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Shadow banking
Sergio Lugaresi, Public Affairs
Milan, 22 November, 2012
AGENDA
 What is shadow banking
 What is securitisation
 Shadow banking and the crisis
 Regulating shadow banking
 Regulation and securitisation
 The PCS initiative
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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.
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).
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/Conduits are 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.
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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
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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)
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Shadow banking boom
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Shadow banking and the crisis

Increased Risk Concentration and
Interconnectedness

Credit Rating Agencies: Conflicts
of Interests and Methodological
Flaws

Over-complexity and nonstandardisation = Opacity

Moral hazard generated by
government intervention in favour
of mortgages

Misalignment of incentives
(Originate-To-Distribute)
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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-hypothecation contributed 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.
Shadow banking: mainly an US phenomenon (1)
ABS Historical Issuance
3500
3000
Eur, bn
2500
2000
1500
1000
500
0
2000
2001
2002
2003
2004
2005
European Issuance
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Source: AFME , 2011
2006
2007
US Issuance
2008
2009
2010
Mainly an US phenomenon (2)
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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.
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How to regulate the shadow banking
1. Strengthen supervision and market transparency for all financial players
1. 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).
2. 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.
3. Internalise negative externalities arising from shadow banking (Tobin tax)
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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]
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A major problem for the Euro-economy: increasing funding gap
Euro area banks: funding gap and ABS issues, Eur bn
2,000
Funding gap (loans to customers - deposits from customers)
1,800
ABS issuance
1,600
1,400
1,200
1,000
800
600
400
200
0
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
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).
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Source: UniCredit Research & Strategy, ECB, Thomson Financial, Companies’ Accounts
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]
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“Un sorcio ner panino”. Informal comment of an high Bank of Italy official to the first presentation of a
securitusation (early 2000s)
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]
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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
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The PCS initiative
 A market led initiative based on three pillars:
1) A working method to develop market standards based on consensus-building
(issuers, arrangers, investors)
2) A market convention with agreeable market standards
3) credible enforcement of self-regulation
 It needs LEADERSHIP (lacking to industry associations)
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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 criteria
for 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
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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.
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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
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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:
1. the bank can credibly certify the quality of the asset it is selling;
PCS
2. private information is less relevant because the loans are less opaque or more
standardised;
3. the loss given default (LGD) is lower (e.g. the loans are collateralised or there is a
direct guarantee).
For long time ESF has advocated the
provision of government guarantees.
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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 would
increase 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.
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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;
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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”.
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
References
 Gorton, G.B., Slapped by the Invisible Hand, Oxford University Press, 2010
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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
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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
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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.
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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
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