Securitisation – Those who forget the past are doomed to repeat it

Initiatives to further develop capital markets in the EU are high on the agenda. A single market for capital would lead to increased investments and savings across borders to the benefit of consumers, companies, and investors irrespective of their location. Integrated capital markets across EU Member States would unlock capital by diversifying funding sources beyond traditional banking. 

As part of this initiatives, renewed interest has emerged in securitisation. Securitisation is seen as a possible way to stimulate capital flows, enhance private risk-sharing across the financial system, and release funding for the real economy. In October, the European Commission initiated a review of the regulatory framework for securitisations with the objective to revive the securitisation market. Insurers are often viewed as key actors who could increase their investment in this asset class.

While some argue that reducing the capital requirements for insurers’ investments in securitisation could help, EIOPA believes this is not the full story. If insurers are required to hold less capital against securitisation products–the argument goes–they may be incentivised to invest more in them. Increased investment from the insurance sector, one of Europe’s largest institutional investors, would contribute to further developing the CMU. However, this is not a silver bullet for stimulating insurers’ investment in securitisation products.

The Joint Committee of the European Supervisory Authorities, including EIOPA, analysed capital requirements and their impact on insurers' investment behaviour. The findings reveal that capital requirements are commensurate with the risks of securitisation investment. Capital requirements are also not the primary obstacle holding back investment in securitisation products by insurers. Rather, insurers face multiple challenges when considering securitisation as an investment option, and capital charges are just one factor in the equation. 

A significant issue is that securitisation products often do not align well with insurers' long-term liabilities. Insurers, by nature, manage liabilities that can extend over decades, such as life insurance policies. These require investments in assets that offer long-term, predictable cash flows. Securitised products, however, are frequently structured in ways that make them less suitable for matching long-term liabilities, creating a mismatch that can complicate asset-liability management.

Furthermore, insurers often perceive securitisation as having a less attractive risk-return profile when compared to other asset classes and its complexity also serves as deterrent. Unlike more straightforward fixed-income products, securitisation requires specialised expertise to manage, given the layers of financial engineering involved. This complexity increases the cost of managing these investments and adds to the perceived risk, further reducing their appeal to insurers who may lack the necessary in-house expertise to navigate this asset class effectively.

Finally, any change to the regulatory framework to reduce the capital charge for investment in securitisation would affect only some insurers, namely those using the standard formula to calculate their capital requirements. Since large insurers–who are the most significant players in the market–use internal models, changes to the standard formula are unlikely to have an impact on their investment behaviour. 

The debate is shifting from capital requirements to the requirements of the Securitisation Regulation. Here it is essential that we keep the lessons of the Great Financial Crisis (GFC) in mind and maintain strict standards on transparency, due diligence and risk retention, though adjustments to make them more proportionate could be explored. 

EIOPA has reservations about unfunded credit protection by insurers for securitisation because, compared to funded protection Unfunded credit protection (banks obtaining an unfunded guarantee, while keeping the risks on their balance sheet) increases the counterparty default risk, may increase the systemic risk and could be detrimental to policyholder protection. Monoline insurers extended their business to unfunded guarantees for securitisation in the years before the GFC. When the value of the securitisation deteriorated, monoline insurers incurred heavy losses. This eventually resulted in the failure of most monoline insurers, which significantly aggravated the crisis. 

Another lesson from the GFC is that the misalignment of interests between the originator and the investor of securitisations needs to be avoided because it may result in poor risk management of the credit portfolios. Therefore, originators should retain a portion of the risk that ensures an appropriate alignment of interest between originator and investor. Investors should be able to assess whether the 5% risk retention ensures a proper alignment of interests and where that is not the case, agree on higher risk retention that would ensure that alignment of interests. 

Finally, it is important to understand that a full comparison with the US securities market is not possible. Banks in the US use securitisation mostly for liquidity management in stead of reducing their capital requirements. While the US market is large, it is important to recognise that 85-90% of the securities is bought by state-funded platforms like Freddie Mac and Fannie Mae. Moreover, the aim of this securitisation market is to stimulate home ownership, not a capital markets union via the banking channel.

Thanks to Maxime Louardi for his contribution to this article.