May 29, 2013
The European Central Bank is talking up securitization as a way to boost lending to small and medium sized enterprises (SMEs), which are the backbone of the region’s economy and have few alternatives to bank funding.
Loans to small companies are capital-intensive, and Europe’s banks are under pressure to deleverage in order to meet stricter capital requirements. Securitizing these loans would get them off banks’ balance sheets, freeing up capital to make more loans.
Yet the market for SME securitization, once an important funding vehicle for small businesses in Spain and Italy in particular, remains virtually shut. A major reason is that spreads on bonds issued by SME securitizations are much higher than spreads on SME loans. It’s simply not economical for banks to bundle these loans and sell them to investors; the interest they earn on the assets is not enough to pay the interest investors are demanding on the liability side.
As a result, most of the deals completed since the financial crisis have been used as collateral in borrowing from the ECB through sale and repurchase (repo) agreements.
There are other disincentives, such as regulatory requirements that deal sponsors hold on to 5% of the risk in securitizations. Capital requirements, proposed under Basel III, which give the senior-most tranches of securitization the same risk-weighting as subordinated tranches, also make SME securitization less attractive to some investors. But this is also true of all kinds of asset-backed securities, including sectors like auto loans and credit cards that have been fairly active.
Despite these hurdles, the ECB believes that securitization could be the key to jump-starting Europe’s economy, which contracted by 0.6% in the fourth quarter of 2012, and to bringing down its intractably high unemployment rate, which stood at 12.1% in March, on a seasonally-adjusted basis. (The unemployment rate ranges from 4.7% in Austria to 27.2% in Greece.)
The central bank is therefore looking for ways to make the process more attractive to both issuers and investors. On May 2, ECB President Mario Draghi said the central bank’s governing council would begin consultations with other European institutions on initiatives to promote a functioning market for ABS collateralized by loans to non-financial corporations.
Draghi’s remarks came after the ECB cut interest rates by 0.25 percentage point to a historic low of 0.5%. The central bank president noted that this accommodative monetary policy has failed to stimulate lending to SMEs.
“Our non-standard monetary policy measures have, therefore, the task of removing these stumbling blocks to ensure that our single monetary policy in fact reaches all parts of the euro area. This is crucial for fulfilling our mandate,” he said.
What would it take to revive SME securitization? Many market participants believe that the ECB, or some other regional institution, would have to either provide a guarantee on the securities or take the first-loss position in deals in order to make them more attractive to investors.
Another option would be for the ECB to purchase SME securitizations in the secondary market, which could drive down spreads just as the U.S. Federal Reserve’s purchase of mortgage-backed securities has driven down spreads on MBS. ECB executive board member Joerg Asmussen recently confirmed that the central bank has discussed this option.
SMEs to the Rescue
SMEs are incredibly important to the European economy; between 2001 and 2010, they contributed to an estimated 85% of new jobs in Europe, according to a report published by the Prime Collateralised Securities (PCS) Secretariat in March. “The biggest problem in Europe now is unemployment,” said Ian Bell, head of the PCS Secretariat. “The deleveraging of banks is going to hammer these smaller companies and, by default, unemployment rates in Europe.”
PCS is the securitization Kitemark launched last June; it is designed as a simple measure to identify securitizations that meet predefined best practice standards with regard to quality, transparency, simplicity and standardization.
The need to boost capital makes lending to capital-intensive assets, like SME loans, which often have terms of five years or longer and are below investment grade, less attractive to banks.
“These are smallish companies with an overall credit quality of maybe double-B or even less than that,” said Richard Hopkin, managing director in the securitization division of the Association for Financial Markets in Europe (AFME).
Securitization of these loans would enable banks to get them off their balance sheets and recycle the capital into new loans, though they would have to hold on to a piece of each deal in order to meet risk retention requirements.