IMF Survey : Reform Securitization to Improve Growth, Financial Stability
IMF News, January 29, 2015
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- Published: January 29, 2015
Overview
- Publication date: January 29, 2015
- Central message: Policymakers have made progress in reforming securitization markets, and they have to finish the task to mitigate the risks and ensure these markets contribute to economic growth and financial stability.
- Context emphasis: Europe stands to benefit most from stronger securitization practices; capital markets are underutilized and banks remain under pressure to deleverage.
What securitization is and what it can do
- Definition: "Securitization creates a financial instrument by bundling financial assets, such as individual loans, and then selling different tiers of the repackaged instruments to investors."
- Example: mortgage-backed securities.
- Key benefits listed:
- "Supports economic growth and financial stability by enabling issuers and investors to diversify risk."
- "Aid in diversifying the funding base of the economy."
- "Help free up bank capital, which in theory allows banks to extend new credit to the economy."
- Regional note: "These issues are particularly relevant in Europe where capital markets are underutilized as a funding source for the economy, and banks remain under pressure to deleverage and are reluctant to lend in an environment with so much economic uncertainty."
- Quoted policy view: “Restarting and expanding securitization would create room for banks to fund small and medium-sized enterprises,” said José Viñals, the IMF’s Financial Counsellor and Director of the Monetary and Capital Markets Department.
Maximize the benefits, minimize the risks
- Risk drivers identified:
- Poor underwriting standards for loans.
- Flawed ratings.
- Incentives that allowed intermediaries to issue securities without assuming any of the risk.
- A fragile and highly-leveraged investor base.
- Historical observation: Global securitization markets expanded without causing disruptions in the three decades leading up to the late 1990s; problems emerged in the years just prior to the global financial crisis when issuance patterns changed and intermediaries repackaged low quality loans without retaining economic exposure.
- Heterogeneity point: "Not all securitizations are the same." Regulators should "identify the features common to securitizations with a track record of success as a guide for reform.
- IMF approach: comprehensive suite of measures targeting both supply- and demand-side reforms.
Strengthening the chain of financial intermediation (supply-side reforms)
To enhance supply-side functioning and reduce risks, policymakers can strengthen existing practices in four main ways:
- First, "beef up the quality of underlying loan origination practices as poor quality loans will always hamper the performance of securitizations."
- Second, "encourage securitization intermediaries to develop structures that are transparent, straightforward to value, and designed to finance the economy."
- Third, "put credit ratings to better use. Full disclosure of the ratings process would help to increase transparency and confidence, and the removal of references to external ratings in regulations should be accelerated."
- Fourth, "ensure consistent application of capital charges across asset classes and borders. Avoiding large step-changes in capital charges (so-called ‘cliff effects’) between classes of assets that do not differ much in underlying quality is likely to be helpful."
Spurring demand for securitization (demand-side reforms)
- Standardization proposals:
- "Standardized classifications of the underlying risk characteristics of securitizations, such as the maturity of assets and the ease with which investors can take possession of collateral in the event of default, could help preserve the benefits of risk labels."
- Aim to mitigate investor shirking of due diligence that occurred with aggregate credit ratings.
- Investor behavior concern: "Investors will tend to treat a single aggregate label for risk as analogous to a credit rating. Changes in the overall rating can also force some investors to buy or sell the assets because they cannot hold assets below a certain rating, which could amplify herding behavior by investors."
- Building a diversified institutional investor base:
- Encourage development of a dedicated non-bank institutional investor base, especially in continental Europe where non-banks have traditionally played a minor role relative to the United States.
- Requirements include "pan-European harmonization of loan level reporting standards, documentation standards, insolvency regimes, and the taxation treatment of securitizations."
- Address "regulatory, institutional, and product design issues, such as extending the maturity of asset-backed securities and easing the hedging of prepayment risk, to invite greater sponsorship from European insurers and pension funds."
- Expected outcome: "Achieving a better balance between bank and capital markets-based intermediation over time will have the added benefit of making Europe’s economy more resilient."
IMF Survey : Reform Securitization to Improve Growth, Financial Stability — January 29, 2015