European Union Amends Capital Requirements Directive to Strengthen Securitization

The Council of the European Union has amended the Capital Requirements Directive in an effort to enhance the originate and distribute model and strengthen securitization practices. The amendments enhance the due diligence and transparency obligations on the originators of securitization operations and on investors. Under the new regime, investors should be able to assess the risks involved in structured products otherwise than solely by the means of the ratings given by rating agencies. In order to encourage better risk assessment, a ``skin in the game’’ amendment requires originators to retain on their balance sheets 5 % of risks transferred or sold to investors.

Due diligence should be used in order to properly assess the risks arising from securitization exposures for both the trading book and the non-trading book. In addition, due diligence obligations need to be proportionate. Due diligence procedures should contribute to building greater confidence between originators, sponsors and investors. It is therefore desirable that there be disclosure of relevant information concerning the due diligence procedures.

As part of the reform, rules on liquidity risk management were adopted, in particular the setting up of liquid asset reserves, conducting liquidity stress tests and establishing contingency plans.

In addition, the amendments tighten the regulation of exposure to a single counterparty, the so called large exposures. The Council approved changes establishing arrangements placing a greater restriction on the extent of exposure to a single counterparty, whatever its nature, including when it is a bank. In all cases, the limit is 25 % of banks' own funds. Within the current framework, concentration limits for bank counterparties are less restrictive than for undertaking counterparties, yet the financial crisis has shown that bank counterparties also present a risk of default.

Recently, French central bank governor Christian Noyer said that the financial crisis is at root a crisis of securitization. Thus, he urged the reform of complex structured securitization. While traditional securitization was a successful tool for bundling loans into asset-backed securities, he said, in the last decade it morphed into the short-term financing of complex illiquid securities whose value had to be determined by theoretical models. The inherent fragility of this new securitization model was masked by the actions of market intermediaries, particularly credit rating agencies. The collapse of structured securitization revealed the ugly reality that, far from managing and dispersing risk, it had increased leverage and concentrated risk in the hands of specific financial institutions.

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