at +50 bps, issuance volumes have decreased once more and are at zero in 2013 (see Figure 2). This reflects the cheap funding alternative made available by European central banks’ loose monetary policies.
Going forward, secured debt issuance could gain greater importance
Although the ECB and the Bank of England (BOE) are currently providing sufficient and attractive funding to European banks, it is certainly not intended to be a long-term solution. Banking institutions, not central banks, need to ensure sustainable access to sources of market funding over the longer term. Based on the expectation that funding with such instruments, which face the risk of being bailed-in, will be getting more expensive over time, achieving the right funding mix for European banks is becoming increasingly important.
ABS offer several benefits
In theory, ABS could potentially be seen as an ideal funding instrument: They ensure reasonably attractive funding for a bank’s lending business to the real economy without further stretching the already large balance sheets of Europe’s strained banking system.
- Off-balance-sheet refinancing for banks
- Cheaper funding through collateralization
- Issuance out of a bankruptcy-remote vehicle, which de-links the securities from the bank’s balance sheet, thereby avoiding bail-in risk for investors
- “Tranching,” or the division of an issuance into classes of securities depending on the level of risk, which enables investors to pick a specific risk/return profile
Unlike other public bodies, the ECB has already been increasingly supportive of ABS, though it differentiates between types of ABS products. While the ECB supports simple, transparent structures that are used to fund the real economy in Europe through eligibility for its funding operations, the ECB doesn’t accept highly leveraged, synthetic and/or complex structures that are designed as arbitrage vehicles rather than funding instruments. During a recent press conference on 2 May, ECB President Mario Draghi announced an ECB initiative to support lending to non-financial corporates through the promotion of ABS backed by loans to small and medium-sized enterprises (SMEs).
Likewise, the inclusion of certain RMBS in the definition of Liquidity Coverage Ratio (LCR) – which addresses the sufficiency of a stock of high-quality liquid assets to meet short-term liquidity needs under a specified acute stress scenario – under the recent Basel III draft might be an indication of a step in the same direction and potentially more positive regulatory treatment going forward.
While it is certainly too early to see a material swing in the regulatory environment for ABS in Europe, there are certain other initiatives in development that seek to open up a more constructive discussion and treatment of ABS. One such industry development is the Prime Collateralised Securities (PCS) initiative, which aims to promote ABS products through common standards with respect to pool quality, transparency and simplicity. We believe that these initiatives should ultimately help to re-establish ABS as a sustainable and attractive funding source for the real economy and open up room for regulators to adjust their treatment of ABS to a more adequate level.
Over the long term, we believe ABS will manage to make their way back to the market and that issuance will increase in Europe. While regulators are currently behind the curve, markets already are making room for a more credit-intense product that undoubtedly has benefits for all – banks as issuers who get cheaper funding, investors who can pick collateralized bonds that are free of bail-in risk, and policymakers who could ensure lending to the real economy without increasing European banks’ balance sheets.