Shadow banking

1. Shadow banking Sergio Lugaresi, Public Affairs Milan, 22 November, 2012

2. AGENDA • What is shadow banking • What is securitisation • Shadow banking and the crisis • Regulating shadow banking • Regulation and securitisation • The PCS initiative 2

3. Seoul: November 2010 • FSB issued a background note dated April 10th 2010 on the need to define approaches for monitoring the shadow banking system and explore possible regulatory measures to address systemic risk and regulatory arbitrage posed by Shadow Banking. • Strengthen regulation and oversight of shadow banking.

4. What is Shadow Banking • The role of Shadow Banking is to transform an asset (collateral) into credit. • Regulated banks transform short term deposits, redeemable at any time, to create medium/long term credit. Convertibility is made possible because counterparties depositing money into a bank need not to worry about their money deposited and counterparties receiving credit do not worry about the value of the “check” received. Today, this is possible because of deposit insurance. Deposit insurance makes the value of bank deposits “information insensitive”. This means that, alike a currency, no one need devoting a lot of resources doing due diligence. • Similarly, shadow banking uses securitised finance (such as covered bonds) and securitisation techniques (asset pooling, tranching techniques and credit enhancements) to create information insensitive debt to be “converted” into credit in the financial markets (such as repo markets).

5. Securitisation • Securitisation played a crucial role both on the availability of “information insensitive” collateral and on the leverage effect, as collateral may be re-packaged and its credit quality enhanced, increasing overall credit supply. • Financial operators did not deem necessary or were often not properly equipped to assess the risk embedded in those assets (rating was often one of prevailing factors for decision making). • Special Purpose Vehicles/Conduitsare sponsored by banks but are nevertheless representing a substantial part of the shadow banking since they were not consolidated from a regulatory perspectives onto the banks’ balance sheets. They contributed substantially to the creation of credit, in many cases for regulatory arbitrage purposes rather than for channelling credit to the real economy. • A crucial role was played by those vehicles investing in long term assets and issuing short-term Asset Backed Commercial papers (ABCPs). Starting from August 2007, the ABCP market closed abruptly to non-bank investors and shrank in terms of size. 5

6. What is securitisation? (1) A form of Credit Risk Transfer (CRT), like syndicated loans and credit derivatives Includes: Asset Backed Securities (ABS), Mortgage Backed Securities (MBS, of which RMBS are the Residential Mortgage Backed Securities), Collateralised loans Obligations (CLO), Collateralised Debt Obligations (CDO) Note: After the markets froze, issuances were mainly retained as eligible collateral at the central banks 6

7. What is securitisation? (2) Benefits for issuers: Additional funding channel Portfolio risk-management (asset liability management) Arbitraging of Basel I regulatory capital requirements, (capital adequacy risk weights were absent on securitized products that were held in off-balance-sheet entities) 7

8. Shadow banking boom 8

9. Shadow banking and the crisis Increased Risk Concentration and Interconnectedness Credit Rating Agencies: Conflicts of Interests and Methodological Flaws Over-complexity and non-standardisation = Opacity Moral hazard generated by government intervention in favour of mortgages Misalignment of incentives (Originate-To-Distribute) 9

10. Panic • Collateral (often sub-prime mortgages)which was perceived as information insensitive became all of the sudden “information sensitive” debt, as a consequences of deterioration of the underlying credit following the burst of the real estate bubble. • As a consequence, uncertainty about the true value of the ABS underlying collateral and other derivatives fluctuated widely, while diversification did not bring any significant risk reduction. Re-hypothecationcontributed to increase the amount of debt exposures. • Lehmann’s default was triggered by an unsustainable short term funding need (about 30bn US$) mainly caused by short term mismatch in the “secured” area with collateral which turned to be illiquid even in secured markets within one week.

11. Shadow banking: mainly an US phenomenon (1) 11 Source: AFME , 2011

12. Mainly an US phenomenon (2) 12

13. Regulation of the shadow banking? • Bank regulation is fundamentally based on creating incentives for banks to limit risk taking. In the past, this incentive was based on the value created for banks by limitations on entry into banking. Bank charter became a title to future monopoly profits. Shadow banking reduces bank charter value. In attempts to maintain profitability, banks enter new activities, very often in riskier activities. • Financial innovation is largely driven by regulation and taxes. 13

14. How to regulate the shadow banking • Strengthen supervision and market transparency for all financial players • Bring under bank regulation shadow activities performed by banks • Conduits and SPV currently off balance sheet should be brought back on balance sheet, hence being subject to accounting and regulatory requirements (including Basel III liquidity ratios, net stable funding rations, and capital requirements). • Provide an adequate framework to better manage risks in the collateralised funding markets: • Standard contracts should be extended as far as possible among financial players,. • Strengthen market infrastructures: activities in Central Clearing Counterparties (CCP) may help increasing transparency, efficiency and manage counterparty risk. • Internalise negative externalities arising from shadow banking (Tobin tax) 14

15. THE CASE FOR RESTARTING Regulation has being (over)-adjusted CRA conflict of interest addressed by oversight (EU Directive, Dodd-Frank Act) Incentive misalignment addressed by 5% retention rate (“skin in the game)”, strongly opposed by AFME/ESF. Transparency is being addressed by the Global Joint Initiative of issuers associations (including ESF) and by the loan-by-loan initiative lead by central banks Interconnectedness addressed by Basel 3 (counterparty risk, be finalised in Dec 2010) There is wide consensus on the need to restart the market: “Given the pivotal role of securitization as an alternative and flexible funding channel, failure to restart securitization would come at the cost of prolonging funding pressures on banks and a diminution of credit”. [IMF 2009] “Securitisation helped cause a crisis that killed it. A proper reincarnation should help the recovery”[FT 15/9/2010] 15

16. A major problem for the Euro-economy: increasing funding gap Euro area banks: funding gap and ABS issues, Eur bn In 2008, €711 billion of securitisations were “issued” in Europe (+57% vs 2007), although approximately 95% was retained for central bank repo activity. Source: European Securitisation Forum. • Between 2000 and 2007 in Eurozone, funding gap rose from Eur 830 bn to Eur 1,540 bn, i.e. 18% of deposits in 2007. Conservatively assuming loans and deposits growing as much as the nominal GDP, the funding gap will increase to around Eur 1,760 bn in 2010. • Between 2000 and 2006, ABS issuance increased from Eur 68 bn to Eur 486 bn. This rise accounted for 77% of the increase in funding gap (Eur 540 bn) over the same period • Hence: (1) funding is likely to become riskier and more expensive; (2) banks will need to increasingly resort to the debt market: even assuming only a slight downscale of the ABS market in the next years, the funding gap not covered by securitised lending would almost double by 2010 - from Eur 784 bn in 2006 (61% of funding gap) to Eur 1,555 bn (89% of funding gap). 16 Source: UniCredit Research & Strategy, ECB, Thomson Financial, Companies’ Accounts

17. What is securitisation for? A “bug in the hotdog”*? “Do banks securitize their loans to reduce risk and diversify their lending portfolio or do they merely use CRT techniques to increase leverage, exploiting asymmetric information on the quality of the loans that are sold to outside investors?”[IMF 2009] 17 “Un sorcio ner panino”. Informal comment of an high Bank of Italy official to the first presentation of a securitusation (early 2000s)

18. Are covered bonds an alternative? “Covered bonds are debt obligations that are secured by a dedicated reference (or “cover”) portfolio of assets. Issuers are fully liable for all interest and principal payments, so investors benefit from double protection against default, and rating agencies have given most covered bonds AAA/Aaa ratings. However, covered bonds do not allow the asset to move off the balance sheet of the issuer and thus do not provide any of the risk transfer benefits and regulatory capital relief normally associated with securitization”. [IMF 2009] 18

19. How to revitalise (or reincarnate) the securitisaton market in Europe WHAT IS STILL MISSING Restore investors’ confidence (“no more bugs in the hotdog”) Regenerate market liquidity (coordination of supply and demand: no investors without liquidity, no liquidity without investors”) Tighten spreads to make issuance economically viable 19

20. The PCS initiative A market led initiative based on three pillars: 1) A working methodto develop market standards based on consensus-building (issuers, arrangers, investors) 2) A market conventionwith agreeable market standards 3) credible enforcementof self-regulation It needs LEADERSHIP (lacking to industry associations) 20

21. THE PCS INITIATIVE - A working method to develop market standards first stage, June 2008 – Sept 2009. European Financial Services Roundtable (EFR): development of the principles and understanding of investors’ needs second stage Oct 2009 - Apr 2010. EFR and Association for Financial market in Europe- European Securitisation Forum (AFME/ESF): draft of the eligibility criteriafor PCS securities by experts (i.e. investors, issuers, traders and arrangers) with ECB and EIB as observers. third stage Apr 2010 – Nov. 2010. A reality check: investors’ and issuers’ surveys. Fourth stage Dec 2010 – February 2011: Pre-implementation 21

22. Investors’ confidence and market liquidity The PCS market convention: Transparency (encompassing also existing initiatives) Standardisation (asset quality, simplicity) A private label to certify asset quality and standardisation (Secretariat) Conditions to support market liquidity (Market Committee). To facilitate trading of PCS securities, the PCS Market Committee will also be engaged to improve over time the conditions and organisational market features of a liquid secondary market. For example, this includes endorsement of specified trading activity on one (or a few) eligible platforms or multilateral trading facilities, and improved transparency in any conditional market making arrangements, which could include two-way prices, especially for benchmarks. 22

23. The PCS initiative and SME loans Market standards for SME loans Exposure Eligibility Ex: Originated by the originator itself in accordance with its standard underwriting and origination criteria and procedures at the time of origination. Min Installment Paid: 2 Obligor Eligibility Ex: Not in arrears for more than 60 days during the 12 months immediately prior to transfer date and not in arrears at the cutoff date Portfolio Credit Quality Portfolio Concentration Ex: Min Effective Number (EN) of obligor groups 500 23

24. The PCS initiative: tighten spreads (the lemon discount) Because banks have private information on the quality of their loan portfolio, outside investors will require a lemon discount on the price of the assets that are sold. The discount is likely lower if: the bank can credibly certify the quality of the asset it is selling; private information is less relevant because the loans are less opaque or more standardised; the loss given default (LGD) is lower (e.g. the loans are collateralised or there is a direct guarantee). PCS For long time ESF has advocated the provision of government guarantees. 24

25. A REALITY CHECK: THE INVESTORS’ SURVEY - sep 2010 • 43 investors: the EIB Group (two), 18 asset managers, 5 insurance companies, 2 pension funds and 16 banks. Many of the major European “real money” investors participated in the survey. • A majority of the investors clearly indicated that the proposed PCS framework wouldincrease the investor base (58%), improve liquidity (61%) and lower spreads (70%) for PCS-eligible assets, without harming non-PCS products (80%). There was also support for an independent PCS secretariat (80%). • A PCS label per sè would cause 30% of investors to look at investing in new securitizations or increase their investment. It has been stressed that due diligence should be performed in any case. For the remaining tighter conditions for the PCS eligibility criteria or changes to the regulatory treatment of securitised products are necessary. 25

26. A REALITY CHECK: THE ISSUERS’ SURVEY - Nov 2010 • 21 issuers: 17 banks and 4 non-banks. Many of the major European ABS issuers participated in the survey. • 57%of respondents consider that benefits of PCS will more than offset the reduced flexibility of the eligibility criteria on asset and structure. Around 75% of respondents would be ready to accept common standards for eligibility criteria or restrictions on eligibility criteria. • The proposed governance structure, and in particular the way to manage events of label withdrawals, seem to be acceptable for a clear majority of respondents (respectively 62% and 74% respondents). • 65% of respondents support the proposed step-by-step approach to implement the PCS initiative; • A clear majority of respondents (ranging from 62% and 74%) considers the PCS initiative is on the whole good for the market, it will speed up the recovery of the securitisation market, it will have a positive impact on the recovery but 66% is concerned about unintended consequences; 26

27. REGULATORY RELIEF? • Regulatory relief for PCS is often seen as a prerequisite of its success. • In the last month and an half, informal feedback from the European Commission and the European Central Bank officials on the implementation of PCS has been positive. If PCS would be implemented, regulatory relief could be possibly recognized in a number of ways. • It is clear, however, that authorities cannot act neither take explicit commitments before the PCS is implemented. We are in front of a classic chicken-and-egg problem. • Therefore we have to appropriately manage expectations of both authorities and market players. • In any case, It is clear that the European Central Bank, through it involvement as active “observer” and lately as clear supporter, is sharing part of the reputational risk with us. It is excluded to involve Mr. Trichet in the official launch of the initiative. • Regarding the European Commission it is worth to quote the unofficial comment: “You have done your job, now it is up to us to do our share”.

28. POSSIBLE PACKAGE DI DISCUSS • MODIFY THE RETANTION RATE FOR PCS • INCLUDE PCS IN THE LCR • MAKE THE RSF FACTOR FOR PCS = COVERED BONDS • REDUCE RW FOR PCS • REDUCE RELIANCE ON CRA

29. References • Gorton, G.B., Slapped by the Invisible Hand, Oxford University Press, 2010 29

30. Next • Th. 11 Oct. h 10.30-12.15, aula 3 1. Introduction. Cross-border banking and regulation • Wed. 17 Oct. dalle 14.30 alle 16.15, aula seminari 2. Prudential Regulation: Lessons from the Crisis • Fri. 26 Oct. h 10.30-12.15 aula 3 3. From Basel 2 to Basel 3 • Thu. 8 Nov. h 10.30-12.15 aula 3 4. Moral hazard • Thu. 15 Nov. h 10.30-12.15 aula 3 5. Crisis Management and Resolution • Thu. 22 Nov. h 10.30-12.15 aula 3 6. Shadow Banking • Thu. 29 Nov. h 10.30-12.15 aula 3 7. Rules and supervision • Thu. 6 Dec. h 10.30-12.15 aula 3 8. Overall assessment of the regulatory reform • Thu.13 Dec. h 14.30-16.30 aula 20 9. The Euro debt crisis and the Banking Union • Mon.17 Dec. 10.30-12.15 aula seminari 10. Wrap-up and conclusion 30

31. What about credit ratings…. IMF Global Financial Stability Report asks whether credit rating agencies and their ratings contribute to financial instability. It finds that… Ratings are inadvertently destabilizing because they are hardwired into rules, regulations and triggers Downgrades can lead to destabilizing knock-on and spillover effects in financial markets Rating agency downgrade smoothing policies create potential procyclical cliff effects 31

32. Reducing credit rating reliance Raison d’etre for SEC’s proposed Regulation AB amendments is to reduce rating reliance SEC Rule 17g-5 aimed at thwarting “rating shopping” by facilitating unsolicited ratings – EC proposed similar measure in June 2010 Dodd-Frank Act voiding of SEC Rule 436(g) aimed at increasing rating agency exposure to legal liability Not so much rating reliance reduction in Europe, but rating overreliance not as extreme as in U.S. 32

33. IMF two-pronged policy recommendations Importance of ratings should be reduced and the rating agency “regulatory license” eliminated But recognize that smaller and less sophisticated institutions will continue to use ratings Ratings that retain their “license” should be subject to more rigorous validation requirements Push rating agencies on procedures, transparency, governance and conflict of interest mitigation Discourage rating change over smoothing Looking ahead, credit ratings should be seen as one of several tools to measure credit risk, not as the sole and dominant one 33