In a shift, French banks are embracing a practice popular in the U.S. What is raising eyebrows is that it involves the creation of financial instruments that led to huge losses not so long ago.
The practice is the packaging of loans into securities to be sold to investors—also known as securitization. It is unusual in French banking.
French banks traditionally keep most of the loans they make on their balance sheets, unlike their U.S. counterparts, which have long put them into securities and sold them to investors. During the financial crisis, scores of those securities went sour as the housing market crashed, leaving investors and banks nursing huge losses.
But French banking executives say stringent new rules on capital and liquidity, passed in the wake of the 2007-2008 meltdown, are crimping profits. That, in turn, has prompted them to ramp up other means of increasing revenue, they say.Regular readers know that in the absence of observable event based reporting buyers of these structured finance securities are not investing, but rather 'blindly betting'.
Under observable event based reporting, all activities like payments or delinquencies involving the underlying collateral are disclose before the beginning of the next business day. It is only with this reporting that market participants have current information and investors know what they own.
BNP Paribas SA, France's largest publicly traded bank, recently issued, packaged and sold billions of euros in real estate, aircraft financing and corporate loans. Other recent deals include Société Générale SA, Crédit Agricole SA and Natixis SA selling securitized loans to French insurer AXA SAand Belgian-Dutch insurer Ageas NV.
French mortgage lender Crédit Foncier said in October it plans to start issuing residential mortgage-backed securities, reviving a market that has been dormant in France since the financial crisis.The lender wants to securitize around €1 billion ($1.3 billion) this year and is targeting issuance of around €2 billion of RMBS per year starting in 2016.
"If you can't adapt, you won't survive," says Fabrice Susini, global head of securitization at BNP Paribas.....The adaptation being to provide observable event based reporting. This information is easily made available because this is how the information systems used by the entities that originate, bill and collect the underlying assets track the underlying collateral.
New regulations have forced banks to increase their reserves to cushion against unexpected shocks. In addition, new rules intended to ensure that European banks aren't caught out if short-term funding from financial markets dries up mean lenders can no longer rely on this borrowing to fund long-term loans. Deposits, another key source of funding, aren't sufficient to cover loan demand.
"The new regulatory constraints are significant," says Xavier Fessart, head of counterparty risk at Crédit Agricole's investment bank. "To continue to lend to our customers we had to find new financing solutions."Done right, securitization is an attractive way of financing loans.
Securitization has two attractions for the banks. It moves assets off their balance sheets, reducing the amount of capital and liquid assets they have to set aside against loans. At the same time, it enables them to earn commissions for creating and selling the securities. The question for banks is whether the commissions will be enough to offset the loss of interest revenue on loans they once held on their books.
"We need to adapt our business model in order to be able to distribute the loans that we issue," said Didier Valet, head of Société Générale's corporate and investment bank, in an interview earlier this year. "Loans will become a raw material to feed this new business model."The originate to distribute business model is a very attractive model for banks. The key to making the model work for the financial system is observable event based reporting.
The lenders say they won't make the same mistakes many of their US peers did before the crisis. Back then, some of the packaged loans were the product of lax lending standards and the banks issuing the loans didn't necessarily end up holding the bonds.
Big French lenders haven't been shy about pointing the finger across the Atlantic. "I am not saying that one model is better than the other," said Frédéric Oudéa, Société Générale's SA chief executive, comparing U.S. and French banking practices at a conference in Paris in March. "But no major bank in Europe went under during the financial crisis."
Analysts say a move into securitization could fuel financial instability instead of taming it.
"If banks don't carry the risk of the loans they issue, there's always a risk they may lower lending standards," says Kepler Capital Markets analyst Benoît Pétrarque.Observable event based reporting is the antidote to the risk that banks will lower their lending standards. Under observable event based reporting, market participants have the information they need to independently assess the risk of the underlying assets.
Market participants can use this risk assessment to make sure they are always being adequately compensated for the risk they take on.
While new rules were drawn up to rein in lax lending practices in the U.S., banking and insurance regulators in Europe haven't really addressed this risk, he said.
The French bank and insurance regulator "is very closely watching" the new deals, said a spokeswoman for the Autorité de Controle Prudentiel, an agency affiliated with the Banque de France. "We can make sure that insurance companies buying these packaged loans from banks understand the risks that these loans carry."Regular readers now that the US National Association of Insurance Commissioners (NAIC) white paper on the Future of Mortgage Finance set the global standard for disclosure by structured finance securities ranging from covered bonds to securitizations. This standard relates the quality of disclosure to the amount of capital needed to support a position.
Specifically, deals that provide observable event based reporting are rewarded with low capital requirements. Everything else is seen as a 'blind bet' and as a result must carry significantly more capital.
AXA, for example, said it won't invest in a securitized loan portfolio unless the bank that has issued it retains 20%-30% on its books. "We do not want to finance the loans that banks won't finance themselves," said Odette Cesari, AXA's chief investment officer.The reason AXA needs such a big retained interest by the seller is that these deals do not provide observable event based reporting. As a result, AXA needs the lender to be absorbing a substantial portion of the credit risk.
But some banks aren't committed to doing that. Société Générale, for one, won't "systematically" hold a part of the loans it issues, said Vincent Tricon, head of Mid Caps Investment Banking at the bank.
Mr. Tricon was responsible for arranging for AXA to buy its securitized debt. The bank plans to rely largely on securitization to fund lending to midcap companies.One of the reasons that the European insurance and bank regulators will adopt the NAIC's global standard is that it assures the regulators that the investors know what they are buying.