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Europe Considers Encouraging Investment Through Shadow Banking

Shadow banking could be coming out into the light in Europe.

Since the cataclysm of the financial crisis, the European Union has been busy regulating both traditional banks and the shadow banking system – hedge funds and other financial intermediaries involved in facilitating credit – as it works to stem the possibility of future crises. But another problem has raised its head, and the EU is changing its approach.

Banks turned away from lending as they sought to boost their capital requirements in response to EU regulations designed to prevent future problems. That has stymied growth, as countries, businesses and individuals could not find money to borrow for infrastructure, expansion, or efforts to make life more comfortable.

The European Commission has estimated that a trillion euros ($1.375 trillion) of investment in just three areas – energy, transportation and telecommunications – between now and 2020 is necessary for long-term growth.

 “Europe has always relied heavily on banks financing the real economy (two-thirds of funding comes from banks, compared to one-third in the U.S.),” the EC said. “As banks are deleveraging, there is less funding available to all sectors of the economy – for example, less than one-third of Dutch and Greek SMEs [small and medium enterprises] and only around half of Spanish and Italian SMEs got the full amount of credit they applied for in 2013.”

While it is certainly not giving up on pushing banks to increase lending, the EU has decided that it’s time to bring back securitization – bundling loans into bonds that pay interest – despite the role such activity played in the financial crisis after subprime bundled loans threw markets into a cascade of descent.

In reconsidering the regulation of securitization and thus the shadow banking system, the EU has decided private sector participation in lending could be key to restoring growth. Fearful of stifling something that could provide up to 70% of the needed funds, the EC is working on a roadmap of specific goals to foster growth in the region.

Nor is securitization the only strategy it’s taking seriously. Crowdfunding also presents a host of possibilities, particularly for those SMEs. As a result, the EC plans not only to take action to promote best practices for crowdfunding, but also to provide training for those seeking such financing for projects. Another possibility is allowing the use of public funds to finance projects through crowdfunding.

On March 27, the EC released its roadmap, consisting of six main areas around which financing might be increased. They are the mobilization of private sources of funding for long-term financing; making better use of public funding; developing European capital markets, including “facilitating SMEs’ access to capital markets and to larger investment pools by creating a liquid and transparent secondary market for corporate bonds;” improving SMEs’ access to financing; attracting private financing to infrastructure, with an eye toward meeting that 2020 goal; and enhancing the wider framework for sustainable finance.

The EC also released documents that included a proposal to revise occupational pension fund rules so that those funds could be “support[ed as] the further development of an important type of long-term investor in the EU” and a communication on “crowdfunding to offer alternative financing options for SMEs.”

John Blank, chief equity strategist for Zacks, said “the good news is that if you bring back securitization, you open the door for quality analysts to basically act like credit officers used to act.” He noted out that prior to the securitization craze, “you used to have a bank officer who would look at all your [data] and give you a mortgage. Now [leading up to the crisis], that work is handed off [and securitized].”

He compared a securitized bundle of loans to “a bundle of sticks. If the sticks are sound, you have a strong bundle, and the bundle is stronger than any of the individual sticks. If [loans] come in the door properly [with all the data appropriately vetted], that’s what happens. But if the sticks are rotten, [which is what happened during the 2008 crisis] the whole bundle is [worthless].”

Blank said, “At the back end, [where] someone buys all those [loans], the buyer has to be super aware that he’s being sold a bunch of sticks and make sure that the sticks are sound.”

That didn’t happen in the financial crisis, but now those responsible for securitization are far more likely to “look down the value chain of [people] getting a mortgage or a car loan or [other loan] and [evaluate the quality of] the receivables [before] they’re collected, bundled, and sold,” he said.

The process will never be perfect, said Blank, and “always will rely on the rebuilding of the ideal credit officer in some context,” so “concerns will have to be monitored.”

In Europe, he added, it’s probably the right time to try it.

“The EU’s idea that credit market growth of this nature at this time is appropriate to expand is probably sound in theory.”

In reality, however, he said it could be a different matter altogether.

“In practice, it will require them to refashion and remerit the worthiness of these types of people [credit officers]. It will never be the case that it works without someone looking over [the data]. Done properly, it’s good financing and works fine. It doesn’t work fine when [credit officers] quit paying attention.”

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