Securitisation Regulation adopted by European Parliament

Publication | October 2017

Summary

On October 26, 2017 the European Parliament voted on and approved the new Securitisation Regulation and related amendments to the Capital Requirements Regulation. While the new rules will be more prescriptive than the current regime, some of the most contentious aspects have been dropped. The new framework will take some getting used to, but market participants have time to start preparing before level two technical requirements are finalised.

Securitisation Regulation adopted by European Parliament

On October 26, 2017 the European Parliament voted on and approved the new Securitisation Regulation (SR) and Securitisation Prudential Regulation (SPR). The SR consolidates the patchwork of legislation governing European securitisations, and introduces the long awaited rules for issuing simple, transparent and standardised (STS) securitisations. The SPR replaces the provisions of the Capital Requirements Regulation (CRR) relating to securitisation, and sets out the framework under which certain institutional investors (e.g. banks and investment firms) can benefit potentially from more favourable regulatory capital treatment for STS securitisation exposures.

Together, this legislative package will bring the EU in line broadly with the “Basel IV” securitisation framework agreed at the G20 by the Basel Committee on Banking Supervision. After the coming into force of the Prospectus Regulation in July 2017, this represents the next most significant step in the EU’s Capital Markets Union (CMU) package of reforms.

Once the texts are adopted by the European Council, they will be published in the Official Journal of the European Union and enter into force on the twentieth day following. However, most provisions are expected to apply on January 1, 2019. In the meantime, the European Supervisory Authorities need to draft, negotiate and agree all related “level II” technical standards that will provide details on how the legislation will be implemented.

While the final texts follow broadly what was agreed politically in June, there are some minor changes, including a new carve-out to the proposed ban on the securitisation of “self-certified” mortgage loans (i.e. where borrowers’ incomes are unverified). We are tracking this and all other CMU initiatives every step of the way, and continue to update our CMU technical resource to provide context when it is needed most.

Headline points

This briefing covers the following headline points in greater detail, below:

  • regulatory requirements will be consolidated, and a general approach to the SR’s application will replace the current sector-by-sector approach
  • investor suitability requirements will need to be satisfied before securitisation exposures are sold to retail investors
  • STS securitisations will be in some cases afforded better capital treatment than non-STS securitisations
  • the STS designation will be available only where the issuer, originator and sponsor are established in the EU, which could have ramifications for UK originators, sponsors and issuers post-Brexit
  • commercial mortgage-backed securitisations (CMBS) and synthetic structures will not be eligible for the STS designation
  • sanctions for non-compliance will vary depending on domestic rules, and could include fines and/or criminal sanctions
  • re-securitisations and residential mortgage-backed securitisations (RMBS) backed by unverified loans will be banned outright, subject to grandfathering and some limited carve-outs
  • significant changes will be made to the risk retention rules, but the 5 per cent retention level is being maintained
  • managers of undertakings in collective investment in transferable securities (UCITS) and occupational pension funds will be brought into scope of the due diligence and transparency rules
  • A new framework for registering “securitisation repositories” will be established to gather and store transaction data
  • securitisation hedging clearing and collateral requirements are under consideration
  • existing securitisations will be grandfathered, but the STS designation will be available for use with securitisations issued before the date of application of the SR.

A unified framework with broader scope

With a unified legislative framework, originators and sponsors of securitisation products will have a single set of rules for offering their products to different types of investors. However, the basis on which the securitisation rules are engaged is changing fundamentally. As a result, a broader range of transactions will be caught in the regulatory net.

Currently, determining what set of rules applies depends on the type of investor. For example, securitisations provisions in the CRR, Solvency II Delegated Act (Solvency II) and Alternative Investment Fund Manager Regulation (AIFM Regulation) are engaged when credit institutions or investment firms, insurance or reinsurance undertakings or alternative investment fund (AIF) managers (respectively) are investing. As a result, the onus is on them as investors to request adequate disclosure and police compliance (for example, ensuring that risk retention requirements are met).

Where an investor falls outside of these categories of investor, for example, multilateral development banks, the securitisation provisions of existing legislation do not apply. Under the SR, this sector-specific approach to regulation is being replaced with a set of rules that applies to all European securitisations, regardless who invests and whether the transaction is private or public.

Who can participate in securitisation transactions?

The SR will not limit investment in securitisation transactions to EU-regulated “institutional investors”, which include banks, insurance and reinsurance undertakings, AIF managers, UCITS management companies and internally managed UCITS, money market funds, institutional occupational pension funds and multilateral development banks. This is a departure from the European Parliament’s proposed amendments, which would have excluded non-EU investors altogether.

This had been a major concern among many market participants, in particular UK-regulated institutional investors that would have otherwise found themselves falling outside of the new rules following Brexit. EU-regulated originators will also be glad to hear that they will not be locked out of the potentially wider and deeper pool of non-EU investors.

The SR does, however, include some significant protectionist aspects. In order for a securitisation to use the STS designation, the originator, sponsor and securitisation special purpose vehicles (SPVs) must be established in the EU. In order for asset-backed commercial paper (ABCP) transactions to qualify as STS, the sponsor must be an EU credit institution supervised under the CRR. Securitisation repositories must also be established in the EU in order to register with the European Securities and Markets Authority (ESMA).

SPVs used in any securitisations (including non-STS transactions) cannot be established in a non-EU jurisdiction that:

  1. is a tax haven
  2. lacks effective exchange of information with tax authorities
  3. lacks transparency with respect to legislative, judicial or administrative provisions
  4. imposes no requirement for a substantive local presence
  5. is listed as a “Non-Cooperative Country or Territory” or is on the EU blacklist of  uncooperative jurisdictions, or
  6. has not signed an agreement to share tax information.

Separately, the SR sets out suitability tests that will need to be satisfied before securitisation exposures can be sold to retail investors. Broadly, “retail investors” includes anyone (individuals or corporates) that are not authorised professional clients” under the recast Markets in Financial Instruments Directive (MiFID II). The SR incorporates MiFID II suitability tests that look at potential investors’ knowledge and experience in investing in such products, financial suitability including the ability to bear losses, investment objectives and risk tolerance. This approach is consistent with the broader MiFID II product governance rules that will apply under in 2018.

A new sanctions regime

While the SR will create a single set of rules, it will also allow Member States to gold-plate their remedial measures as they see fit, including administrative and/or criminal sanctions. Member States’ discretion in this area is very wide; they merely need to ensure that sanctions are “effective, proportionate and dissuasive”. They must take into account whether the infringement was intentional or resulting from negligence, and must take into account the materiality, gravity and duration of the infringement. While taking into account intention or negligence suggests a move away from strict liability for non-compliance, the sanctions framework creates a minefield of compliance issues that could discourage cross-border securitisation and runs contrary to the stated aim of CMU.

A new STS regime

Capital relief is welcome, but limited in scope

The Commission’s original aim was to help kick-start the European securitisation market, on the basis that by promoting a “high quality” form of securitisation, investors will get over the lingering bad taste left by the financial crisis. The idea is for the Securitisation Regulation to identity “high quality” securitisations that are “simple, transparent and standardised”, which therefore pose less risk and could qualify for more relaxed capital rules than other securitisations. The idea was to incentivise institutional investors to build up their portfolios of STS products since they will need to set less capital aside than they do now.

Not all STS securitisations will receive the preferential capital treatment. CMBS have been excluded from the STS eligibility criteria, due to perceived vulnerabilities arising from a strong reliance on the on the sale of the underlying loans in order to repay the CMBS obligations. While better capital treatment for some products is certainly welcome, it is discouraging that a large number of securitisations that have performed historically well (such as some synthetic or more actively managed structures) will continue to be disadvantaged relative to more traditional asset-backed securities (ABS) and ABCP.

In its 2015 report to the Commission on synthetic securitisation, the European Banking Authority (EBA) recognised that synthetic transactions that are used by credit institutions to transfer the credit risk of their lending activity off-balance sheet (i.e. balance sheet synthetics) have performed relatively well. The EBA recommended extending preferential regulatory capital treatment to senior retained tranches of synthetic transactions, provided that specific criteria are satisfied. Among other things, the transactions would need to be comprised of fully cash-funded credit protection provided by private investors in the form of cash deposited with the originator institution.

At the time, the Commission was reluctant to introduce eligible STS synthetic products on the basis that it lacked sufficient information to take a view. Currently, despite being armed with the EBA’s recommendations, the Commission appears to have compromised with the European Parliament on this issue. However, the SR does contemplate the possibility of including synthetic products in the future.

The SPR, which focusses on CRR-regulated credit institutions and investment firms, does not afford the same STS capital relief to other institutional investors such as pension funds, insurance and reinsurance undertakings. The Commission has made encouraging noises in respect of extending STS capital relief to insurers, the impact of the new STS framework will be muted if they are effectively locked out of the market.

There is a second hurdle to be met under the SPR, which is being developed in parallel. The SPR establishes a set of conditions and the process by which credit institutions and investment firms can determine whether such conditions are satisfied. The test for determining whether a transaction receives preferential prudential treatment is twofold: first, the transaction must pass the STS designation process according to the SR. Second, the transaction must meet certain credit risk criteria set out in the SPR.

If the two regulations come into force at the same time, then the STS framework could have a positive effect on the market. However, if they are staggered, with the SR’s additional reporting requirements coming before the SPR’s capital relief, then market participants may be put off STS securitisations before the new framework has a chance to take hold.

STS eligibility and the labelling process

The SR sets out the eligibility criteria for the STS designation, which are grouped under the virtues of simplicity, standardisation and transparency. There are separate but broadly similar STS criteria for term securitisations and ABCP. Examples of the criteria include requiring the underlying assets to be homogeneous by type and in most cases limiting eligibility to true sale ABS only. “Homogeneous” for these purposes means being in the same asset type where the contractual, credit risk, prepayment and cash-flow related characteristics are sufficiently similar. We expect further detail to be set out in the level two technical standards.

In respect of STS-eligible ABCP transactions, “homogeneous” also concerns the maturities of the underlying asset pool. STS-eligible ABCP must be backed by a pool of assets with a remaining weighted average life of no more than one year, and no such transactions may have a residual maturity of longer than three years. Following intense lobbying by the auto industry (one of the largest sectors to use ABCP), ABCP backed by auto loans, auto leases or equipment leases can have a remaining exposure weighted average life of up to three and a half years, provided that none of the underlying assets has a residual maturity of longer than six years.

Originators, sponsors and issuers will be jointly responsible under the SR for assigning the STS designation, and would face the consequences (yet to be determined) for falsely making such a designation.

The SR sets out an optional process whereby an authorised third party can attest to the satisfaction by of the STS criteria, using a “light touch” set of rules. In order for a third party to receive regulatory authorisation to assess satisfaction of STS criteria, it must be independent, be established for that sole purpose, operate on not-for-profit basis, charge only non-discriminatory fees on a cost-recovery basis, and have professional qualifications, knowledge and experience and a good reputation. Use of such third party certification, however, will not absolve originators, sponsors and issuers from liability for making STS assertions that turn out to be false.

It should be noted that publication by ESMA on the STS register is not intended to amount to a supervisory approval. Investors will still be expected to conduct their own due diligence based on the data provided under the transparency provisions of the SR.

If the originator or original lender of the underlying assets is not an EU regulated credit institution or investment firm, then it must include its credit criteria with the STS notification. The details on the exact information and format are likely to be included in the level two technical standards.

A new ban on re-securitisations and ABS backed by unverified residential loans

Since the financial crisis, re-securitisations (i.e. securitisations backed by other securitised exposures) have faced stringent capital requirements. In fact, the original draft of the SR proposed that re-securitisations would be subject to a significantly higher risk weight floor of 100 per cent. The final text of the SR looks to ban them altogether, subject to grandfathering of transactions that are outstanding before the date of application of the SR and subject to limited carve-outs (such as ABCP structures). Considering the historical treatment of re-securitisations, this does not come as a surprise. However, due to prolonged capital charges, such transactions are already rare.

An earlier compromise text sought to ban RMBS backed by loans that are marketed and underwritten on the premise that the loan applicant or intermediaries were made aware that the information provided by the loan applicant might not be verified by the lender. However, the final agreed text only applies the ban to mortgages that were originated after the entry into force of the Mortgage Credit Directive 2014/17/EU in March 2016.

A new risk retention regime

The securitisation industry breathed a sigh of relief on the news that risk retention levels are staying put. Risk retention could have ramped up to levels that would have made many types of transactions uneconomical, particularly those most closely involved in financing the "real economy". Some members of European Parliament including Paul Tang, who spearheaded the proposal on behalf of the European Parliament, had proposed increasing risk retention requirements to 20 per cent for some types of ABS.

The required level of risk retention was arguably the most contentious issue in the “trilogue” discussions. Originators, sponsors and industry associations lobbied hard to keep requirements at the current five per cent, for fear that such transactions would become uneconomical. It is now confirmed that levels will remain at five per cent.

Under existing regulatory schemes the onus is on investors to ensure that risk retention requirements are satisfied. Current market practice is to include contractual provisions to that effect in the transaction documentation. Under the SR, Originators, sponsors and original lenders will be under a new positive obligation to retain a five per cent net economic interest in securitisation transactions.

Imposing risk retention and reporting obligations directly on the originators, sponsors or original lenders is more in line with the risk retention requirements in the US, but a significant departure from the current EU regime. Currently, the penalty for non-compliance is a punitive capital charge against investors’ balance sheets. Under the new regime, originators and sponsors could face a myriad of administrative (or even criminal) sanctions depending on how the SR is implemented in each Member State (although capital charges remain for investors that fail to conduct proper due diligence).

While there may be some new similarities to the US risk retention regime, the EU rules still contain some significant differences. For example, the SR requires that the amount of retained interest is determined by the notional value for off-balance sheets items, as opposed to US rules which apply the “fair value” measurement framework under US GAAP.

A new disclosure regime

Under the SR, due diligence, transparency and risk retention requirements currently imposed on credit institutions and investment firms under the CRR and on AIF managers under the AIFM Regulation will be repealed and set out in the SR.

The SR will also bring UCITS management companies, internally managed UCITS that are authorised investment companies and occupational pension funds into the regulatory framework. For UCITS management companies and internally managed UCITS, no due diligence rules will apply in the short term. The Commission may, however, adopt further delegated regulations under the UCITS Directive to bring them into the due diligence rules. It will be the responsibility of investment fund managers to double check that issuers have complied with the various detailed transaction structuring, documentation, risk retention and transparency requirements.

Under the SR, institutional investors will need to have (and observe) clearly defined criteria and processes for making investment decisions and ensuring that the risk retention requirement is satisfied. They will also need to establish procedures for monitoring asset performance and compliance by the originator, sponsor or original lender of the securitisation. They will need to be able to demonstrate to their regulators that they have a comprehensive and thorough understanding of the securitisation investments and their management.

The loan-by-loan disclosure requirements in the Credit Rating Agency Regulation (CRA Regulation) (known as “article 8b” disclosure) are reproduced in the SR (presumably with the intention of replacing them). The information to be produced ranges from credit quality to performance data and cashflows, and must be provided to investors on a quarterly basis for ABS or a monthly basis for ABCP. Again, there is a dual responsibility on the originator to produce the information and on the investor to request it. The fine details of the transparency and due diligence requirements will need to be worked out in technical standards which will follow.

Originators and sponsors will also be required to make available data on static and dynamic historical default and loss performance covering a period of no less than five years. This is a reduction in the seven year period proposed by the European Parliament for non-retail exposures. In addition, the proposed requirement that external verification of such data have 95 per cent confidence level has been dropped.

New “securitisation repositories” to be established

How will this mountain of data stored and used? The SR establishes a new framework setting out the registration, authorisation and supervision of third party “securitisation repositories” (repositories) that will collect and administer the mountain of regulatory disclosure. The intention is for supervisors, investors and potential to have access to the information stored with the securitisation repositories.

In addition to the relevant national competent authorities and ESMA who will jointly enforce compliance with the SR and SPR, the European System Risk Board will also have an interest in accessing the data stored in the securitisation repositories. The SR establishes a new macro-prudential oversight role for the ESRB, which will be on alert for asset bubbles developing in different market segments or asset classes. The coming level two technical standards should shed more light on how this will work.

A special case for clearing and collateral requirements for securitisations under EMIR

On May 4, 2017 the Commission proposed amendments to the European Market Infrastructure Regulation (EMIR) that would reclassify SPVs as financial counterparties (FCs). FCs, subject to certain thresholds, are subject to the clearing obligation and requirement to accept and post collateral (also known as “margin”) in respect of any uncleared derivative contracts they enter into.

While the proposal still needs to be approved by the Council and the European Parliament, and its effective date is not yet certain, it contains several features which, if not modified, may impact the ability of SPVs to enter into currency and interest rate hedge transactions. When published, the proposal caused a furore among market participants.  Broadly, all of an SPV’s the funds are used to acquire the underlying assets, leaving nothing left over to use to acquire collateral for the purposes of posting to a hedging counterparty. In addition, the sorts of assets that are securitised are generally not liquid and not capable of being posted in the way that derivatives are normally collateralises.

The SR may allay some of these concerns. With respect to clearing, the SR includes provisions that, if adopted, will amend EMIR to include securitisations in the same carve-out to the clearing obligation that is applied to covered bond transactions. This carve-out will apply provided that the derivatives are used only for the purposes of hedging interest rate or currency fluctuations.

While there are encouraging signs that the SR could give rise to level two measures that disapply margin requirements for SPVs, the language in the SR itself is not entirely clear. The SR recognises that counterparties to uncleared derivative contracts with SPVs are secured creditors under the securitisation arrangements and adequate protection against counterparty credit risk are usually provided for. That being said, the SR requests that the European Supervisory Authorities (ESAs) develop level two measures specifying criteria for establishing which arrangements under securitisations that adequately mitigate counterparty risk such that margin posting is unnecessary. It remains to be seen whether, how widely and the extent to which the ESAs will exempt SPVs from the margin obligation.

Grandfathering

There will be grandfathering. The SR will apply to securitisations that are issued on or after the date of application of the SR, which is expected to be January 1, 2019. However, once the SR enters into force, the STS designation will be available for use with securitisations issued before the date of application provided that the SR’s requirements are satisfied.


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