Standard & Poor's Responds To The European Commission's Green Paper On Long-Term Financing Of The European Economy

Primary Credit Analyst: Paul Watters, CFA, London (44) 20-7176-3542; paul.watters@standardandpoors.com Secondary Contacts: Michael Wilkins, London (44) 20-7176-3528; mike.wilkins@standardandpoors.com Rob C Jones, London (44) 20-7176-7041; rob.jones@standardandpoors.com Karlo S Fuchs, Frankfurt (49) 69-33-999-156; karlo.fuchs@standardandpoors.com Joyce T Joseph, New York (1) 212-438-1217; joyce.joseph@standardandpoors.com

Table Of Contents
Overview A Six-Point Plan For Improving Funding Support 1. Infrastructure Finance Will Require More Diverse Sources Of Funding 2. Private Placements And Direct Lending Offer An Alternative To Long-Term Bank Finance 3. Policymakers Rediscover Structured Finance And Securitization 4. Regulation Dampens Institutional Investors' Appetite 5. The Role Of Fair Value Accounting 6. More Transparent Information And Reporting Should Reduce Risk Notes

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Standard & Poor's Responds To The European Commission's Green Paper On Long-Term Financing Of The European Economy
(Editor's Note: The following is the text of a response sent by Standard & Poor's Ratings Services to the European Commission regarding its Green Paper titled "Long-Term Financing of the European Economy," dated March 25, 2013. The views in this letter represent those of Standard & Poor's Ratings Services and do not address, nor do we intend them to address, the views of any other subsidiary or division of Standard & Poor's Financial Services LLC or of its parent, the McGraw-Hill Companies.) Standard & Poor's Ratings Services (Standard & Poor's) welcomes the opportunity to respond to the public consultation in relation to the European Commission's (EC's, or Commission's) Green Paper on "Long-Term Financing of the European Economy," published on March 23, 2013.

Overview
We concur with the Commission's view that commercial banks in Europe have historically played a disproportionately large role in the credit transmission process for long-term lending, and that further deleveraging over the next couple of years to meet stricter regulatory requirements is likely to limit their activities in this area. Higher underwriting standards and spread margins, along with prioritizing domestic markets over international and wholesale market activities, has reduced overall lending capacity and clearly added to the degree of financial fragmentation within the European Economic and Monetary Union (eurozone). In our view, these developments are potentially problematic, as the EC Green Paper identifies, for the provision of long-term private sector funding for vital infrastructure and for stabilizing credit conditions across the eurozone for small and midsize enterprises (SMEs) that traditionally rely on bank financing. To encourage non-bank lenders to commit capital to support these market segments over the longer term, we believe certain principles are important: A stable regulatory environment divorced from the political cycle to facilitate long-term investor participation and reduce default risk. A recognition that loan pricing needs to be higher to reflect credit risks on a stand-alone basis, unless government risk-sharing or other funding support is provided. Full transparency in information provision and financial reporting should be best practice, allowing investors to benchmark their risk exposure against other investments and stakeholders. The reinforcement of common standards promoting the single European market in financial services. This could in our view include enhancing the cross-border insolvency framework and developing a pan-European private placement market. But even if a policy framework conducive to private sector funding for long-term investment in infrastructure and SMEs were established, we believe it would still take 5-10 years for a funding market to develop critical mass and become self-sustaining.

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Standard & Poor's Responds To The European Commission's Green Paper On Long-Term Financing Of The European Economy

A Six-Point Plan For Improving Funding Support

Based on our experience of providing credit ratings to the European credit markets, we believe there are six key areas to address in supporting long-term infrastructure investment and SME financing. These cover: more diverse sources of funding; the establishment of a European private placement market; greater use of structured finance and securitization; a considered approach to regulation and its effects on institutional investors; the role of fair value accounting; and greater transparency around company information and reporting to enable investors to better assess their risk exposures.

1. Infrastructure Finance Will Require More Diverse Sources Of Funding

Despite increased participation by institutional investors in project finance, we believe that funding sources should diversify further. As we see it, the main reasons that institutional and other investors avoid infrastructure lending are lack of industry data, inexperience, and an unwillingness to take on construction risk. Recently, a better understanding of construction risk and how it can be mitigated through structural and credit enhancements has led to some European institutions becoming more comfortable with pre-completion project investments. One example is the 143 million 'A-' rated project bonds raised to finance the University of Hertfordshire's student accommodation facilities in June 2013 (see "Postsale: ULiving@Hertfordshire PLC," published June 6, 2013, on Ratings Direct). We believe banks can (as they have in other parts of the world) play a role in shaping institutional investors' perceptions about these areas by providing credit enhancement, contingent liquidity, and financing for the construction phase of infrastructure projects. Risk mitigation techniques, such as credit and risk guarantees, have been welcomed by institutional investors. And subordinated debt positions taken by the European Investment Bank (EIB) under the Project 2020 Bond Initiative have enhanced the credit quality of senior debt issued by project finance issuers (see "How Europe's New Credit Enhancements for Project Finance Bonds Could Affect Ratings," published Nov. 13, 2012, on Ratings Direct). Nevertheless, credit enhancement is not necessarily the panacea for attracting long-term institutional financing. Institutional investors have recently invested in U.K. projects without requiring credit enhancement--anecdotal evidence suggests that institutional investors may invest in unenhanced project bonds if the yield is right and their credit appraisal is positive. We believe the provision (and maintenance) of equity in long-term infrastructure projects is an important consideration. Typically, equity investors require incentives to compensate for the back-ended nature of their return, with much of their investment risk and outlay occurring in the concession's early years. Such incentives have, in our experience, included performance-based "earn-out returns" after a certain point in the life of the concession. They have also included the ability for investors to sell their equity positions in the secondary market after a certain period. Absent such incentives, equity will often find itself deeply subordinated for the life of the financing, leading to high return expectations that can materially increase financing costs.

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Standard & Poor's Responds To The European Commission's Green Paper On Long-Term Financing Of The European Economy

2. Private Placements And Direct Lending Offer An Alternative To Long-Term Bank Finance
Standard & Poor's agrees with the EC that SMEs are highly reliant on bank funding when they require external financing to fund growth. However, this funding is threatened by the deleveraging process being undertaken by the European banking sector. While many large European banks have made progress in deleveraging, the sector overall has further to go to meet regulatory requirements. In our view, it is likely to take several more years for the sector to deleverage and strengthen its balance sheets. Accordingly, non-bank financing for midsize companies and SMEs should be a priority, although factoring, asset-based lending, and supply chain financing can all play a role. Policy initiatives such as the U.K. government's Funding for Lending and Business Finance Partnership should also provide an incentive to banks and alternative institutional lenders to increase direct term lending to corporates with additional incentives for SMEs. However, these funding schemes have yet to gain traction, largely because of their lack of standard terms and conditions, credit support, and public subsidy. We therefore propose two alternative routes to tackle midsize company financing--a pan-European private placement market and direct lending--coupled with a recent Standard & Poor's initiative, the Mid-Market Evaluation (MME).

European private placement (PP) market

We believe that European institutional investors would support the development of a pan-European PP market with harmonized regulations and information standards. In our experience, there appears to be appetite among midsize and larger companies to diversify funding sources to a pan-European PP market that shares some of the characteristics of the U.S. PP and German Schuldscheine markets. A pan-European PP market might be characterized by privately placed, euro-denominated long-term loans or bonds featuring standard documentation. We understand that secondary market pricing and liquidity are not essential requirements at this stage. However, there are other factors to consider: The U.K. Association of Corporate Treasurers' report "PP15+ working group on developing a UK Private Placement market" (see note 1), published in December 2012, provides an assessment of the (mostly minor) impediments preventing a flourishing PP market to take hold in the U.K. In our view, this reasoning might well equally apply at the European level. Two substantive impediments are the lack of rules addressing how insurers might invest in long-term debt of varying credit quality; and the lack of a 10-year track record for European corporate PP issuers, thereby preventing the calculation of regulatory capital requirements.

Direct lending
Direct lending comprises bilateral loans provided or funded by non-bank institutions. In our view, there is scope to develop the direct lending market in Europe for midsize corporate issuers. The main difficulties for non-bank lenders appear to be originating loans, assessing and monitoring credit quality, and setting pricing at the appropriate level to achieve satisfactory risk-adjusted returns after transaction costs. Pricing direct loans remains difficult because relationship banks typically subsidize spreads with ancillary fees derived from other services provided by the banks.

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Standard & Poor's Responds To The European Commission's Green Paper On Long-Term Financing Of The European Economy

Various non-bank lending channels are developing. But two offering potential scalability are: Non-bank lenders partnering with a commercial bank to provide term loan funding on a nonrecourse basis. Essentially, non-bank lenders source loan transactions through the bank's retail branch network that meet certain credit standards. Agencies such as the EIB, or government schemes such as the Business Finance Partnership in the U.K., providing non-bank lenders with cheap capital or guarantees.

Mid-Market Evaluation (MME)

The lack of reliable third-party credit information about midsize companies and SMEs is one of the factors hampering such companies' ability to access non-bank debt financing. To this end, we recently introduced the MME. This private credit evaluation is not a rating. It assesses a company's creditworthiness, following a similar methodology to that used in Standard & Poor's corporate ratings but using a simplified and customized analytical framework. MMEs are assessed on a separate scale and privately distributed with a written evaluation of the borrower to investors and intermediaries selected by the borrower. We believe that these evaluations may support institutional investors' own internal credit appraisals and may contribute to the development of a pan-European PP market by establishing a credit benchmark. It remains to be seen to what extent such credit evaluations will be accepted by insurers.

3. Policymakers Rediscover Structured Finance And Securitization

Despite regulatory initiatives such as Solvency II and the Basel Committee on Banking Supervision's work on bank capital requirements, there appears to be a resurgence of interest among policymakers of the merits of securitization, particularly as most European securitizations have performed as expected over the past few years. One industry initiative to revitalize the use of securitization is the Prime Collateralised Securities (PCS) designation created in 2012 by the Association for Financial Markets in Europe and the European Financial Services Roundtable. Currently, the PCS is applied only to the most senior tranches of four asset classes, of which SME loans is one. Regulators also appear to view the use of covered bonds more favorably as a form of secured funding. Covered bonds usually have dual recourse to the financial institution behind the covered bond program and to the assets in the cover pool. Consequently, they are typically rated no lower than the covered bond issuer. The degree of potential uplift for the rating reflects among other factors the credit quality, payment structure, and cash flow characteristics of the assets in the pool. Part of the analysis estimates the default frequency and loss severity of the specific assets to determine the potential expected loss post default. Traditional covered bond asset types comprise residential or commercial mortgage loans, or public sector assets. Over time, we expect secured SME loans to increasingly be classified as eligible collateral in covered bond frameworks. In essence, we would expect an SME covered bond issue to resemble an SME securitization, with the added benefit of a guarantee from the sponsoring bank, making it a dual-recourse debt instrument. This structure could allow the covered bond to be rated higher than the issuer's senior unsecured debt. However, recovery assumptions would be materially lower than more traditional covered bond-eligible collateral. Certain structural elements of a covered bond could mitigate the risk of any asset liability mismatch in the event that the issuer defaults and fails to pay the bonds at maturity. In our opinion, SME covered bonds could eventually become as systemically important as

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traditional covered bonds.

4. Regulation Dampens Institutional Investors' Appetite

In our view, Solvency I gave limited guidance for insurers and reinsurers regarding their long-term investments, or asset risk as a whole. Solvency II, by contrast, focuses on risk management and credit benchmarking, with criteria applying to the credit quality of fixed-income instruments. Incentives to more closely match assets and liabilities are proposed under Solvency II, but other features may limit insurers' appetite to make long-term equity and debt investments because planned capital requirements are significantly influenced by short-term market volatility. In terms of debt instruments, the insurance industry has demonstrated its willingness and track record for buying-to-hold (which may limit exposure to market volatility). Nevertheless, a report issued by the European Insurance and Occupational Pensions Authority (EIOPA) on the regulatory treatment of long-term guaranteed insurance products (and the investments that match them) titled "Technical Findings on the Long-term Guarantees Assessment," dated June 14, 2013 (see note 2) has not allayed the industry's concerns about the onerous treatment applied to the impact of short-term market volatility on capital requirements. For occupational pension schemes, however, we understand that the EC has recently abandoned plans to adopt a Solvency II-type quantitative solvency regime. In our view, applying such a regime could cause a major shift in pension schemes' investment appetites, as well as a significant increase in contributions from plan sponsors that would have adverse implications for long-term investment and economic growth.

5. The Role Of Fair Value Accounting

In the wake of the recent market stress, some market participants have questioned whether fair value accounting provides useful information for investment and credit decisions. In our view, the optimal accounting treatment of financial instruments (that is, whether they are presented at amortized cost or fair value on the statement of financial position) should consider a company's asset-liability management model and its business strategy. In some cases, fair value accounting would best achieve those objectives; in other cases, amortized cost treatment may provide a better representation. However, we believe fair value measures should be complemented by other pertinent information such as account composition, manner of measurement, availability of a liquid market, susceptibility of amounts to change, range of potential outcomes, and the circumstances under which the value may change in the future. From our perspective, better disclosure by banks about how they determine fair values and the range of possible outcomes given varying assumptions could boost market confidence in the banking sector.

6. More Transparent Information And Reporting Should Reduce Risk

In our opinion, a key reason behind institutional investors' failure to materially invest in long-term infrastructure debt is the lack of information about the projects to be funded. A good example is the demand for investment in offshore wind

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farms in Western Europe. These large-scale, difficult projects utilize new technology and have little in the way of a proven earnings record. Utility balance sheets and state lending organizations have been the dominant sources of funding for this relatively new asset class, but these are unlikely to be sufficient to fund the ambitious investment needed by 2020. Poor transparency and risk disclosure heightens uncertainty and creates market risk. In our view, much European financial reporting disclosure lacks completeness, consistency, and clarity. Of particular concern is the general lack of information regarding operations, financial statement line items, and the nature and effect of other events and conditions that are relevant to the analysis of the company. Furthermore, potential investors require easy access to, and use of, financial reporting information to facilitate analysis. For these reasons, we believe a comprehensive, uniformly applied disclosure framework, perhaps requiring a publicly sponsored central European depositary for financial information for companies with public securities outstanding, is crucial to the comprehensive analysis of companies, projects, and financing vehicles. In analyzing a company's performance, including its business and financial risks, financial position, and cash flow prospects, users consider information in the financial report as a whole. This includes information contained in the Management's Discussion and Analysis section, and that presented in the primary financial statements and notes. Yet, investors' analysis is often impeded by incomplete, contradictory, and confusing presentation. Accordingly, we recommend the adoption of a framework that requires companies to disclose in a predictable and consistent fashion: Their accounting policy selections and applications; The related balances in the financial statements and accounts composition; and The significant assumptions on which material account balances are based, along with events that could cause these assumptions and balances to change, and an assessment of the probability or likelihood of such changes occurring. We understand that the Financial Accounting Standards Board and International Accounting Standards Board are working on such a framework, and look to them to avoid meaningful distinctions in financial information reported globally. In terms of the frequency of reporting, we are of the view that all stakeholders should receive information at the same time and frequency. Most companies typically provide quarterly financial reports to their relationship banks. While some of this information may be confidential and commercially sensitive, we believe that sufficient information should be provided publicly to investors holding a company's securities to enable them to make informed investment choices and minimize the risks of creating a two-tier market where bond investors are materially disadvantaged relative to private loan investors. This should include important details about financial covenants and compliance as well as notice of important waivers and amendments relating to any loan agreements. In our view, consistent, reliable, periodic disclosure provides the foundation for an efficient, liquid secondary market.

Notes
1. More information on the Association of Corporate Treasurers report establishing a PP market in the U.K. can be found at http://www.treasurers.org/node/8624

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2. More information on the EIOPA report can be found at

https://eiopa.europa.eu/fileadmin/tx_dam/files/consultations/QIS/Preparatory_forthcoming_assessments/final/outcome/EIOPA
Additional Contact: Industrial Ratings Europe; Corporate_Admin_London@standardandpoors.com

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