New regulations are having a profound impact on structured finance and securitisation markets. But the bigger banks are mostly coping, with some even exploiting the situation to build their investor-advisory services.

Mounting regulatory requirements have dramatically changed the banking landscape in the past five years. Banks have spent a large part of that period increasing and improving the quality of their capital bases to meet the demands of politicians and regulators adamant that taxpayers should not have to bail out banks in future.

For many investment banks, the focus has shifted to how rule changes will affect their business lines and the products they can offer. And it is not only regulations directed at banks that are having an impact, but also those meant for their clients. “Regulation is at the forefront of everything,” says Eric Viet, head of financial institution advisory in Société Générale’s cross-asset solutions division.

“The way banks, insurance companies and pension funds manage their businesses is to a large extent driven by it,” he says. “It’s not just banks that are affected, but their counterparts too. That’s because the regulations impact the price of products and ultimately the ability of banks’ clients to manage risk.”

Structured products target

The structured finance market has been particularly hard hit by new legislation and directives. Much of the regulatory push stems from European and US watchdogs blaming structured products, not least asset-backed securities (ABSs), for helping to cause the 2007-08 global financial crisis. Among the adjustments has been the creation of risk retention rules, which aim to make ABS originators or sponsors hold a certain percentage of their deals. Most capital markets practitioners believe these rules will not fundamentally change the market on their own, given that ABS issuers had already started to move towards holding some risk.

Perhaps of greater consequence will be the capital charges imposed on ABSs. Bankers have expressed fears that these could curtail demand from investors. The Solvency II Directive, designed to harmonise the EU’s insurance regulation, is one source of concern.

“Capital and liquidity standards change the incentives to issue or invest in ABSs quite significantly, particularly when compared with other products,” says Nicole Rhodes, consultant counsel at law firm Allen & Overy. “Under Solvency II, there’s a capital charge for insurers investing in ABSs that’s penal relative to raw loans or covered bonds. That difference in treatment is very important.”

Basel III eligibility

Market participants are also eagerly awaiting the final pronouncement regarding which types of ABS will be eligible under Basel III’s liquidity coverage ratio, which is meant to ensure banks have enough liquid assets to survive a short-term funding squeeze. Although some residential mortgage-backed securities are likely to qualify, there is still confusion over whether other types of ABS, such as those backed by car loans, will too.

A decision is expected in the next few months, at about the same time that US regulators are supposed to finalise risk retention and disclosure standards for ABS. As such, bankers describe this year as 'make or break' for the ABS market. Although some are pessimistic and think regulators will clamp down too harshly on their market, many believe there are signs that policy-makers have softened their stance on ABSs. They cite a joint discussion paper from the European Central Bank and the Bank of England in late May that spoke of the benefits of securitisation as a bank funding tool and acknowledged that regulatory capital charges might have deterred investors from holding ABSs.

“This is an important time. It’s a tipping point,” says Franz Ranero, a capital markets partner at Allen & Overy. “There’s a lot of positive dialogue between regulators, politicians and market participants. We just hope it’ll be translated into sensible changes to the proposed regimes.”

Structured targeting

Beyond securitisation, regulators have also been busy focusing on more bespoke structured investor products. They have been especially keen to target products made for retail investors. Among the key developments in Europe are the introduction of a second Markets in Financial Instruments Directive (known as MiFID II), which seeks to boost transparency across all asset classes; an agreement to regulate packaged retail and insurance-based investment products (PRIIPs); and a revision to the European Commission’s Prospectus Directive, which governs the regime for securities prospectuses.

These, plus separate proposals from the influential European Securities and Markets Authority (ESMA), have combined to increase transparency requirements for manufacturers and distributors of retail structured products. “PRIIPs, MiFID II and the ESMA recommendations have a direct impact on the way products are distributed to retail investors in Europe,” says Pierre Lescourret, head of European structuring at Société Générale.

The changes have been broadly welcomed by banks, despite the greater workload it will entail for them, as well as investors. Bankers say an agreement earlier this year on key information documents for PRIIPs was a significant milestone in Europe’s regulatory reform agenda. From around mid-2016, each PRIIP will have to contain a short key information document of no more than three sides of A4 paper. Written in layman’s terms rather than legalese, it should succinctly outline basic information, including the risks, potential returns and investment fees related to the product being sold.

Country vs region

Bankers are less enthusiastic about policy-makers in Europe tinkering with pan-European measures, such as MiFID II, and creating their own national rules. “One point of contention is that national regulators are allowed... to intervene and ban retail products allowed in other countries if they consider them as toxic for investors,” says Mr Lescourret. “It means that national regulators will be allowed to override European directives, such as the Prospectus Directive, which are meant to harmonise Europe’s markets.”

This has already led to confusion. Belgium initially banned all complex products, although its definition of what fell into that category was ambiguous. Italian regulators stopped the sale of credit-linked notes because of their association with credit default swaps. And French officials introduced a cap of three mechanisms per product, which bankers say made little sense because some mechanisms, such as performance floors, are designed to protect investors.

“Adding more mechanisms doesn’t necessarily make a product more risky,” says Richard Quessette, global head of Société Générale’s cross-asset solutions division. “Some kind of risk classification could be more appropriate than a three-mechanism limit.”

Fragmented Europe

The consequence of localised rules, say bankers, is that it has become difficult to sell the same product across Europe. “As of today, offering one retail product on a pan-European basis has become too complex for providers,” says Mr Lescourret.

While most market participants agree, they add that the traditional peculiarities in each European market, including the different preferences of investors and the way products tend to be distributed, also play a role. “The market’s fragmentation isn’t always due to legal factors,” says Andrew Sulston, a lawyer at Allen & Overy specialising in derivative securities. “It’s also down to how retail distribution networks – which are key to getting the products out to market – have traditionally operated.”

Another source of controversy involves the regulation of index-based structured products, which have grown in popularity in recent years. Although they are often sold to a very small number of investors and are sometimes even designed for and used by a single client, there are signals from policy-makers that they will fall under the International Organisation of Securities Commission’s definition of benchmark indices. In an extreme scenario, that might force banks with index businesses to transform them into separate legal entities, although few believe it will come to that (see article on index-based structured products, page 7).

A few banks have used the surge of new regulation to offer advisory services to their clients, including investors such as insurance firms or pension funds. Société Générale’s cross-asset solutions team generates a significant amount of business advising investors on how to adapt to new regulations. It has, for example, helped insurance firms comply with Solvency II by developing ways for them to reduce their equity, longevity and mortality risks.

Creating opportunities

“We need to take the regulatory environment into account more and more also because clients are increasingly looking at their regulatory constraints, as well as their market risks,” says Mr Quessette. “We are working on products that are adapted to Solvency II and which can help insurance companies reduce their capital needs. This is an example of the new environment creating opportunities for us.”

Despite the sweeping regulatory changes to the structured product and securitisation markets, bankers and investors generally say that they are not hindering issuance volumes much. Where they are subdued, it is more down to market conditions. And although some small originators and distributors might struggle with the extra regulatory burdens, the bigger ones will cope. “A major institution which views retail structured products as a core part of its operations will be focused on how best to meet the requirements in the most efficient way,” says Mr Sulston.

Others point out that for all the hassle they will cause banks and investors, the new requirements, if enforced correctly over the coming few years, should achieve regulators’ aim of making structured finance and securitisation markets safer. “There might be businesses that banks are backing away from because they feel the regulations have become too harsh,” says Adrian Docherty, head of banking advisory at BNP Paribas. “But it could be that the real risks of those businesses were very high anyway and that some banks simply didn’t recognise them because the regulations were previously too lax.”


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