Securitisation framework: Ten things you need to know
The race is on to finalise “level II” implementing measures in time for when the new securitisation framework applies on January 1, 2019.
Securitisation framework now in force
On January 1, 2019 a new framework for European securitisations will take effect. Two Regulations, which came into force on January 17, 2018, will apply:
Regulation (EU) 2017/2402 (the Securitisation Regulation)
Regulation (EU) 2017/2401 (the Securitisation Prudential Regulation, or SPR).
Together, this legislative package represents a major milestone in the EU’s Capital Markets Union (CMU) reform agenda. What next? To help you prepare for the deadline, the ten most important points are examined in detail, below.
Ten things you need to know
The new framework repeals and replaces existing securitisation legislation
The Securitisation Regulation consolidates the patchwork of legislation governing European securitisations, and introduces the long awaited rules for issuing simple, transparent and standardised (STS) transactions. The SPR replaces the provisions of the Capital Requirements Regulation (CRR) relating to the regulatory capital treatment of securitisation exposures held by EU credit institutions and investment firms.
Currently, determining what set of rules applies depends on the type of investor. For example, securitisation 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 (multilateral development banks, for example), the securitisation provisions of existing legislation do not apply.
Under the Securitisation Regulation, this sector-specific approach to regulation is replaced with a set of rules that applies to all European securitisations, regardless who invests and whether the transaction is private or public.
Some STS securitisations might benefit from favourable capital treatment
The Securitisation Regulation sets out eligibility criteria for applying the STS designation, which includes separate but broadly similar 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 asset-backed securitisations (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.
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.
Not all securitisations or investor types will benefit from preferential capital treatment
Not all STS securitisations or investor types will receive preferential capital treatment. Commercial mortgage-backed securitisations (CMBS) have been excluded from the STS eligibility criteria, due to perceived vulnerabilities arising from a strong reliance 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 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 Securitisation Regulation 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.
Obtaining preferential capital treatment is a multi-stage process
Originators, sponsors and issuers will be jointly responsible for assigning the STS designation, and may face the consequences (yet to be determined) for falsely making such a designation. The Securitisation Regulation sets out an optional process whereby an authorised third-party can attest to the satisfaction of the STS criteria. This may be particularly useful because draft technical standards indicate that the notification process will likely include a cross-referencing exercise to the prospectus (if there is one), and require justifications or explanations as to why the STS criteria are satisfied. third-party certification, however, will not absolve originators, sponsors and issuers from liability for making STS assertions that turn out to be false.
In order for a third-party to receive authorisation to assess satisfaction of STS criteria, it must be independent, charge only non-discriminatory fees on a cost-recovery basis, and have professional qualifications, knowledge, experience and a good reputation. Credit institutions, investment firms, insurance undertakings and credit rating agencies are not eligible to act as third-party certification providers.
There is a second hurdle to be met under the SPR, which sets out a two-fold test for determining whether a transaction receives preferential prudential treatment. First, the transaction must satisfy a separate set of prudential eligibility criteria. For example, the underlying assets must not, on their own, have a risk weighting above a prescribed set of thresholds. Second, the transaction must meet further criteria, such as maximum borrower concentrations and loan to value limits.
Legacy securitisations will be grandfathered, but potentially eligible to use the STS designation after January 1, 2019
While the legislation applies to securitisations completed after January 1, 2019, legacy securitisations outstanding on that date will also be able to use the STS designation, provided that the structure complies with certain procedural requirements at the time of notification to the European Securities and Markets Authority (ESMA), and for other requirements (such as criteria for credit-granting) at the time of origination. In such instances, legacy transactions will be brought into the new regime as a whole, including the new transparency and risk retention frameworks.
New risk retention rules take effect on January 1, 2019
Risk retention is a well-established regulatory response to the financial crisis, which is intended to align originators’ and investors’ interests for securitisations. Under the CRR’s risk retention provisions (to be repealed on January 1, 2019), institutional investors must ensure that originators, sponsors or original lenders retain a five per cent economic stake in the viability of a transaction.
While risk retention levels will be maintained at five per cent, the Securitisation Regulation departs from the existing CRR approach. Under the CRR, 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 Securitisation Regulation, originators, sponsors and original lenders will be under a new positive obligation to retain a five per cent net economic interest in securitisation transactions.
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 Securitisation Regulation is implemented in each Member State (although capital charges remain for investors that fail to conduct proper due diligence).
New disclosure and due diligence requirements take effect on January 1, 2019
Due diligence and transparency 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 Securitisation Regulation. The Securitisation Regulation will also bring UCITS management companies, internally managed UCITS that are authorised investment companies and occupational pension funds into the regulatory framework. Insurers and reinsurers are also caught by the definition of “institutional investor” and are therefore subject to the Securitisation Regulation, even though existing provisions in Solvency II will remain in place.
Under the Securitisation Regulation, 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 (known as “Article 8b” disclosure) are reproduced in the Securitisation Regulation. 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 ensure that it has been provided. Details of the transparency and due diligence requirements will be worked out in technical standards to follow.
Re-securitisations and ABS backed by unverified residential loans will be banned
Since the financial crisis, re-securitisations (i.e. securitisations backed by other securitised exposures) have been subject to stringent capital requirements. The Securitisation Regulation bans them altogether, subject to grandfathering (securitisations outstanding before January 1, 2019 are exempt) and limited carve-outs (such as ABCP structures). Considering the historical treatment of re-securitisations, this does not come as a surprise and as a result of the abovementioned capital requirements, such transactions are already rare.
In addition, the Securitisation Regulation bans residential mortgage-backed securitisations (RMBS) that are backed by loans that were 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 ban applies only to securitisations issued after January 1, 2019, and to underlying loans that were originated after the entry into force of the Mortgage Credit Directive (MCD) in March 2016.
Sanctions for non-compliance could vary along national lines
While the Securitisation Regulation creates a single, harmonised set of rules, it also allows 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.
Consultations on draft technical standards are underway
The European Supervisory Authorities (ESAs) are consulting on draft technical standards to provide details on how the legislation will be implemented. Progress has been made in a number of areas, including: transparency requirements, risk retention rules, the homogeneity requirement for asset pools backing STS securitisations, significant risk transfer (SRT) rules. Technical standards are also being developed with respect to procedural aspects such as STS notifications and authorisation of data repositories and third-party STS certification providers.
ESMA’s draft technical standards relating to transparency aim for consistency with existing arrangements (e.g. ESMA and central bank reporting templates and credit rating agency practices). Adjustments will likely include due diligence and stress tests, supervisory assessments, market monitoring and disclosure of new items such as legal identity identifier numbers. third-party data repositories are expected to run tests for completeness and consistency and provide written confirmations. However, they will not verify accuracy or give guidance on how to comply with the transparency requirements.
In its consultation paper on risk retention, the EBA proposes keeping the technical standards consistent with existing rules wherever possible. Draft measures includes some targeted amendments, including further detail as to when an entity is deemed to have been established for the sole purpose of securitising exposures (which would render it ineligible to act as retainer of risk). Draft measures also set out the conditions under which the retainer of risk can transfer its remaining retained exposure to a new entity where it becomes ineligible to retain risk due to legal reasons beyond its control.
The Securitisation Regulation has been criticised for the vague nature of the STS eligibility criteria relating to the homogeneity of underlying asset pools. One common question has been how granular the homogeneity requirement will be, i.e. will asset pools need to be grouped by class, or according to sub-sets exhibiting common characteristics.
The EBA is consulting on an approach that would specify a list of asset categories as well as list of “risk factors” to be considered when determining whether an asset pool is sufficiently homogeneous. Risk factors include type of obligor, type of credit facility and collateral, repayment mechanics and industrial sector. Under this approach, not all risk factors would be relevant to each category. For example, it makes no sense to describe the type of immovable property relating to an auto loan securitisation (for which there is none), or type of obligor for owner-occupied residential loans (who are obviously individuals). In an effort to tick off each relevant risk factor, originators may struggle to pool together enough sufficiently similar assets to benefit from economies of scale.
The EBA’s proposals for SRT rules will set out the parameters for a reduction in capital achieved via securitisation when justified by a commensurate transfer of risk to third-party purchasers of securitisation products. Originator institutions will want to follow SRT developments closely, as achieving SRT and associated regulatory capital relief may be an important consideration when structuring a securitisation transaction.
With primary legislation now in force, the overall framework is finalised and a definite timeline for implementation is in place. However, market participants need to keep an eye out for developments relating to implementing measures throughout 2018 in order to be ready for the January 1, 2019 deadline.