Bank of England wades in on securitisation capital framework: not all that glitters is gold-plating

The final implementation of Basel III, published in December 2017 as an updated global framework for capital requirements, is fast approaching. Basel III introduced a number of changes to the credit, market and operational risk calculations, and also introduced the output floor to reduce the variability of risk-weighted asset calculations between internal models and the standardised approach. There is widespread agreement in the industry that the Basel III regulatory landscape is a significant factor in the stagnation of securitisation in Europe. Over the summer, both the EU and the US published proposals for the Basel III implementation. The Bank of England, on 31 October 2023, published a discussion paper on proposals for securitisation capital requirements. In this article we review some of the approaches taken by the UK and how they compare with the EU, in what can be seen as a positive development for UK banks.  

Background of EU and UK positions

On 27 June 2023, the negotiations for the EU's amendments to the Regulation EU No 575/2013 (the "CRR"), which contains the bulk of the Basel III implementing provisions, was concluded (such amended regulation being the "CRR3"). This is expected to come into force from 1 January 2025 (with a phased-in implementation for the output floor). The Prudential Regulation Authority ("PRA") published a news release on 27 September 2023 confirming that it intended to publish near-final policies on market risk, credit valuation adjustment risk, counterparty credit risk and operational risk in the fourth quarter of 2023, and near-final policies relating to the remaining elements of Basel III (including the output floor) in the second quarter of 2024. The UK's implementation of the final legislation is expected to come into force six months after the EU (i.e. by 1 July 2025).

On 31 October 2023, the Bank of England published a discussion paper (the "Discussion Paper") focusing specifically on the capital requirements applicable to securitisations and how the Basel III framework impacts them. This comes in light of significant feedback from the industry which views a number of Basel III changes as being (perhaps unintentionally) adverse to securitisations without an appropriate rationale or credit-related justification. The Bank of England has invited feedback on the Discussion Paper with a view to incorporating views into new PRA rules that will replace the current firm-facing requirements in the “Securitisation Chapter” of the CRR1.

Comparison of key issues  

We review the three main issues highlighted in the Discussion Paper and compare them against the positions taken by the EU in the CRR3.

Output Floor

As expected, the Discussion Paper sets out the full incorporation of the output floor, which broadly ensures that the total risk-weighted assets (i.e. the value of an asset held by the bank multiplied by a risk-weighting commensurate with its level of creditworthiness, with higher risk categories carrying a higher risk-weighting, or "RWA") calculated by firms using internal regulatory-approved ("IRB") models would not fall below 72.5% of the RWA under the standardised ("SA") approach. This sets a minimum floor to RWAs, and was highly controversial given the data received to date, which suggests that a lot of IRB positions are well below the 72.5% mark and would therefore be impacted by having to hold additional capital as a result.  

The impact of the output floor would also be applicable to investors in securitisation positions (when using the Securitisation Internal Ratings-Based Approach ("SEC-IRBA"), which would be capped at 72.5% of the Securitisation Standardised Approach ("SEC-SA")). This exacerbates a pre-existing constraint flagged by market participants, which is the relatively conservative parameters used to calculate RWAs under the SEC-SA. Some of the larger and more sophisticated banks could previously avail themselves to the IRB approach and therefore obtain more favourable capital treatment which was seen as more proportionate to the level of risk they were exposed to (and hence were not as concerned with the SEC-SA calculations). The position is now different, as notwithstanding the SEC-IRBA approach, IRB banks may nevertheless find themselves stifled by the imposition of the output floor as a result of conservative SEC-SA RWAs. This may put renewed focus on the SEC-SA approach, even from IRB banks.   

Although the output floor itself will be incorporated, as per the position of the EU in CRR3, there will be a phased-in implementation of the output floor, starting at 50% and then moving up by 5% increments, with the final 72.5% reached on 1 January 2030. However, given that the UK implementation is expected to become effective 6 months later than the EU, the overall transitional period for the output floor in the UK will be 4.5 years (rather than 5 years). It is unlikely that this will generate significant pushback, as most large banks (using the IRB methodology) will already have factored in the EU regime in their capital planning.   

The PRA has also recognised from prior feedback that the imposition of the output floor may have significant negative consequences on significant risk transfer transactions – in particular on-balance sheet synthetic securitisations ("SRT Transactions"). SRT Transactions are frequently used by banks as an effective capital management tool to ensure that credit risk is transferred to an investor and/or a guarantor (which itself may not be subject to capital requirements). This has been seen by a number of regulators as a prudentially advantageous position to ensure that banks are able to manage their risk without having to liquidate and/or exit capital-intensive product lines. Unfortunately, one of the common structures of SRT Transactions involves the originating bank retaining a thick senior tranche position which, although in theory could have a relatively low RWA if using the SEC-IRBA approach (given the higher amount of principal losses which need to accrue before the senior tranche starts absorbing losses, being determined by the tranche attachment and detachment points), the imposition of the output floor would mean that the originating bank may be subject to holding a significantly higher amount of capital as a result of the SEC-SA floor. This is even in scenarios where such originating bank may have significant knowledge of the reference portfolio in question, and may have a substantial amount of historic data (including delinquencies) which would allow them to properly assess the actual credit risk under the SEC-IRBA approach. Even though the output floor is applied at a consolidated aggregated level across the entire portfolio, evidence in the Basel and EBA monitoring reports suggests that there will be material increases in RWAs for SRT Transactions. The Discussion Paper has asked for feedback from industry participants in respect of the perceived costs and benefits for SRT Transactions.  

The PRA has acknowledged the difficulties with the imposition of the output floor and invites feedback in respect of a (potentially) permanent recalibration of the output floor. The PRA has also gone further than the CRR3 on the recalibration of the supervisory parameter (including in the context of SRT Transactions) by suggesting potential avenues where a more proportionate and potentially risk-adjusted non-neutrality factor could be applied (see below).

The securitisation capital surcharge  

The Discussion Paper has also noted industry concern relating to the non-neutrality factor (or the supervisory parameter p), which is a capital surcharge applied to securitisation positions to address what the regulators perceive as modelling and agency risk (broadly, that the interests of the originator and the investor do not align). Clearly for the purposes of retained senior tranches of SRT Transactions (i.e. where the originator and the investor are the same entity) these perceived costs would not arise. However, under the proposed regime (and under the EU CRR3 approach) this would not be relevant and the originator would be subject to the full supervisory parameter (being 1 (for non-STS)2 and 0.5 (for STS) under SEC-SA and a minimum of 0.3 (regardless of STS / non-STS) under the SEC-IRBA). Although the supervisory parameter can be much lower under the SEC-IRBA approach, given the imposition of the output floor, it is likely that the supervisory parameter embedded in the SEC-SA approach would be determinative and result in the minimum floor being higher. The CRR3 included a temporary halving of the supervisory parameter in the SEC-SA approach for the purposes of calculating the output floor, but this remains temporary (until 31 December 2032) and does not assist banks using the SA model more generally (which remain disadvantaged by the conservative non-neutrality factor). The Discussion Paper does not seem to envisage a temporary relief against the supervisory parameter, although this may be raised in the feedback.

The Discussion Paper has, however, gone further than the CRR3 in outlining potential options for recalibrating the supervisory parameter on a more permanent basis (this is somewhat alluded to in Article 506ca of the CRR3 which requires a report by the EBA on potential prudential treatment of synthetic securitisations, but the implementation timing is expected to be no earlier than 2028). The Discussion Paper outlines three potential options:

  1. Option 1: implementation of the output floor as is (i.e. no changes to supervisory parameter);
  2. Option 2: implementation of the output floor with targeted and data-based adjustments, including to the supervisory parameter; or
  3. Option 3: implementation of carve-outs from (or other qualifications to) some or all securitisation exposures.

Option 1, whilst aligning with the current proposals, is acknowledged by the PRA to be constraining for firms subject to the output floor and queries whether it adversely affects UK bank SRT originators, is proportionate and advances the PRA’s objectives to achieve competitiveness and growth.

Option 2 would seem to be a more permanent variation of the EU CRR3's transitional output floor relief for supervisory parameters and is seen by the PRA as being a persuasive alternative to Option 1 as benefiting PRA firms and facilitating SRT transactions; however, whilst advancing the PRA’s objectives it does not align entirely with the Basel framework. The PRA analysis suggests that there is scope to reduce the supervisory parameter for SEC-SA, although there was reluctance to significantly reduce it so as to create parity with STS and non-STS positions (which the PRA wants to avoid). The PRA also considers having a risk-based approach to calculating the supervisory parameter, where different factors and structural features of a securitisation could result in a different supervisory parameter. This is currently not the case for SEC-SA, and would address one of the biggest issues with the imposition of a one-size-fits-all surcharge on all SEC-SA positions. It would also mean that senior tranches of SRT Transactions could get more favourable treatment under the output floor where they could demonstrate they meet some of the criteria (which could be based on variables such as delinquency rates and pool granularity) as a result of their deep knowledge of the underlying assets in question.

Option 3 seems to go much further than the current CRR3 approach and is most in line with feedback from the industry suggesting the creation of "resilient" securitisations which would grant capital relief to, among other "safe" securitisations, senior retained tranche of SRT Transactions. Although the PRA invited feedback on Option 3, they have made clear that it raises prudential concerns, is not in line with Basel standards and they are currently not minded to adopt this approach. It remains to be seen what the feedback to this will be, although it is possible that market participants will focus their feedback on optimising the non-neutrality factor under Option 2.  

STS Treatment for Synthetic Securitisations

The PRA has in the past cast doubt on whether the simple, transparent and standardised ("STS") label should be extended to synthetic securitisations. This effectively means that SRT Transactions would be excluded from the beneficial capital treatment available to STS "true sale" securitisations. It is not entirely clear why this approach has been adopted, as there has been significant positive evidence from the EU of the benefit this has provided to SA banks (in respect of which the STS label remains the key regulatory capital relief they are able to rely on, given their inability to use SEC-IRBA).

Although the EU's adoption of the STS label for SRT Transactions goes beyond the scope of the Basel III framework (which does not extend the so-called "STC" (the Basel equivalent of "STS") designation to synthetic securitisations), the general view has been that this was an acceptable deviation and within the general principles of the framework.

The PRA has stated that it remains unconvinced of the real economy benefits of SRT Transactions and is minded not to extend STS treatment to synthetic securitisations. It has also noted the bespoke nature of SRT transactions and questioned to what extent complex structural features could be streamlined into a "standardised" securitisation. An obvious argument against this line of reasoning is that the STS rules never intended to standardise every aspect of a securitisation – that would have a dampening effect on innovation. The rules on standardisation simply require certain features – those which are deemed by regulators to be most crucial to investors – be aligned, and this is in line with the EU approach (with the STS rules for SRT transactions being more numerous and comprehensive than the true sale securitisations).  

In the context of evidence for tangible benefits, it is hoped that industry feedback would be able to evidence the real economy benefits of SRT and that UK securitisation is enormously disadvantaged by this limitation. One of two ways in which this can be done include (i) the ability for banks to remain in capital-intensive markets and therefore continue originating financing to the real economy (as a result of the more favourable capital treatment available to them) and (ii) the excess capital which may be unlocked as a result of SRT Transactions which can be used to either originate further reference obligations in respect of an SRT Transaction or be targeted at other product lines of the bank. In a joint response, on 30 October 2023, to the consultations on draft securitisation rules published by the PRA and the Financial Conduct Authority, AFME, UK Finance and CREFC Europe supported the extension of the STS framework for synthetic securitisations.3  

Next steps

The deadline for feedback is the 31 January 2024. The PRA then intends to publish a consultation paper in H2 2024 on draft rules to replace relevant firm-facing requirements in the securitisation chapter of the CRR, once HM Treasury takes steps to effect the repeal of the securitisation chapter. We expect that industry participants will be keen to respond both the Discussion Paper and the future consultation to try to secure much needed improvements to the current framework.

Final thoughts

Although it remains to be seen what the ultimate feedback and updated PRA position will be, it seems like the PRA has taken on board a number of industry criticisms and feedback which were raised in the context of the CRR3. This may be positively received by UK banks, which may have hoped that the PRA would use the divergence from the EU post-Brexit as a platform to increase the competitiveness of UK banks by removing and/or recalibrating unnecessarily punitive capital parameters.   

Allowing for the possibility of a permanent recalibration of the output floor and a more proportionate and potentially risk-adjusted non-neutrality factor  gives some room for optimism. This should hopefully pave the way for SRT market participants to provide further evidence of the important role of such transactions and to argue for a proportionate regime which encourages the re-deployment of capital through SRT Transactions. This also shows a clear departure by the UK from the EU position, which has largely delayed the Pillar 1 re-calibration discussion by interposing a temporary transitional relief on the application of supervisory parameter in the context of the output floor.

Regrettably, the PRA has not moved on its earlier statements on the application of STS treatment for synthetic securitisations. The STS treatment has the advantage of significantly reducing the supervisory parameter under SEC-SA and therefore allowing banks using SA to really participate in the SRT space. Removing this treatment has the dual negative consequence that SA banks may be discouraged from entering into SRT Transactions, but also that IRB banks may be impacted with an artificially higher output floor (given the SEC-SA calculations will not include the STS relief). This also has the impact of gold-plating capital treatment under Basel III as compared to the EU, which could be very detrimental to UK banks compared to their EU counterparts, where the extension of the STS label to SRT Transactions in 2021 has seen a significant revival of the SRT pipeline (including the entry of more than 10 new banks into the market). Given that the PRA acknowledges the need for improving competitiveness and growth, and that the EU has already demonstrated that the application of STS to synthetics is in alignment with international standards, it would seem a missed opportunity to dismiss the extension of the STS label at this juncture, and industry participants may be hopeful that the position may ultimately be conceded by the PRA.  

For more information the relevance of capital requirements on the securitisation market please also see Securitisation and capital requirements - match (not) made in Basel?,  From Basel (III) to Brussels: no direct train service for securitisation capital requirements.

This note is for guidance only and should not be relied on as legal advice in relation to a particular transaction or situation. Please contact your normal contact at Hogan Lovells if you require assistance or advice in connection with any of the above.

Authored by Tauhid Ijaz and George Kiladze.
1 Part Three, Title II, Chapter 5 of the CRR contains the securitisation chapter.
2 A supervisory parameter of 1.00 (i.e. the one embedded in non-STS SEC-SA securitisation positions) represents a 100% capital surcharge to a securitisation position. Thus, even though the capital surcharge for the SEC-IRBA position may only be 0.30 (i.e. a 30% capital surcharge), the output floor would still be calculated on the basis of the 100%-capital surcharge calculation.
Response by AFME, UK Finance and CREFC Europe to the consultation on draft securitisation rules published by the PRA and FCA


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