This is the second part of a three-part series on the regulation of securitization before and after the crisis. This part’s topic: The states’ helping hand: finance ministries and the expansion of securitization in the EU.

As I explained in part 1 of this series, securitization required the transfer of credits from banks’ banking books into shell companies, where the cash flows from these credits would be redirected to serve debt instruments that the shell company (or Special-Purpose Entity, SPE) emitted. The banks remained linked to the revenues and risks of these assets by providing liquidity lines to these shell companies in case the market fell dry.

When the crisis in the subprime mortgage market became evident, the buyers of debt instruments emitted by SPEs which had assets on the asset side whose cash flow was seen as deteriorating. Buyers in the market refused to take up the risk, as they could not price it and feared to have to take losses. In this moment, the liquidity lines of banks were drawn, and banks bought the papers from the SPEs they had initially set-up to get rid of these assets.

Now that they ended up refinancing the assets they had sold to the SPE, they in fact became again the owner of these assets, which is why they reappeared on their balance sheets, but only in the worst of moments. The first SPEs which experienced such a buyers strike were those which did not even have a liquidity line and where the buyers were supposed to carry the entire credit risk themselves. Rather than imposing losses on their clients, many banks took the assets they had transferred into the balance sheets of these SPEs (called Structured Investment Vehicles) back on their own books for reputational reasons. Banks argued that they could better cope with the deteriorating value of these assets by holding them to maturity and that imposing losses on their clients would endanger their future financing possibilities.

An important question for the impact of these developments on banking systems in Europe was how states dealt with the guideline issued by the Committee of European Banking Supervisors in 2004, which recommended to ignore any financial accounting treatment of these shell companies which forced them onto the balance sheets of banking groups, as long as a true sale from banking group to SPE had been achieved. This in essence meant that banks had to withhold no capital to deal with unexpected losses emanating from these assets and until the introduction of Basel 2 requirements (latest by 2008) did not even have to hold any capital against the liquidity risks posed by the liquidity lines banks had granted. In essence, if the banking regulators did not force regulatory actions upon their banks which contradicted the CEBS guidelines, their banking systems would be totally unprepared to deal with the shock.

Some European countries still forced banking groups to withhold regulatory capital for assets of shell companies which were on their balance sheet, and in order to make this more effective they made financial accounting rules more stringent, goldplating them (Spain, Portugal, s. Thiemann 2011). In these two countries, no short-term securitization developed which reduced the immediate fall-out of the financial crisis in these countries. Other prudential supervisors struggled to install prudential consolidation and gave up their resistance only late to finance ministries and banks, by replacing prudential consolidation with other restrictions. This is the case of France, which up until the end of 2005 used prudential consolidation, i.e. applying regulatory capital charges to SPEs on the balance sheets of banks, for then to switch under the pressure of their banks and the finance industry to the Basel rules on securitization. Importantly however, they moved capital charges for SPEs earlier, applying them from 2006 onwards. As a consequence, the shell companies of French banks were smaller and their impact in the financial crisis relatively small.

Lastly, nations like Germany or Netherlands had no linkage between the financial regulator and the accounting standard setter, which led to the fact that financial supervisors were either not involved (Netherlands) or resisted moves aiming at forcing shell companies on the balance sheets of banks (Germany). As a consequence of this lax regulation, we find in these two countries the largest markets for short-term Asset Backed Commercial Papers, which had the biggest impact during the crisis. Netherlands got lucky in that they developed a different measure, the liquidity coverage ratio which forced banks to have the capital at hand to serve all liquidity needs in the next months, so that the fall-out was not so immediate. In contrast, German banks had basically set aside no capital to deal with the liquidity risks associated with their SPEs, which led to the direct collapse of two banks in the summer and fall of 2007 (IKB and Sachsen LB)

But securitization in European countries had even more obstacles to overcome than only their accounting and prudential treatments. All these shell companies are part of the shadow banking system in that they don’t fall under the same regulation banks do while engaging in maturity transformation just as banks do. But how come they were not regulated? Did the state not see these constructs and their usage? In short, are we dealing with a clueless state, outmanoeuvred by cunning financial engineers?

A closer look at state action before the crisis reveals the tacit acceptance of these organizations, and indeed their promotion by providing regulatory relief. The German finance ministry, for example, wholeheartedly followed the measures proposed by a study of the Boston Consulting Group in 2003 and eliminated regulatory hindrances to securitization, going as far as categorizing SPEs as microenterprises and relieving them from business taxes (2003) (for other dubious microenterprises engaging in financing on a smaller scale, but no less dangerous, see microfinance in India). That is, a corporation with assets of up to 500 million Euro or more was counted as a micro-enterprise, due to its small equity.

Similar actions were taken with respect to financial regulation, excluding SPEs systematically from the perimeter of prudential regulation. The European banking directive specifies that in order to qualify as a credit institution, two cumulative criteria must be met: to receive deposits or other repayable funds from the public and to grant credits for its own accounts.” (s. EFMLG 2007)

SPE’s might be seen to fulfil both criteria, as they are at least implicitly involved in the generation of credit. Instead, what we find is that countries decided to ignore the credit creating function of SPEs, in order to avoid more stringent regulation which would impose costs on SPEs and therefore might make securitization unprofitable. This happened either explicitly or implicitly, such as in France where there seems to have been a tacit agreement to not identify SPEs as credit institutions (s. European Financial Markets Lawyers Group 2007 Legal obstacles on cross-border securitizations).

So summarizing this analysis of securitization from an organizational perspective: banks were setting up shell companies to make securitization possible. These shell companies were under the control of banks and were transferring the profits they generated in their operation as fees to the banks, now as service providers. States were not only well aware of these shell companies, they also engaged in their promotion in order to increase the credit supply in their domestic economies and strengthen their domestic financial market places (s. paradigmatically Asmussen 2006). In an interesting twist, Basel 2 was itself providing the rationale for these state actions in the case of Germany. The new rules regarding the need for credit ratings to be taken into account by banks when providing credit to enterprises generated the fear of a credit crunch for small and medium sized enterprises, the backbone of the German economy. In order to counter this threat, Germany supported securitization as a new way for SMEs to access the credit market.

Rather than financial engineering per say, securitization involved legal and organizational engineering, and rather than having a clueless state overwhelmed by the ingenuity of financial actors, we might speak of a state as an accomplice trying to increase the capacity of its financial system to provide cheap credit to its economy. In these relationships it can be seen how the state not only allowed banks to create a false sense of security in their books, but also failed to regulate against what in hindsight should have been obvious risks. How has the financial crisis changed the regulatory dynamics in this field, and how much policy space is left to individual nations when dealing with this issue? This will be the concern of the next and last blog entry.

(matthias)