EU's Proposed Bank Rules Reflect Credit-Crisis Lessons

Euro is proposing for stricter rule for bank securitization. More capital will be set aside. US will follow suit. Banks will be less profitable.... The European Union is considering rules that would force banks to set aside more capital when they sell some of the credit products that were at the heart of the financial crisis, a move designed to rein in practices that led to the current market turmoil. The rules would affect all banks operating in Europe, including European units of U.S. banks, and make it more expensive to package and sell products like mortgage-backed securities, a process known as securitization. Banking groups and trade associations including the British Bankers' Association have objected to the proposed requirements. Among their complaints: the rules would prevent the stalled market for securitized assets from recovering, they say, and would stymie lending of all types because setting aside more capital would stretch banks' balance sheets even further. With the rules, regulators are trying to align the incentives of sellers and buyers of securitized assets. In the "originate and distribute" model, banks have passed the risk of loans to investors, prompting accusations that this encouraged banks to make risky loans. Traditionally, banks held on to any loans they made, meaning they remained exposed to their risks. The proposed European rules go further than existing practices in the U.S. In the U.S., banks don't generally face capital charges related to assets they securitize, but they must set aside capital for assets that remain on their books. Lesson Learned The move reflects a big lesson from the credit crunch: Banks often packaged and sold assets as a way to move assets off their books, even though they remained exposed to them. In many cases, banks retained interests in the assets they sold, continued to service the assets or pledged to provide backup funding if the vehicles holding the assets couldn't raise short-term cash. Hit by the credit crunch, the market for securitization has dried up this year. Global structured-finance issuance in the first half of 2008 totaled $245.7 billion, down 84% from the first half of 2007, according to data provider Dealogic. That is the lowest semiannual volume since the first half of 1997. Issuance of $105.1 billion in mortgage-backed securities was down 89% from the first half of last year. A draft of the new policy is being reviewed by banks, investors and regulators globally, which have until July 18 to give any feedback. The European Parliament is expected to pass it into law by the end of the year. The proposal strengthens existing rules adopted by the European Commission in 2006 and implemented this year. Under existing rules, banks must set aside capital for some assets that they sell to investors, or securitize, if they can't show that they have transferred a significant portion of the risk. Different people have different interpretations of how the new rules will work, and EU officials haven't explained. According to one interpretation by market participants: under the new proposals, at its most basic, a bank that securitized $100 million of mortgages might need to retain a $10 million stake in that deal and then also retain cash to cover that $10 million. The commission had initially suggested a 15% stake but recently scaled that back. Any banks wanting to sell securities to a European bank would have to hold on to a portion of the deal they are selling, even if they aren't based in Europe. The Syndicate The proposed rules are also designed to cover loans that banks make but syndicate out as well as products such as credit default swaps, which act as insurance on credit. Some complain that the new rules -- including how much of a deal banks must hold -- haven't been explained clearly and, as a result, will be impractical to implement. The commission says it is aware of the criticism and this is why it is seeking input from bank trade groups and others before approving the requirements. It may make changes as a result of the criticism, said a spokesman for Charlie McCreevy, the EU commissioner for internal markets and services. The British Bankers' Association said the commission's proposals won't help because banks already hold on to pieces of deals they securitize, often the riskiest parts. "That didn't prevent the credit crunch, so I do not see why making this a requirement should make any difference," said Simon Hills, the association's executive director of prudential capital. Much of the opposition to the proposals is coming from London, the center of European financial markets. On Monday, representatives of the U.K. Treasury and market regulator Financial Services Authority met with bank representatives and the British Bankers' Association to discuss the proposals, a person familiar with the matter said. The FSA declined to comment. The Treasury didn't return calls seeking comment.