Convinced that reviving the moribund securitization market is the best way to channel funding to small and medium size enterprises, the ECB is now championing the financial technique at the centre of the systemic collapse five years ago. Convinced any U-turn is justified to support the small companies that might drive Europe's economic recovery, the ECB now finds itself at war with regulators still determined to clamp down hard on securitization.
Yves Mersch, executive board member of the European Central Bank, ratcheted up the pressure on banking regulators in Basle to ease their punitive stance on securitization in a speech last month.
Mersch cited an S&P finding that the default rate of asset-backed securities in the EU was just 1.4% from mid-2007 to the first quarter of 2013, compared with 17.4% in the US. There have been no defaults for senior tranches of European SME ABS.
The ECB, working with the European Investment Bank and the European Commission, has decided that securitization is the best way to help SMEs transit from their traditional reliance on bank funding to the capital markets, which most are too small to tap directly.
But the securitization market in Europe has withered and investors have all but abandoned higher-rated senior tranches, discouraged by a lack of paper offering an acceptable yield. Bank regulators have been wary of letting banks count high-rated asset-backed securities in their liquidity buffers, so damning them as illiquid in the eyes of investors.
The European insurance and occupational pensions authority looks likely to set high capital charges for non-bank investors in ABS, such as insurance companies, based on the high volatility these instruments showed through the sub-prime crisis. In this, it follows Basle regulators, which have imposed extreme capital charges on originators retained exposure of unrated risk so removing a key incentive for banks to securitize for capital relief while not recognizing risk offsets for senior tranches through portfolio diversification or protection from junior holders taking risk at lower attachment points.
Mersch now characterizes this as an over-reaction based on misconceptions about ABS and says that calibrating regulation for the entire market based on US sub-prime is like calibrating the price of flood insurance on the experience of New Orleans and applying it to Madrid.
Madrid, of course, stands 2,000 feet above sea level. Do plain-vanilla, high-quality ABS stand at a similar remove from the US junk that poisoned banking systems on both sides of the Atlantic five years ago? It might be that they do and that the excessive regulation imposed on the ABS market will in years to come be a textbook study of the damaging unintended consequences of a regulatory response that hobbled a vital link from the capital markets to the real economy.
Its not too late to act. Next year the ECB will become the lead regulator for Europes largest banks. Hopefully, given its own revised view of ABS, which it now accepts as collateral in its money-market operations, the ECB can repair some of the damage.
However, the ECB now seems to be holding to two articles of faith that are not terribly convincing. The first is that all that is holding SMEs back from investing is lack of term funding. In fact, the banking system is highly liquid and desperate to lend across most of Europe, with obvious gaps in parts of Italy, Spain, Greece and Portugal. The ECBs own most recent survey of financial conditions for 8,000 sample SMEs found half of them not applying for loans because internal sources are adequate. Only 12% of those that did apply were turned down.
Remember that this comes as the ECB itself prepares to review banks asset quality amid suspicion that they have offered excessive forbearance to keep troubled companies out of bankruptcy. Given the recent prolonged recession, it would probably be a flashing red light to investors in bank credit and equity if they were approving more SME loans, given that many companies need restructuring and injections of equity, not more debt they cannot service.
The low level of loan demand hints at weak order books as well as lack of confidence. Greater availability of finance will not alter this.
The second article of faith is that securitization is a good mechanism to free up more capacity for banks to extend SME loans. In fact, on the long list of asset classes for which ABS is a good tool for expanding capacity from banks into the capital markets, prime mortgages stand first, consumer credit such as auto loans and credit card receivables second, while even lumpy commercial mortgages are much more amenable than SME loans to historical portfolio analysis, standardization of terms for inclusion in ABS and subsequent monitoring.
If the ECB wants to drive quantitative easing directly to SMEs, it might be better to set up some Fannie Mae equivalent, with core sovereign strength subsidizing the periphery, to ramp up diverse portfolios of SME loans, slap on guarantees, and then fund these through ABS.
Of course, the US precedent argues for caution in letting any such policy tool run unchecked for a long period.