Reforms adopted by the G20 in response to weaknesses exposed by the global financial crisis have enhanced the resilience of securitization markets, the Financial Stability Board says. However, the revamped market hasn’t been fully tested, and possible vulnerabilities remain, it noted.
In the wake of financial crisis, the G20 introduced reforms that sought to address the distorted incentives, moral hazard, and unchecked accumulation of risk concentrations that arose in securitizations, such as residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs).
Among other things, these reforms — which were developed by the International Organization of Securities Commissions (IOSCO) and the Basel Committee on Banking Supervision — included tougher prudential requirements and measures to require intermediaries to retain certain risk exposures.
In a new report reviewing the impact of these changes, the FSB said that the reforms have enhanced the resilience of securitization markets overall.
While systemic risk and moral hazard are not directly observable, the review aims to assess the circumstantial evidence of these phenomena — such as the complexity and opacity of the markets, the credit quality and performance of underlying assets, and the behaviour of these markets in recent episodes of market stress — to evaluate the market’s resilience.
To that end, the review found that the use of the kinds of complex structures that contributed to the crisis, such as sub-prime securitizations, CDOs, and re-securitizations, has “declined significantly” since the reforms were adopted.
Additionally, it found that the quality of the collateral used in these transactions has improved in certain segments (RMBS), and that the market is now more transparent than it was in the years preceding the crisis.
“The reforms appear to have contributed to a redistribution of risk from banks to the non-bank financial intermediation (NBFI) sector,” the FSB said — with the so-called “shadow banking” sector taking a bigger role in both securitizations, and in providing financing to the real economy.
However, the implications of this shift in risk for financial stability is, “difficult to assess,” the report said, as it’s not clear how well shadow banks will be able to cope with losses created by episodes of intensified market stress.
The FSB also cautioned that the sector’s improved resilience hasn’t been fully tested through a complete credit cycle.
“This is particularly relevant for [collateralized loan obligations (CLOs)] that have grown significantly in recent years but have not yet experienced a prolonged downturn,” it said.
As a result, the report calls on regulators and policymakers to monitor emerging risks in the securitization markets, given the increased risk transfer, and the growing use of private credit in securitization vehicles.
It also recommended that policymakers consider the need for risk retention requirements in the global CLO market, which currently doesn’t operate under these constraints due to a 2018 court decision in the U.S. that overturned risk retention requirements for CLOs.
“The evaluation highlights the importance of the G20 reforms in enhancing securitization market resilience. Nonetheless, recent market developments reinforce the need for authorities to monitor risks and to ensure the alignment of incentives between securitization originators, sponsors and investors,” said Benjamin Weigert, chair of the FSB group that carried out the review, and director general for financial stability at the Deutsche Bundesbank.