The EU securitisation framework came into force on 1 January 2019 and was comprised of Regulation (EU) 2017/2402 (as amended, the "Securitisation Regulation")1 and the banking regulatory capital requirements in EU Regulation 575/2013 (as amended, the "Capital Requirements Regulation")2 and EU Directive 2013/36/EU (the "CRD IV") (through which the EU incorporated the original Basel III requirements).3
Both the Securitisation Regulation (Article 46) and the Capital Requirements Regulation (Article 519a) tasked the European Commission with preparing reports on the performance of the revised framework and to accompany such reports with legislative proposals. To support its assessment, in July 2021 the European Commission launched a targeted consultation pertaining to both the prudential and non-prudential parts of the functioning of the securitisation framework applicable to banks and (re)insurance companies (the "Consultation"), which was followed by a call for advice to the Joint Committee of the ESAs in October 2021 (the "Call for Advice"). The Call for Advice sought feedback on the performance of the rules on capital requirements for banks and (re)insurers and liquidity requirements for banks relative to the framework’s original objective of contributing to the revival of the EU securitisation market on a prudent basis. The ESAs published their Report in response4. The Report consists of two parts: the assessment of the recent performance and appropriateness of the rules on capital and liquidity requirements for banks5 and the review of the securitisation capital framework applicable to (re)insurers6. The Report follows on from the recent report from the European Commission to the European Parliament and the Council on the functioning of the Securitisation Regulation ("Article 46 Report").7
We set out below some of the key proposals in the Report, focussing mainly on the Banking Report.
The ESAs' view on what is hindering the securitisation revival
In response to the Consultation, stakeholders emphasised that current capital charges for securitisations restrict issuance volume as the requirements are too prohibitive, relative to comparable asset classes such as covered bonds, and insufficiently risk sensitive.
The ESAs do not agree that the current capital framework is a key obstacle to the revival of the securitisation market in the EU; whilst the treatment of securitisation in the capital framework may have a role, especially for significant risk transfer ("SRT") deals, the ESAs consider that the current subdued status of the securitisation market is impacted by multiple factors including high due diligence costs of securitisation and cheap funding elsewhere which have affected supply and demand in the market.
No reduction of the p-factor but a reduction of risk weight floor ("RWF") proposed
Industry participants have advocated a reduction of the p-factor used in the formulas and will be disappointed that the ESAs have not opted to take this route. The p-factor is widely viewed as a premium charge on securitisations (particularly those using the securitisation standardised approach). As highlighted in our recent article From Basel III to Brussels: no direct train service for securitisation capital requirements, it had been hoped that a relaxing of some of the regulatory parameters applicable to the SEC-SA model would indirectly mitigate the impact of the incoming output floor.
Instead, in order to improve risk sensitivity in the framework the Banking Report recommends a reduction in the RWF applicable to senior tranches retained by originators. The EBA considers that this would be a more impactful measure than a reduction of the p-factor, which it believes increases cliff effects (i.e. the p-factor incorporates the capital non-neutrality but also serves as a smoothing parameter to avoid cliff effects; in the EBA’s view this dual role limits considerably any room for manoeuvre in a revision of the capital non-neutrality for the originator based on prudential considerations). In particular, the ESAs believe that a RWF reduction would give originators an incentive to engage in more resilient transactions (e.g. based on granular pools) and increase the risk sharing through a transfer of thicker junior and/or mezzanine tranches. Whilst modifications to the RWF may be welcome, it remains to be seen whether any benefits would survive the impact of the output floor. AFME has commented that any benefit of the reduced RWF may be negated by the impact of the output floor.8
What is proposed?
An originator’s retained senior tranches of both traditional and synthetic transactions will be in scope of the measure, however the expectation is that synthetic SRT transactions will benefit the most. The ESAs believe that this measure together with the new capital requirements for synthetic excess spread ("SES") under the Capital Requirements Regulation as further specified in the consultation paper for the RTS on the exposure value of SES, will make the framework more risk sensitive on both ends of the transaction structure (i.e. senior tranches and first losses).
The reduction of the RWF would be targeted to:
- originators only;
- transactions that satisfy specified eligibility criteria (including in relation to amortisation mechanics, counterparty credit risk (for synthetics), thickness of sold senior tranches and granularity); and
- securitisation positions held in senior tranches of both STS and non-STS transactions in the case of SEC-IRBA and securitisation positions held in senior tranches of non-STS transactions only in the case of less sophisticated approaches, as indicated in the table below.
The ESAs observe that this measure could lead to a possible unintended risk of sabotaging the STS label because the originators may prefer to structure their transactions to qualify for the reduction of the RWF at lower costs rather than targeting to obtain the STS label. Mitigants have been taken into consideration in order to avoid this risk. To the extent that STS should result in beneficial pricing however, this may operate as a better incentive than a reduction in the RWF.
This proposal deviates from the original Basel requirements but the ESAs justify this as being an increase in risk sensitiveness of the framework. Furthermore, requiring originators, holding securitisation positions in their own securitisations, to set aside high capital buffers for agency and model risk is not justifiable. Also, the proposal is targeted at a limited set of securitisations complying with specified criteria and so, while being mindful of the overall compliance with Basel, the proposal aims to ensure a positive forward-looking impact primarily on the SRT securitisation market.
Technical quick fixes
The Banking Report proposes technical quick fixes which aim at resolving some inconsistencies and/or improving risk sensitivity in the current securitisation framework. Below is an overview of the most material technical quick fixes proposed.
Caps for securitisation
The current prudential framework includes caps for securitisation positions pursuant to Article 267 of the Capital Requirements Regulation for the most senior securitisation position and Article 268 of the Capital Requirements Regulation for all tranches, intended to counter conservative approaches. In the view of the ESAs, the cap for the most senior securitisation position pursuant to Article 267 of the Capital Requirements Regulation seems to work (but also suggest a targeted review of the RWF may be required) and Article 268 of the Capital Requirements Regulation could be improved to better take into account securitisations with fully capitalised tranches. When taking into account securitisations with fully capitalised tranches the calculation of the maximum capital requirement would become more risk-sensitive and applicable to a wider range of securitisations.
To better cater for securitisations which include fully capitalised tranches the ESAs recommend including an option for institutions to carve out from the calculation of V (i.e. the largest proportion of interest that the institution holds in the relevant tranches) under Article 268(3) of the Capital Requirements Regulation any tranche in full to which the originator applies a 1250 % risk weight ("RW") (i.e. fully capitalised (parts of the) first loss tranche). Such carved out tranche shall then be added to the calculation of the maximum capital requirement.
After the revised calculation the remaining exposure of the institution to the senior position and the mezzanine position is less risky than a pro rata V% share of the whole pool of underlying exposures.
Furthermore, the ESAs also recommend aligning the overall cap in Article 268(1) of the Capital Requirements Regulation with the recent legislative change made for NPE securitisations as per Article 269a(5) of the Capital Requirements Regulation by allowing originators using the SEC-IRBA to deduct specific credit risk adjustments (SCRAs) from the expected loss amounts when calculating the capital requirements for the underlying exposures in case of securitisations other than NPE securitisations.
Treatment of SCRAs
Article 248(1)(d) of the Capital Requirements Regulation allows originators to deduct from the exposure value of a securitisation position which is assigned a 1250% RW the amount of SCRAs on the underlying exposures of the pool.
The ESAs now propose to extend the deduction of a securitisation position which is assigned a 1250% RW also to other tranches that have been assigned a risk weight lower than 1250% RW under specific preconditions. The proposed option would allow the deduction of SCRAs from mezzanine tranches when the preconditions are met.
The ESAs also recommend deleting the EBA mandate, under Article 248(1) of the Capital Requirements Regulation, to develop draft RTS as to the calculation of the nominal amount for the undrawn part of a liquidity facility, on the basis that no further clarification is needed.
The hierarchy of the approaches
The ESAs also recommend changes to Article 254 of the Capital Requirements Regulation to clarify (i) what are the conditions under which SEC-SA may not be used, i.e. when SEC-ERBA shall be used by an institution, (ii) when a switch to SEC-ERBA shall be made and (iii) that the Internal Assessment Approach cannot replace the mandatory application of SEC-IRBA but rather only be used as an alternative.
Maturity adjustments in accordance with Article 252 of the Capital Requirements Regulation
Further clarifications are made by the ESAs around the interpretation of Article 252 of the Capital Requirements Regulation on maturity mismatches in connection with Article 238 of the Capital Requirements Regulation which governs the determination of the maturity of a credit protection and, in a securitisation context, is of particular relevance in case of the existence of an originator time call. In this respect further clarification of the interpretation of the term “positive incentive”, as referred to in Article 238 of the Capital Requirements Regulation is given. The ESAs also elaborate on the potential need for clarification for specific types of times calls if the relevant recommendations included in the EBA report on SRT in respect of such time calls are not followed up by a delegated act or such delegated act does not include a respective requirement on the eligibility of such time calls. Of interest to SRT transactions, the ESAs state that, whilst a time call per se (without any conditions attached in the terms of the credit protection agreement) should not create a positive incentive (under Article 238(2) of the Capital Requirements Regulation) and that a time call set before the weighted average life would be interpreted as being characterised by positive incentives.
Securitisation of state-guaranteed exposures
The ESAs also make some recommendations on how to structure a traditional securitisation using exclusively state-guaranteed exposures, for example with loans as an underlying. The ESAs are of the view that it would be possible to transform a state guarantee from an unfunded credit protection arrangement, covering the state-guaranteed exposures, to a guarantee covering a senior securitisation tranche. Under such a structure the institution that receives credit protection on its senior tranche would calculate RW amounts in accordance with Part Three Title II Chapter 4 of the Capital Requirements Regulation for the protected portion (in accordance with Article 249(6)(b)) whereas the institution that invests in mezzanine or junior securitisation positions would not be able to recognise the effect of the state guarantee on the underlying exposures. The senior securitisation position would then have a RW equal to zero. The ESAs also share in a footnote their view on how a securitisation structure should be treated in which the guarantee would not be a state-guarantee but a commercial guarantee.
Treatment of portfolio guarantees in the securitisation framework
The ESAs are of the view that the upcoming legislative banking framework should include a mandate to the EBA to assess the treatment of portfolio guarantees, in particular whether portfolio guarantees are already correctly addressed under the existing securitisation framework and, if not, how the securitisation framework could be clarified. The ESAs are particularly interested in clarifying the conditions under which a guarantee might be considered as a tranching and, if so, whether the full Securitisation Regulation and Capital Requirements Regulation requirements for securitisation positions should be applied.
Risk weight formulas – a possible further review
In addition to the reduction of the RWF for originator-retained senior tranches, the EBA considered whether risk sensitivities in general are insufficient. The ESAs do not propose fundamental changes to the securitisation RWFs at this time. However the EBA will consider a more detailed review in the medium to long term which may involve review by the Basel Committee of Banking Supervision ("BCBS") of risk sensitivities in the formula-based approaches of SEC-IRBA and SEC-SA. Areas for future consideration with the BCBS are set out below.
- Current design of the formula-based approaches. Three regulatory goals of the formula-based approaches are identified (i.e. reduce cliff effects, ensure deduction of capital as high as the capital before securitisation and avoid an unreasonable level of non-neutrality). To the extent that these goals may conflict with each other, changes to the framework should be considered.
- Securitisation of non-granular pools. A re-designing of the RWF might facilitate a more optimal framework for non-granular pools. This is especially the case for senior tranches which may have a particular sensitivity to less diversified pools and could pose a particular risk for SRT transactions if the risk of more correlated and concentrated pools is underestimated thereby underestimating the risk of losses impacting the senior tranches. The Report also notes that the p-factor under SEC-IRBA is also limited as only retail and non-retail are identified (and not the underlying asset classes) so it may be that this will be reviewed.
- Improved framework for the reduced agency and model risk for originators. This would make transactions more attractive for originators, particularly for SRT purposes. Notwithstanding that the ESAs do not propose a reduction in the p-factor, given concerns about cliff effects, the ESAs believe that the framework could benefit from a less conservative approach, distinguishing between credit institutions investing in third-party and originated securitisations and considering a reduction in capital non-neutrality for originators.
- Risk weight function in relation to the distribution of losses. Consideration should be given to the overall design of the framework.
No recalibration of the liquidity coverage ratio (LCR)
Some market participants had proposed that STS securitisations should be upgraded as liquid assets, thereby improving diversification, in the LCR, comparable to the treatment for covered bonds. The ESAs have not observed an increased share of ABS in the liquid assets of credit institutions and, as they have not witnessed evidence from any liquidity stress period that could warrant or inform a potential recalibration, have not been minded to make any changes.
Note that the ESAs have recommended that the LCR Delegated Regulation9 should be amended to reflect what is likely to be an unintended consequence of recent changes in increased granularity of the credit quality steps ("CQS"). Changes were made to the CQS in the ITS on the mapping of ECAI's credit assessments for securitisation positions under the Capital Requirements Regulation10, resulting in limiting STS securitisation tranches to AAA. Therefore cross-references in the Capital Requirements Regulation require updating to ensure eligibility of STS securitisation tranches also rated AA+ - AA-.
No proposed changes to Solvency II
No proposed changes to Solvency II are proposed in the Insurance Report with regards to the prudential treatment of securitisations. The ESAs have not been convinced that the current Solvency II capital requirements relating to securitisations are inappropriately calibrated and that, whilst capital charges might play a role for some, most investment decisions are not sufficiently influenced by capital requirements (including better capital treatment for STS securitisations). There is a reluctance also to make a recently modified framework more complex.
What is the overall impact of the Report?
The targeted amendments proposed will not be a silver bullet to the revival of the securitisation market and further measures will be needed to boost supply and demand. With the exception of SRT transactions, the ESAs believe that the current capital framework is not a key obstacle to the improvement of the securitisation market; they believe this is, at least in part, due to a combination of factors, not least supply and demand issues and due diligence requirements. It remains to be seen to what extent any of the targeted changes, particularly for SRT, will facilitate any improvements.
The ESAs recommend that areas, not within scope of the ESAs mandate for the Report, be investigated including monetary policy, potential benefit of non-financial corporate activity in the market, proportionality of current investor protection requirements and overall "stigma" attached to securitisations. The ESAs noting of heavy due diligence requirements the securitisation market indicate a desire for improvements to the current disclosure templates following on from the Article 46 Report which is welcome.
Whilst encouraging that the ESAs intend to remain focussed on analysing how to address areas that can be improved to facilitate EU securitisation recovery and to review certain aspects of the framework, the market will no doubt be disappointed that there is no proposal at this time for movement on the p-factor, the LCR or to Solvency II as part of an overall cumulative set of measures for revival. No doubt these issues will continue to be raised as areas for further debate.
It is interesting to note that in the UK, HMT's Review of the Securitisation Regulation Report and call for evidence response11, pursuant to Article 46 of the Securitisation Regulation (as onshored in the UK post-Brexit), although not tasked to report on prudential matters, recognised concerns of stakeholders on the effect of capital and liquidity treatment as an area of priority. Similarly, HMT was not convinced that the current capital treatment of securitisation should be substantially changed at this time. However, going forward the Prudential Regulation Authority ("PRA") will be responsible for considering these matters and the implementation on Basel requirements so we will watch this space to see to what extent the PRA might adopt a different approach.12
The Report is with the European Commission to determine whether to implement any regulatory changes. The ESAs will continue to monitor the securitisation market as a whole and raise prudential matters with the BCBS where relevant. In the meantime, it is expected that the current disclosure templates will be reconsidered following the Article 46 Report, with the end result, we hope, being less burdensome and that this, together with improvements in other areas, such as SRT, may help to move the market forward. No doubt discussions on prudential matters will rumble on.
For more information the relevance of capital requirements on the securitisation market please also see Securitisation and capital requirements - match (not) made in Basel? and 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 Sven Brandt, Sebastian Oebels, Jane Griffiths, and Deborah Giurgola.
On 27 October 2021, the European Commission published legislative proposals for amendments to the Capital Requirements Regulation and CRDIV in order to implement the updated final Basel III standards.
HM Treasury is consulting on legislative changes necessary to facilitate the PRA's implementation of Basel 3.1 in the UK, the final set of Basel reforms introduced following the financial crisis. The consultation closes on 31 January 2023. The PRA is also consulting on its intended rules to introduce Basel 3.1.