Did ECB Allow European Structured Finance Legislation to Be Influenced by Sell-Side?

by: Richard Field
In May 2009, despite intense opposition from the sell-side lobbyists, the European Parliament passed Article 122a as an amendment to the European Capital Requirements Directive. It applies to European credit institutions which are broadly defined to include commercial and investment banks.

Article 122a embodies the sensible notion that investors in structured finance securities should "know what they own". If they do not know what they own, the article requires that they not be able to use any leverage to support their purchases of these assets. This too is sensible as it prevents the credit institution from losing more than its equity capital on investments where it is effectively blindly betting.

Why would the sell-side lobby against investors knowing what they own? It implied a change in how information was disclosed to the buyer. As readers of this blog know, disclosure has two equally important parts: What is disclosed and when it is disclosed.

There appears to be little debate about what loan-level information should be disclosed. The disagreement is over when it should be disclosed.

Your humble blogger has been pushing for observable, event-based loan-level disclosure for structured finance securities so that all market participants can see the current status of any loan (see here, here, here and here). As demonstrated using the Brown Paper Bag Challenge, this is the frequency of disclosure that investors need if they are to really know what they own.

Since the start of the credit crisis, investors have mostly been on a buyers' strike because they are unwilling given current once per month or less frequent disclosure to bet blindly on the value of the security.

Under Article 122a, the bank regulators were left to define what "know what you own" means and then to enforce this definition.

Paul Volcker, Mervyn King, Jean-Claude Trichet and the Group of 30, in the January 2009 report, "Financial Reform: A Framework for Financial Stability", offered a relevant recommendation to regulators tasked with defining what "know what you own" means (emphasis added):

The appropriate national regulator should, in conjunction with investors, determine what information is material to investors in these products and should consider enhancing existing rules or adopt new rules that ensure disclosure of that information, for both asset-backed and synthetic structured products

It seems entirely reasonable that only investors would know what it would take in the way of disclosure for them to know what they own when it comes to structured finance securities.

In a June 2009 speech in Cambridge, then EU Commissioner for Internal Markets Charlie McCreevy noted the problem for regulators with not adhering to this recommendation when he observed (emphasis added):

It is readily apparent that the Brussels financial services lobby is dominated by the sell side of the market. As regulators, we need to be conscious of this and do everything possible to ensure that the buy side's views are adequately and well represented:

When I talk about the buy side, I am not so much talking about the retail consumer – who is generally well represented by consumer organizations - : I am talking about the professional "buy side" of the market in areas like, for example, structured products:

We have become more conscious of this in recent times. That's why I have indicated to the Commission Services that equal weight be given to the views of the buy side and to the representation of the buy side in expert and consultative groups in the future - because by definition the buy side of the market is as important a player as the sell side.

On December 16, 2010, the European Central Bank as part of its ABS loan-level initiative, proposed its definition of "know what you own".

The Governing Council of the European Central Bank (ECB) has decided to establish loan-by-loan information requirements for asset-backed securities (ABSs) in the Eurosystem collateral framework. The Governing Council intends to introduce the loan-by-loan information requirements approximately within the next 18 months, first for retail mortgage-backed securities (RMBSs) and thereafter gradually for other ABSs.

Loan-level data will be provided in accordance with the template which is available on the ECB's website, at least on a quarterly basis on, or within one month of, the interest payment date of the instrument in question. To allow the processing, verification and transmission of the data, the Eurosystem will encourage market participants to establish the necessary data-handling infrastructure. This is expected to facilitate the application of the loan-by-loan information requirements and contribute to further developing transparency in the ABS market.

When the necessary data-handling infrastructure has been established, the provision of loan-by-loan information will become an eligibility requirement for the instruments concerned. The Eurosystem will continue to accept securities not meeting the new information criteria until the obligation to submit loan-level data comes into force.

Why would the ECB adopt the current once-per-month or less frequent disclosure practices? After all, the European Parliament was aware of these disclosure practices and specifically did not include them as part of Article 122a. Perhaps the answer lies in the composition of the ABS Technical Working Group that drafted the ECB's position.

Did the ECB follow the recommendation of the Group of 30 and include only investors on the ABS Technical Working Group or any of its subcommittees? No!

Did the ECB follow the recommendation of Commissioner McCreevy and include an equal number of investors and sell-side participants (lobbyists, investment banking, issuers and rating services)? No!

A brief look at the composition of the ABS Technical Working Group shows that there are many more sell-side participants than investors. As noted by Commissioner McCreevy, these sell-side participants have a significant vested interest in not changing the frequency of disclosure from the current practices (for example, think of how much pressure is put onto the rating services business model if all market participants can access current data).

Did the ECB realize that with its adoption of current once per month or less frequent disclosure, the ECB is saying that the current disclosure practices satisfies the "know what you own requirement" of Article 122a? Probably not! [at least that is what your humble blogger hopes is the case]

Your humble blogger suspects that the sell-side used its position on the ABS Technical Working Group to effectively end the "know what you own requirement" of Article 122a and the ECB representatives, who are not experts in disclosure or did not understand the implications for Article 122a, went along with it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.