Let’s start by dismantling the barriers to long-term investment

Marie-France Baud: How do you view the changes in financial regulation in Europe and the implications for long-term investment?
Jacques de Larosière:  There is no doubt that financial regulation has strengthened the capital base and made the system more secure, but it has also discouraged long-term investment. Under the Solvency II regulation, insurance companies face a capital charge of 39% on their equity investments. The capital ratios imposed on banks are also based on the idea that long-term investment is risky. So the first step is to stop discouraging long-term investment for no reason. This also applies to accounting rules, which have a very negative impact on long-term investment.  Generally speaking, financial and fiscal regulation discourages capital investment and increases debt, since the interest on debt is tax deductible whereas this is not the case for dividends and capital gains. The NSF ratios1 applicable to banks, based on their medium and long-term liquidity characteristics, are defined in such a way that they shorten the balance sheet of banks and discourage long-term investment. Let’s be clear, the flood of regulations both in Europe and worldwide has no doubt made the financial system more secure, but it has stifled long- term investment.
M.-F.  B.: Do we need to introduce specific rules and regulations for long-term investment?
J.de L.: Of course, but  we should start first by dismantling those that prevent it. Let’s take an example: a few years ago, the European Investment Bank decided to encourage the use of project bonds for financing projects by agreeing to assume a share of the short-term risk, but it didn’t change a thing. Why? Because banks and insurance companies are penalised more heavily for holding 15-year project bonds in their portfolios than for holding 10-year bonds (even if they are partially guaranteed). We should stop trying to do well and start taking practical action instead.
M.-F.  B.: How can we take the pressure off the banks? Should we organise a transition towards controlled disintermediation?
J.de L.: Given the deleveraging that is currently taking place, the banks are reducing their expo- sure to risk and SMEs, for example, are struggling to get loans. On the other hand, the banks are lending to “zero-risk” entities, i.e. governments. This aversion to risk has even greater economic consequences because the banking system plays a major role in financing the economy, much more so in Europe than in the United States. In Europe, banks finance around 70% of the economy, whereas almost 70% of the US economy is financed by the market. You are perfectly right to suggest that a transition towards controlled disintermediation is the best option if the regulations do not change. Personally, I don’t believe they will change because Europe has always supported its Anglo-Saxon counterparts on the Basel committee. So we need to organise a transition towards market financing. Securitisation is one option, which consists in moving business loans from the balance sheets of banks and selling them to interested investors on the open market.

M.-F. B.: Securitisation is of course seen as a possible remedy to the credit crunch, but didn’t it cause the crisis in the first place?
J.de L.: Securitisation does get a bad press because it was misused by American banks, which led to the subprime lending crisis in 2007. The very concept of subprime loans is outrageously paradoxical: it consists in selling poor-quality loans to households that do not have the means to pay them off, in the expectation that property prices will rise indefinitely and hence solve the problem. This practice backfired in 2005-2006 when property prices in the United States began to drop. The continuous climb in prices that underpinned subprime lending shattered the securitisation market and the system collapsed. Obviously, subprime lending is not an issue in Europe. Securitisation, which consists in transferring some risks to investors, has been around for a long time. It should be organised in a straightforward, transparent manner that does not increase the number of tranches and allows for loan rating. Subprime loans were rated triple-A despite the flaws that I have just pointed out. At Eurofi, we believe that to bring the concept of securitisation back on track, the focus should be placed on very high-quality assets. Our idea is very simple: since it is SMEs that have the most trouble obtaining loans and are the most reliant on bank lending, securitisation efforts should focus on them. The first step is to identify the best risks. We know that this can be done because the Central Balance Sheet Data Office at the Banque de France has been identifying the very best com- panies – or superprimes – for a hundred years now. The total amount of very high-quality loans recorded by the Banque de France is over €100 billion, which is far from negligible. Since we know how to rate SMEs and to distinguish the good ones from the bad – and those who don’t know can learn – then we can ensure that the securitised assets offered to investors, insurance companies, pension funds and management funds are of the very best quality and have the stamp of approval of a public institution such as a central bank. If this were the case, then the regulatory penalties provided for in Basel III and Solvency II, which are applicable to securitised products, would have to be implemented more fairly. Right now, securitised assets are subject to much higher capital con straints than similar, very high-quality but non-securitised assets. The taxes on a securitised asset of equal quality – i.e. with a 0.4% possibility of default over a period of three years or more – are eight times higher. This is completely unwarranted. Assets of equal quality should be subject to the same capital charge. This is so obvious that I’m amazed the regulatory constraints that stifle and prevent any securitisation effort on behalf of SMEs have not yet been lifted. So I have come to the conclusion that talking won’t get us anywhere, however good our ideas may be. We have to act now to change the regulations.
M.-F.  B. : Will facilitating securitisation in the Eurozone to stimulate lending mean harmonising rating systems?
J.de L. : That should be the ultimate goal, yes. But we are not ready yet. We should let the central banks take responsibility for setting up a straight- forward but reliable rating system in their respective countries. We already have a system in France, Germany has the expertise and our evaluation methods are similar. If we want to develop a mechanism for evaluating SME portfolios Europe-wide, particularly in the countries that need it most – i.e. southern European countries – then we should look to the Banque de France and the Bundesbank for inspiration. If the central banks refuse or are reluctant to set up a system of evaluation in their country, then another option would be for them to delegate the task to other more willing organisations. This is doable, especially since the European Central Bank has, for several years, accepted portfolios of SME receivables as collateral when supplying liquidity to banks. It therefore has a method for classifying such assets. Of course, the goal is not to rubber stamp portfolios randomly, but to approve port- folios of very good SMEs. This would resolve your concern – which I fully share – about the stigma that is still attached to securitisation in general. With the support of the central banks and the possibility offered by Mario Draghi of directly purchasing ABS1– i.e. packages of loans granted by banks to the private sector – securitisation could make a comeback. But investors would have to be interested in the ABS market. Right now, they are not interested because of the regulatory overkill
M.-F.  B. : What  advice would you give the new Commission?
J.de L.: I would advise the Commission to investigate the increase in risk aversion over the last seven years. There is a very easy way of doing this, and that is by looking at the balance sheet of the European banks aggregated into a single European commercial bank. I have done it myself. The balance sheet shows that banks are lending less to businesses, especially SMEs. Loans are much shorter term and new incentives have probably been introduced for holding zero-risk sovereign bonds and certain more remunerative financial products. The question is, is the 2014 aggregated bank better than its 2006 predecessor? The Commission should be asking whether these changes are in Europe’s best interests. It should also be looking at another issue, which has more to do with businesses themselves than with regulation: until they recover from the recession, which was caused by the excessive tax burden they carry, their profit margins and competitiveness will continue to decline.
To sum up, two fundamental trends have emerged. The first is a structural one: the process of governing is  very  costly, which means a heavy tax burden is placed on the public (including businesses) to cover excessive public spending. As a result, businesses (especially SMEs) do not have the balance sheet needed to obtain a bank loan. The second trend is that banks are less and less willing to lend. Unfortunately, both trends are negative.