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Published online by Cambridge University Press: 20 January 2017
This article focuses on misaligned incentives in the lending process caused by the shift from the traditional relationship banking model to a more transaction-oriented ‘originateto-distribute’ model of bank finance as one of the major factors contributing to the financial crisis of the years 2007–2009. Based on a theoretical analysis of banks as financial intermediaries and the agency costs involved if banks distribute assets they have created to other parties in the financial system, empirical studies are reviewed which demonstrate that market mechanisms apparently contain these agency costs in loan syndications and loan sales, but failed to do so in securitisations during the years before the onset of the financial crisis. The EU has already reacted to this breakdown of market mechanisms by an amendment to the Capital Requirements Directive with the purpose of aligning incentives in securitisation transactions by getting more securitiser ‘skin in the game’. Similar legislation has been adopted in the US. This article places the EU and US response to perceived shortcomings in securitisations in the context of the theoretical and empirical literature and discusses alternative regulatory solutions.
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32 Radhakrishnan Gopalan, Vikram Nanda and Vijay Yerramilli, “Does Poor Performance Damage the Reputation of Financial Intermediaries? Evidence from the Loan Syndication Market”, Journal of Finance, Forthcoming.
33 Wood, International Loans, supra note 20, at para. 9-018.
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36 Wood, International Loans, supra note 20, at para. 9-039.
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44 See for descriptions of securitisation transactions, e.g., Benjamin, supra note 21, at paras. 18.10 et sqq.; Wood, Project Finance, supra note 21, at paras. 6-001, 6-015 et sqq.
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47 See for descriptions of the parties involved in the securitisation of mortgage-backed loans and analyses of the various agency problems resulting from the division of the lending process Ashcraft/Schuermann, supra note 46, at pp. 5 et sqq.; Franke, Günther and Krahnen, Jan Pieter, “The Future of Securitization”, in Fuchita, Yasuyuki, Herring, Richard J. and Litan, Robert E. (eds), Prudent Lending Restored. Securitization after the Mortgage Meltdown (Tokyo/Washington, D.C.: Brookings Institution, 2009), pp. 105 et sqq., at pp. 122 et sqq.Google Scholar; John Kiff and Paul Mills, “Money for Nothing and Checks for Free: Recent Developments in US Subprime Mortgage Markets”, 17 August 2007, IMF Working Paper No. 07/188, available on the Internet at <http://ssrn.com/abstract=1006316> (last accessed on 25 July 2011), at pp. 11 et sqq.; Ingo Fender and Janet Mitchell, “The Future of Securitisation: How to Align Incentives?”, 14 September 2009, BIS Quarterly Review, available on the Internet at <http://ssrn.com/abstract=1472970> (last accessed on 25 July 2011), pp. 27 et sqq., at pp. 30 et sqq.
48 Ashcraft/Schuermann, supra note 46, at p. 5.
49 A credit score attempts to reduce a borrower's credit history to a single number indicating the borrower's probability of default by weighing various elements such as the borrower's payment history and any previous defaults of the borrower.
50 Keys/Mukherjee/Seru/Vig, supra note 15, at pp. 309, 317 et sqq.
51 Amiyatosh K. Purnanandam, “Originate-to-Distribute Model and the Subprime Mortgage Crisis”, 20 May 2010, AFA 2010 Atlanta Meetings Papar, available on the Internet at <http://ssrn.com/abstract=1167786> (last accessed on 25 July 2011), at p. 2.
52 Uday Rajan, Amit Seru and Vikrant Vig, “The Failure of Models that Predict Failure: Distance, Incentives and Defaults”, 2 August 2010, Ross School of Business at the University of Michigan Research Paper No. 1122, available on the Internet at <http://ssrn.com/abstract=1296982> (last accessed on 25 July 2011), at p. 3; Diamond/Rajan, supra note 1, at pp. 606 et sqq.; Keys/Mukherjee/Seru/Vig, supra note 15, at pp. 309 et sqq., 318.
53 Franke/Krahnen, supra note 47, at pp. 117 et sqq.
54 Steven L. Schwarcz, “Private Ordering of Public Markets: The Rating Agency Paradox”, University of Illinois Law Review [2002], pp. 1 et sqq., at p. 12.
55 Schwarcz, supra note 54, at p. 15; Ashcraft/Schuermann, supra note 46, at pp. 10 et sqq.; Schwarcz, Steven L., “Protecting Financial Markets: Lessons from the Subprime Mortgage Meltdown”, 93 Minnesota Law Review (2008–2009), pp. 373 et sqq., at pp. 400 et sqq.Google Scholar; Eggert, Kurt, “The Great Collapse: How Securitization Caused the Subprime Meltdown”, 41 Connecticut Law Review (2009), pp. 1257 et sqq., at p. 1298.Google Scholar
56 See for example The Economist, “Securitisation: When it goes wrong…”, 20 September 2007; Frederic S. Mishkin, “Leveraged Losses: Lessons from the Mortgage Meltdown”, Speech at the US Monetary Policy Forum, New York, New York, 29 February 2008, available on the Internet at <http://www.federalreserve.gov/newsevents/speech/mishkin20080229a.htm> (last accessed on 25 July 2011); Eggert, supra note 55, at pp. 1276 et sqq.
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58 Keys/Mukherjee/Seru/Vig, supra note 15.
59 Keys/Mukherjee/Seru/Vig, supra note 15, at pp. 310, 330 et sqq.
60 Keys/Mukherjee/Seru/Vig, supra note 15, at pp. 311, 338 et sqq. See for similar empirical findings Rajan/Seru/Vig, supra note 52, at pp. 1 et sqq., 13 et sqq.
61 Purnanandam, supra note 51.
62 Purnanandam, supra note 51, at pp. 12 et sqq.
63 Efraim Benmelech, Jennifer Dlugosz and Victoria Ivashina, “Securitization without Adverse Selection: The Case of CLOs”, 11 August 2010, AFA 2010 Atlanta Meetings Paper, available on the Internet at <http://ssrn.com/abstract=1344068> (last accessed on 25 July 2011), at pp. 16 et sqq.
64 Benmelech/Dlugosz/Ivashina, supra note 53, at pp. 1 et sqq.
65 Schwarcz, Steven L., “Disclosure's Failure in the Subprime Mortgage Crisis”, Utah Law Review [2008], pp. 1109 et sqq., at pp. 1117 et sqq.Google Scholar
66 See in particular International Monetary Fund, Global Financial Stability Report October 2009, supra note 3, at pp. 78 et sqq. (Box 2.1. The Case for Restarting Securitization). See for some empirical evidence on the value creation in commercial mortgage loan securitisation, An, Xudong, Deng, Yongheng and Gabriel, Stuart A., “Value Creation through Securitization: Evidence from the CMBS Market”, 38 Journal of Real Estate Finance and Economics (2009), pp. 302 et sqq.CrossRefGoogle Scholar
67 See for an overview of current regulatory proposals: International Monetary Fund, Global Financial Stability Report October 2009, supra note 3, at pp. 93 et sqq.
68 Related to the disclosure-based regulatory approach but addressing shortcomings exposed by the recent financial crisis going beyond incentive problems in the lending process is the regulation of credit rating agencies as gatekeepers in financial markets which would primarily process additional information provided pursuant to improved disclosure standards. New legislation has been recently introduced in the EU and the US marking a decisive move away from self-regulation in this area and trying to reduce conflicts of interests affecting credit rating agencies: See Regulation (EC) No. 1060/2009 on credit rating agencies, OJ 2009 L 302/1; sections 931–939H Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. No. 111–203.
69 See Financial Stability Forum, supra note 4, at pp. 30 et sqq.; Technical Committee of the International Organization of Securities Commissions, Report on the Subprime Crisis, supra note 4, at pp.7 et sqq.; Technical Committee of the International Organization of Securities Commissions, Unregulated Financial Markets and Product. Final Reports (Madrid: International Organization of Securities Commissions, September 2009), at paras. 60 et sqq.Google Scholar; US Department of the Treasury, Financial Regulatory Reform. A New Foundation: Rebuilding Financial Supervision and Regulation (Washington, D.C.: US Department of the Tresury, June 2009), at p. 45 Google Scholar; Treasury, HM, Reforming Financial Markets, CM 7667 (London: The Stationary Office, July 2009), at paras. 6.09 et sqq.Google Scholar
70 See the initiatives by the Securitisation Division of the Association for Financial Markets in Europe (formerly the European Securitisation Forum), available on the Internet at <http://www.afme.eu> (last accessed on 25 July 2011) which expressly include the “reduction of information asymmetries and improvement of alignment of incentives between originators, investors, and other market participants”. A joint effort of regional industry bodies exists further under the umbrella of the Global Joint Initiative to Restore Confidence in Securitization Markets which commissioned the report “Restoring Confidence in Securitization Markets” in December 2008 as an early stage of a practical, industry-led response to restore confidence in market practices. These projects seem not yet as developed as the American Securitization Forum's Project on Residential Securitization Transparency and Reporting (‘Project RESTART’), information available on the Internet at <http://www.americansecuritization.com/restart> (last accessed on 25 July 2011).
71 Franke/Krahnen, supra note 47, at p. 120; Darrell Duffie, “Innovations in Credit Risk Transfer: Implications for Financial Stability”, 1 July 2008, BIS Working Paper No. 255, available on the Internet at<http://ssrn.com/abstract=1165484> (last accessed on 25 July 2011), at pp. 16 et sqq.
72 Engel/McCoy, supra note 46, at pp. 2065 et sqq.
73 Franke/Krahnen, supra note 47, at pp. 152 et sqq./157; Fender/Mitchell, supra note 47, at pp. 40, 42; US Department of the Treasury, supra note 59, at p. 45.
74 Franke/Krahnen, supra note 47, at p. 153.
75 Gorton, supra note 45, at p. 37; Schwarcz, supra note 57, at pp. 1113 et sqq.
76 International Monetary Fund, Global Financial Stability Report. Containing Systemic Risk and Restoring Financial Soundness (Washington, D.C.: International Monetary Fund, April 2008), at p. 55 Google Scholar; Franke/Krahnen, supra note 47, at p. 146. Therefore, new legislation in the EU now requires credit rating agencies to introduce clearly differentiated rating categories for structured finance instruments using an additional symbol which distinguishes them from rating categories used for any other entities, financial instruments or financial obligations: Art. 10(3) Regulation (EC) No. 1060/2009 on credit rating agencies, OJ 2009 L 302/1. A similar proposal has been made in the US but has not yet found its way into legislation: US Department of the Treasury, supra note 59, at p. 46.
77 Schwarcz, supra note 55, at pp. 386, 399 et sqq.
78 See The High-Level Group on Financial Supervision in the EU, supra note 4, at para. 95; US Department of the Treasury, supra note 59, at p. 44; HM Treasury supra note 59, at para. 6.13 and in particular Technical Committee of the International Organization of Securities Commissions, Unregulated Financial Markets and Product, supra note 59, at paras. 58 et sqq.
79 See on the main implications of this regulatory change Freshfields Bruckhaus Deringer LLP, The Bank of the Future, (November 2009), available on the Internet at <http://www.freshfields.com/industries/reports/bank_of_the_future/26595.pdf> (last accessed on 25 July 2011), at pp. 68 et sqq.
80 Directive 2009/111/EC amending Directives 2006/48/EC, 2006/49/EC and 2007/64/EC as regards banks affiliated to central institutions, certain own funds items, large exposures, supervisory arrangements, and crisis management, OJ 2009 L 302/97.
81 Directive 2006/48/EC relating to the taking up and pursuit of the business of credit institutions (recast), OJ 2006 L 177/1.
82 Directive 2006/49/EC on the capital adequacy of investment firms and credit institutions (recast), OJ 2006 L 177/201.
83 Art. 122a(8) Banking Consolidation Directive (as amended).
84 Article 13 of the Commission Proposal for a Directive of the European Parliament and of the Council on Alternative Investment Fund Managers and amending Directives 2004/39/EC and 2009/…/EC, COM(2009) 207 final.
85 Art. 122a(7) Banking Consolidation Directive (as amended).
86 Art. 122a(4) Banking Consolidation Directive (as amended).
87 Public Law No. 111-203.
88 15 USC. §78a et seqq.
89 Section 941 Dodd-Frank Act.
90 Sections 942, 943 Dodd-Frank Act.
91 Data provision used to be at pool-level: Fender/Mitchell, supra note 47, at p. 35.
92 Ingo Fender and Janet Mitchell, “Incentives and Tranche Retention in Securitization: A Screening Model”, 1 September 2009, BIS Working Paper No. 289, available on the Internet at <http://ssrn.com/abstract=1481663> (last accessed on 25 July 2011); John Kiff and Michael Kisser, “Asset Securitization and Optimal Retention”, 1 March 2010, IMF Working Paper No. 10/74, available on the Internet at <http://ssrn.com/abstract=1578672> (last accessed on 25 July 2011). See also International Monetary Fund, Global Financial Stability Report. October 2009, supra note 3, at pp. 101 et sqq. (Box 2.7. Optimal Retention Policies for Loan Securitization) and Fender/Mitchell, supra note 47, at pp. 37 et sqq.
93 The Economist, “Securitisation: Earthbound”, 25 March 2010.
94 Similarly Fender/Mitchell, supra note 47, at p. 41.