The European Commission’s well-intended ‘Securitisation Regulation’ proposal is an attempt to rescue the European securitisation markets, but the reality is that it may be one step forward, two steps backward. The proposed Securitisation Regulation forms one of the main thrusts of its recently announced Capital Markets Union (CMU) initiative, under the belief 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 pose less risk and could qualify for more relaxed capital rules than other securitisations. The aim is also to make securitisation more appealing by consolidating the current patchwork of securitisation rules into one place.
- Criteria to be provided for the STS category of asset-backed products
- STS securitisations to be in some cases afforded better capital treatment
- Regulatory requirements across sectors to be consolidated
- Significant changes to be made to risk retention rules
- Certain investment and pension funds to be added to due diligence and transparency requirements
The good news is that Europe will have a more unified legislative framework, which will create a category of simple, transparent and standardised (STS) asset-backed securitisations (ABS) and short-term asset-backed commercial paper (ABCP) for favourable (or at least, less punitive) capital treatment. This means that originators and sponsors of asset-backed products will have a single set of rules for offering their products to different types of investors, which should diversify the investment base. ‘Institutional investors’ in the Securitisation Regulation includes EU-regulated credit institutions, insurance companies, alternative investment fund (AIF) managers, undertakings in collective investment in transferable securities (UCITS) and occupational pension funds.
Banks and other institutional investors should be incentivised to build up their portfolios of STS securitisations since they will need to set less capital aside than they do now. Not all STS securitisations will receive the preferential capital treatment, however. There is a second hurdle to be met under the Securitisation Prudential Regulation, which is being developed in parallel. While better capital treatment is certainly welcome, it is discouraging that a large number of securitisations that have performed historically well will continue to be disadvantaged relative to similar exposures or products.
The draft law needs some work. In their current form, the rules could end up being counterproductive to the stated aims of encouraging cross border securitisations and broadening the range of participating investors. The proposals will mean a sea change for European securitisation, since it creates a new compliance regime with its own set of administrative sanctions and remedial measures. The proposal now awaits the opinion of the European Parliament, where a committee vote is scheduled for November 2016.
A new sanctions regime
While the Securitisation Regulation will create a single set of rules, it will also allow Member States to gold-plate their remedial measures as they see fit, including either criminal or administrative sanctions. Member States’ discretion in this area is very wide; they merely need to ensure that sanctions and remedial measures are “effective, proportionate and dissuasive”. Any sanctions must take into account whether the infringement was intentional or resulting from factual error, and must take into account the materiality, gravity and duration of the infringement.
This will create a minefield of compliance issues that could discourages cross-border securitization and runs contrary to the stated aim of CMU. In March 2016, the European Central Bank (ECB) provided an opinion to the Council of the EU that, among other things, expressed concern over a patchwork approach to sanctions. The ECB says that it is difficult to reconcile the imposition of heavy administrative and criminal sanctions on a strict liability basis with the well-established principle of legal certainty in criminal matters, or with the overall aim of encouraging market participants to use and apply the proposed Securitisation Regulation. The ECB goes on to say that such uncertainties and sanctions could in fact deter market participants from using the securitisation framework. We agree.
A new Compromise Text emerges
There were concerns that the Securitisation Regulation would reflect the European Banking Authority (EBA)’s recommendation to require homogeneous asset pools in terms of asset type, currency and legal system. This obviously would preclude most cross-border securitisations; however, the Commission has limited the homogeneity requirement to asset type only. While it is unclear how homogenous ‘asset types’ will need to be in all cases, the Council Presidency compromise text of the Securitisation Regulation (the Compromise Text) provides some examples. The text’s non-exhaustive list includes pools of residential loans, pools of commercial loans, leases and credit facilities to undertakings of the same category to finance capital expenditures or business operations, pools of auto loans and leases to borrowers or lessees or loans and pools of credit facilities to individuals for personal, family or household consumption purposes.
Thankfully, the Commission also declined to follow the EBA’s recommendation to exclude ABCP backed by exposures with maturities longer than one year from the STS label. This would have been problematic for a number of asset classes notwithstanding strong historical performance or good risk profiles. For example, auto loans and leases and consumer loans typically have maturities of 12 months to two years. The Commission’s proposal instead limits underlying exposure maturities to three years (provided the weighted average life of the pool is two years or less). Separate limits on average weight averages lives for auto loans and leases and equipment leases are currently being negotiated by the Commission, Council and European Parliament.
It is also worth noting that the Compromise Text clarifies the definition of ‘securitisation’. Recital (50) of the Capital Requirements Regulation (CRR) says that an exposure that creates a direct payment obligation for a transaction or scheme used to finance or operate physical assets will not be considered an exposure to a securitisation, even if the transaction or scheme has payment obligations of different seniority. This language has historically been interpreted to mean that secured project bonds, whole business securitisations and real estate securitisations are outside the ambit of the securitisation regime. In the Compromise Text, this language has been moved to the definition of ‘securitisation’, which is in the operative text of the legislation. By moving the language to the operative text of the regulation, it will be more likely that regulators will agree with this commonly-held interpretation.
STS securitisations – labelling process
The Securitisation Regulation 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 (i.e. limited synthetics, see below). Re-securitisations cannot be STS securitisations.
Originators, sponsors and issuers will be jointly responsible under the Securitisation Regulation for assigning the STS designation, and would face the consequences (yet to be determined) for falsely making such a designation. Alternatively, the Compromise Text sets out an optional process where an authorised third party can attest to the satisfaction by of the STS criteria. In its opinion to the Council, the ECB recommended against inclusion of a third party authorisation regime, largely for fear of encouraging moral hazard due market participants equating third party certification with supervisory endorsement.
It should be noted that publication by the European Securities and Markets Authority (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 Securitisation Regulation.
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 required are yet to be determined.
Under the Compromise Text, the EBA, ESMA and European Insurance and Occupational Pensions Authority (EIOPA) are tasked with determining whether synthetic securitisations can be brought within the STS criteria. At the end of 2015, the EBA submitted to the Commission a report on synthetic securitisation.
In its report, the 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 advised the Commission to extend 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.
One cloud on the horizon, however, may be that a significant number of MEPs have declared their opposition to STS treatment for any synthetic transactions. It remains to be seen whether any proposals to bring synthetic transactions into the STS label would survive the legislative process.
A new risk retention regime
The Securitisation Regulation will ensure that originators, sponsors or original lenders continue to maintain a 5 per cent net economic exposure to their securitisations (as is the case under existing legislation). This promotes the alignment of their interests with the interests of the investors.
Under existing regulatory schemes including the CRR, Solvency II Delegated Act and Alternative Investment Fund Manager Regulation (AIFM Regulation); the onus is on credit institutions, insurance companies and AIF managers (respectively) to police compliance with the risk retention requirement where they invest in securitisations. Market practice is to include contractual provisions to that effect in the transaction documentation.
The current proposal imposes a direct risk retention requirement and reporting obligation on the originators, sponsors or original lenders, which 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 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).
Originators, sponsors and original lenders will be under a new positive obligation to retain a 5 per cent net economic interest in securitisation transactions, including those invested in by UCITS and occupational pension funds.
The new regime has not completely abandoned the ‘indirect method’ of requiring risk retention, since the new ‘direct’ requirements may not bite on originator/sponsors located outside the EU. As a precaution, certain EU-based institutional investors will be required to ensure that the 5 per cent retention requirement is met for fear of a regulatory capital hit. The result is that investors and originators will need to ensure that they satisfy this dual-compliance regime.
One additional change is that an originator established or operating for the sole purpose of securitising exposures without a broad business purpose will be excluded from acting as the retainer of risk. This exclusion is intended to close a perceived loophole where the definition of originator was interpreted generously to include entities that would not have the capacity to meet payment obligations from resources unrelated to the securitisation. In other words, the Commission wants a bona fide operating company and not a shell to have a “skin in the game” in the transaction. Fortunately, the Securitisation Regulation excludes companies with the ‘sole purpose’ rather than the anticipated ‘primary purpose’, which means that managers of collateralised debt obligation portfolios should not be categorically excluded from retaining risk.
Transparency and due diligence
It is not all bad news. The Commission’s drive for reform should reduce some existing duplication in disclosure requirements. For example, securitisations usually involve a Prospectus Directive-regulated prospectus, transaction summaries for the central banks, and structural disclosure with ongoing, loan-by-loan disclosure of the underlying assets under the Credit Rating Agency Regulation (CRA III Regulation). In addition, CRR and Solvency II requires additional disclosure to investors so that investor credit institutions can meet their due diligence requirements.
A number of these requirements will be repealed and located in one place – the Securitisation Regulation. The prospectus requirements are being reformed under a proposed Prospectus Regulation, which is developing separately. The Prospectus Regulation proposal has been met with mixed reviews as to whether it will deliver on the promise of a less complex and costly disclosure regime. Please see our related briefing on the Prospectus Regulation proposal on the CMU homepage.
Where a prospectus is not required and not being produced, however, the Securitisation Regulation will require that a transaction summary be produced to outline the main features of the securitisation.
Under the Securitisation Regulation, due diligence, transparency and risk retention requirements currently imposed on banks and investment firms under the CRR and on AIF managers under the AIFMD will be repealed and set out in the new Securitisation Regulation.
The Securitisation Regulation will 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 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 found in the CRA III Regulation are reproduced in the Securitisation Regulation (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.
Prudential treatment – the second hurdle
Just because a securitised product receives the STS label does not mean it will receive a preferential capital treatment. Prudential Regulation Banks and investment firms the prudential treatment of asset-backed products will only receive a favourable capital treatment if they satisfy the conditions in the securitisation. The relevant regulations for other classes of institutional investors have yet to be published. The test for determining whether a transaction receives preferential prudential treatment is twofold: first, the transaction must pass the STS designation process; next, the transaction must meet certain credit risk criteria.
Capital treatment of asset-backed securities will be based on a credit risk assessment using one of three approaches, applied in the Commission’s order of preference. The first method is the securitisation internal ratings based approach (SEC-IRB), which uses an institution’s own internal rating models. The rating methodology must be pre-approved by the institution’s regulator. The Commission prefers the SEC-IRB approach because it avoids using credit ratings from third party agencies, the overreliance on which the Commission sees as one of the causes of the financial crisis.
If the IRB approach is not available, then the securitisation external ratings based approach (SEC-ERB) may be used. Under the SEC-ERB approach, capital requirements are assigned on the basis of credit ratings assigned by external rating agencies to the securitisation tranches. If the institution is based in a jurisdiction that does not permit the SEC-ERB approach or if it lacks the information needed to use that approach, then the securitisation standardised approach (SEC-SA) may be used. This ‘approach of last resort’ relies on a formula provided by the relevant regulator. If the SEC-IRB, SEC-ERB or SEC-SA approaches are not available, then the risk weight applicable to the securitisation is 1,250 per cent.
Under the first condition in the Securitisation Prudential Regulation, the underlying assets must not, on their own, receive a risk weighting above a set of prescribed thresholds. Second, the value of all underlying exposures to a single obligor must not exceed 1 per cent of the value of all exposures in the ABS asset pool or at the ABCP programme level.
In addition to determining capital treatment of STS securitisations, this proposed hierarchy of approaches will replace the capital treatment provisions of the CRR, affecting all securitisations where CRR-regulated banks and investment firms are investors. Once this is adopted, the Commission intends to amend the Solvency II Regulation (Solvency II) Delegated Act to bring insurance companies within the ambit of this approach.
The Commission will follow up with an amendment to the Liquidity Coverage Requirement (LCR) Delegated Act to bring it in line with the Securitisation Regulation. The aim of the latter is to bring STS securitisations into banks’ liquidity coverage ratios as ‘high quality liquid assets’ under the LCR Delegated Act. This change cannot come soon enough.
It should be noted that the Securitisation Prudential Regulation does not just lower regulatory capital treatments. Special treatment for certain other exposures will be eliminated, namely second-loss or better positions in ABCP programmes, unrated liquidity facilities and additional own funds securitisations of revolving exposures with early amortisation provisions. Re-securitisations (i.e. securitisations backed by other securitised exposures) will be subject to a significantly higher risk weight floor of 100 per cent.
SME securitisations – a new asset class?
A specific category of small and medium-sized enterprise (SME) loan-backed ABS undertaken alongside public authority guarantee schemes where the senior tranches have been singled out for the preferential prudential treatment – even if they would not otherwise satisfy all of the STS criteria. In addition, the risk retention requirement does not apply in certain cases where the securitised exposures are guaranteed by the public sector. On the fiscal side, this ties into Commission President Jean-Claude Juncker’s Investment Plan for Europe, which seeks to harness private sector investment via EU institutional guarantees. We may see growth in this area as a new asset class.
We note, however, that certain additional criteria must also be satisfied. First, the securitisation position must be a senior securitisation position. Second, the structure would need to be backed by a pool of assets comprised of 80 per cent SME loans at the time of issuance. Third, the credit risk associated with the positions not retained by the originator must be transferred through a guarantee or counter-guarantee meeting eligible unfunded credit protection under the CRR. Third, the guarantor or counter-guarantor must be the central government or central bank a EU Member State, a multilateral development bank or an eligible international organisation. Finally, the exposures to the guarantor or counter-guarantor must qualify for a 0 per cent risk weight under the CRR.
While the Securitisation Regulation, combined with the Securitisation Prudential Regulation, offer better regulatory capital treatment for certain STS securitisations, the Commission’s proposals suggests nothing to lighten the non-capital regulatory burden for STS securitisations. Overall, the proposed regulations seem more likely to have a chilling than enhancing effect on the market due to the added regulatory burden. Adding another five years of regulatory uncertainty and adjustments just when the securitisation industry was beginning to recover from the financial crisis, is frustrating. The challenge, however, is to find hidden opportunities, such as taking advantage of the better regulatory treatment of certain senior positions in public sector-guaranteed SME loan-backed ABS.