What has happened?
The Financial Services and Markets Act 2023 (“FSMA 2023”) received Royal Assent on 29 June 2023, and provides the mechanisms for the repeal of retained EU law and a new framework of laws and rules in the UK. On 11 July 2023, HM Treasury published a near-final version of The Securitisation Regulations 2023, (the “Securitisation SI”) together with an explanatory Policy Note. The Securitisation SI empowers the Financial Conduct Authority (the “FCA”) and the Prudential Regulation Authority (the “PRA”) to make certain rules which will be more principles-based and replace some requirements that are currently contained in the UK Securitisation Regulation (“UKSR”) R, with rules to be set out in the PRA Rulebook and the FCA Handbook (the “Rules”). Consultations on the proposed Rules were published by the PRA on 27 July 2023 and by the FCA on 7 August 2023.1 The Securitisation SI, together with the Rules, when final, will replace the current UK securitisation framework as part of a new regime for the regulation of securitisation in the UK. The new framework is part of the wide-ranging measures introduced by the Edinburgh Reforms and is part of HM Treasury’s plan for “Building a smarter financial services framework for the UK” which will enable the regulators to adapt more swiftly to market needs and adjust Rules where required.2 For more information on proposals for the broader regulatory regime for the UK please see these Engage articles.
As market participants will be well aware, there are already divergences between the UK and EU securitisation frameworks and more divergence may well arise as the new regime beds down. Whilst a new, more agile and responsive framework may prove beneficial for UK transactions, given the requirements on investors to comply with their applicable local securitisation rules this may still mean that UK securitisation participants are asked to comply with EUSR rules to allow EU regulated investors to lend to or invest in the securitisation. We discuss below some of the key highlights of the proposal and what it means for the securitisation market going forward.
The EU Securitisation Regulation ("EUSR”), in effect in the UK and the EU since 1 January 2019, was onshored3 post-Brexit with effect from 1 January 2021, with minimal changes. Since then, a number of measures have been adopted by the EU, such as various technical standards and guidelines, which have not been onshored and resulted in areas of divergence between the UK and the EU. Also, HM Treasury, in its Review of the Securitisation Regulation: Report and call for evidence response of December 2021 (the “HM Treasury report”) identified a number of areas for possible reform. The FCA and PRA have clearly considered these in their proposals and the new regulatory framework should facilitate further clarity in some of these areas.
The Securitisation SI carries over most of the headline provisions of the UK Securitisation Regulation. However most firm-facing provisions, including provisions covered currently by technical standards, are devolved to the regulators with securitisation activities becoming “designated activities” under the new “Designated Activities Regime” as introduced by FSMA 2023.
What are the key highlights of the Securitisation SI and the Rules?
The Securitisation SI and the Rules do not intend to disrupt the current requirements for securitisation and largely align with market expectations and EU standards. The PRA and FCA are also largely aligned; though there are some disparities in a few areas it may be that these will be ironed out as part of the consultation processes. Some highlights of the current proposals are discussed below.
Scope and regulatory perimeter. The scope is unchanged and the majority of the provisions of the UKSR remain the same but most firm-facing provisions will be determined by the FCA and the PRA in the Rules. In particular, requirements relating to due diligence (other than for Occupational Pension Schemes (“OSPs”)), risk retention, transparency, resecuritisation and criteria for credit-granting are not included in detail in the Securitisation SI but will be covered by the Rules.
Prohibition on establishing securitisation special purpose entities (“SSPEs”). It is clarified that compliance is the responsibility of the originator and the sponsor and that institutional investors cannot invest in prohibited jurisdictions. The jurisdictions that may be prohibited by the EUSR are not aligned with UK requirements so this remains an area of divergence with the UK.
Due diligence. The FCA and the PRA will determine the Rules for institutional investors (other than OSPs; as the Pensions Regulator does not have rule-making powers so provisions for OSP due diligence are expressly included in the SI). Key changes are highlighted below.
Due diligence requirements for Alternative Investment Fund Managers (“AIFMs”) will only apply to UK authorised AIFMs. This reflects the outcome of the HM Treasury Report and will be a welcome clarification for the market. The FCA also has specific rulemaking power in relation to small, registered UK institutional investor AIFMs.
Clarification as to what is “sufficient” disclosure for non-UK securitisations. Requirements that information provided in relation to non-UK securitisation is “substantially” the same as under Article 7 of the UK Securitisation Regulation is replaced with a requirement for “sufficient” disclosures to assess risk, with access to further information. In terms of what is “sufficient”, the FCA and the PRA each provide a list of information that must be included as a de minimis.4 The jurisdictional scope of the UKSR and ambiguities as to interpretation of what is ”substantially” the same have been problematic for the market. There have been calls for a more principles-based approach or even an equivalence standard to apply; however, the HMT Report was clear that for investor protection the best outcome we could expect was clarification as to what information is required. The EUSR requires Article 7-compliant transparency for investors, including in third-country securitisations and so technically the regimes diverge on this, though the new proposed UK standards in the Rules could in practice correspond in large part to the current Article 7 transparency requirements but without the requirements for templates. Uncertainty in this area, and requirements that have not corresponded with those familiar to third-country originators, has often resulted in third country transactions not targeting UK or EU investors or including disclaimers in documentation that disclosure and on-going reporting may be non-compliant and each relevant investor should make its own decision on whether to invest. Whether the UK approach will facilitate sufficient inroads for investment in third country securitisations remains to be seen but removal of the requirement for the templated information is a welcome development.
Responsibility for delegated investment management decisions. Where institutional investors delegates another institutional investor as a managing party the regulatory responsibility for due diligence can reside with the managing party. An exception is where delegation is to an OSP in which case the due diligence remains with the delegating party.
Risk retention. Changes are proposed to certain risk retention requirements, particularly given that these have not been updated to reflect significant changes made to the EU risk retention regime and will align the UK position with the EU in some, but not all, areas, as discussed below.
On 7 July 2023, the EU Commission endorsed the long awaited final text of the risk retention RTS (the “EU Final RTS””), replacing the previous draft published in 2018 (the “2018 Draft RTS”). A number of changes in the EU Final RTS reflect amendments made to the EUSR in 2021 (by the “capital markets recovery package”) which created a new framework for synthetic STS securitisations and facilitated securitisations of non-performing loans or non-performing exposures ("NPE"). Although markets have long adapted to provisions contained in the 2018 Draft RTS, the old retention standards published in Chapters I, II and III and Article 22 of Delegated Regulation (EU) No 625/2014 (the “CRR RTS”)5 still apply in the UK and the EU. This will remain the case until, in the case of the EU, replaced by the Final Draft RTS or, in the UK, the Securitisation SI and the Rules.6 For more information on the EU Final RTS please see our Engage articles: Journey’s end - EBA publishes final risk retention RTS and Are we there yet? EBA published final risk retention draft RTS.
Change of risk retainer to be permitted in insolvency or, where no longer part of the consolidated group. Restrictions on transfer of the risk retention will not apply (i) on the insolvency of the risk retainer or (ii) if the retainer is no longer included in the scope of supervision on a consolidated basis, in which case retention by one or more entities supervised on a consolidated basis may assume the retention. These proposals will align with the EU rules. The Rules do not include provisions, as discussed in the HM Treasury Report, for (i) retention by servicers (which is permitted by the EU Final RTS) or (ii) allowing transfer of the retention where the retainer, for legal reasons beyond its control and beyond the control of its shareholders, is unable to continue acting as a retainer. These may be points that market participants will raise as part of the consultation process.
Risk retention on NPE securitisations. in alignment with the EUSR, where a non-refundable purchase price discount has been agreed for the purchase of non-performing exposures, the calculation of the retention may be based on the sum of the net value, based on the non-refundable purchase price discount, of the securitised exposures that qualify as non-performing exposures and, if applicable, the nominal value of any performing securitised exposures.
Sole purpose test. The PRA proposals broadly adopt the EU position. There are some drafting differences between the EU Final RTS and the proposed UK equivalent; however we would not expect this to create a major area of divergence given the other requirements of the sole purpose text and the historic concerns on thinly capitalised retainers with which the market is very familiar.
Resecuritisations. The PRA and FCA adopt a slightly different approach as to how these will be managed but both say that these remain broadly prohibited and so should be in line with current expectations and the EUSR, any permitted resecuritisations must have retention at each transaction level subject to some very limited exceptions. These exceptions include (i) where an originator securitises in excess of the minimum net economic interest with no maturity mismatch, (ii) fully supported ABCP and (iii) retranching into contiguous tranches.
Asset selection and comparability of assets. Clarity is provided, broadly in alignment with the EU Final RTS, as to what is “comparable”, thereby limiting “cherry-picking", for assets that meet the documented eligibility criteria. It is also clarified by the PRA and FCA that originators can transfer assets with a higher than average risk profile subject to clearly communicating this.
Areas impacting synthetic securitisation
Exemption from cash collateralisation requirements for synthetic/contingent retention for all capital requirements regulation (“CRR”)7 and Solvency II8 firms. Currently only credit institutions are exempt from the collateralisation requirement but the exemption will be extended to all PRA-authorised CRR and Solvency II firms. This could result in a welcome cost reduction for some clients and is in line with EU requirements as per the EU Final RTS.
Under the CRR, as recently amended9, synthetic excess spread (“SES”) must be considered as a securitisation position by originator institutions, and is subject to risk weighting as a retained first loss tranche at 1250% for originator retainers. Although such institutions could elect to implement transactions without SES (and with a corresponding thicker junior tranche) this would impact economics negatively. The final regulatory technical standards specifying the exposure value of synthetic excess spread made proposals as to how the exposure value of SES should be calculated, introduced grandfathering provisions and included a new helpful derogation in relation to synthetic excess spread for future periods where certain conditions are met, allowing for the lesser of the actual cash excess spread generated from the underlying assets and one-year expected losses. Unlike in the EU Final RTS, the proposals in the Rules do not provide for SES to be taken into account when measuring the retainer’s net economic interest, therefore impacting negatively on transaction economics as mentioned above. The HM Treasury Report had contemplated allowing SES to count towards the risk retention requirement in significant risk transfer transactions. It is disappointing that provision for this is not proposed at this stage, though the HM Treasury Report had noted that further work would need to be done in this area before adopting such a change So this might well be an area of future focus including as to whether regulators will consider rules akin to the regulatory technical standards for SES as set out in the EBA’s Final Report of 24 April 2023.10
Areas discussed in the HM Treasury Report that are not covered by the proposals. Whilst the PRA addressed some points raised in the HM Treasury Report, other items remain to be addressed for another day. In addition to not providing for excess spread and servicers as servicers as retainers, as discussed above, L-shaped risk retention (i.e. a combination of a vertical slice a first loss tranche) as an element of risk retention is not yet permitted, though this is not surprising given that the HM Treasury Report had noted that this would require further review. There is also no provision for recognition of overseas retention but this was not expected as the HM Treasury Report consider the current situation satisfactory as parties are not prohibited as such from investing in overseas transactions.
Disclosure and Transparency. The PRA and FCA do not propose changes at this time but contemplate a further consultation in this area, including on changes to the private and public disclosure templates, taking into account points discussed in the HM Treasury Report. The FCA has outlined a possible approach these matters in Chapter 7 of the FCA Consultation Paper with discussion as to (i) which securitisations should be considered public and be required to report via a securitisation repository and (ii) whether those transactions defined as private securitisations should be subject to a less stringent, more proportionate reporting regime. The public/private distinction was also discussed in Report from the Commission to the European Parliament and the Council On the functioning of the Securitisation Regulation and the European Securities and Markets Authority was invited to consider a dedicated template for private securitisation transactions but no changes to the definition of private transaction were proposed. We will watch this space with interest and particularly for areas of divergence between the two regimes as they develop.
STS requirements. The criteria will be determined by the FCA and PRA and remain broadly the same but adapting for a model that may work better under the new framework11 with relevant changes being made to other related legislation to ensure the equal treatment of STS-equivalent non-UK securitisations. The HM Treasury Report was sympathetic to considering further the recognition of equivalent third-country securitisations and the draft Securitisation SI clarifies that HM Treasury will take into account the supervision and enforcement framework of third-country jurisdictions and also simplicity, transparency and comparability criteria (perhaps bearing in mind the Basel-IOSCO STC standards which, as noted in the HM Treasury Report, various jurisdictions have or are currently considering implementing). It remains to be seen to what extent, especially where there is no reciprocal recognition, HM Treasury will be willing to recognise any third country STS-equivalent transactions but it may be that HM Treasury has kept the door ajar for recognition of third country equivalence. In addition, although as mentioned above the STS label was introduced to on-balance sheet synthetic securitisations from April 2021 under the EUSR as part of the COVID-19 recovery package, in the UK although the implementation of an STS regime for UK on-balance synthetic securitisations was considered in the HM Treasury Report, that report concluded that there was insufficient risk reduction relative to the lower capital requirements that STS securitisations are eligible for, and that HM Treasury and the regulators were not currently minded to consider the inclusion of synthetic securitisations in the UK STS framework. In particular, the extension of the STS framework to synthetic securitisations reduced the “p” factor (see below) used in the calculation of the risk-weights for the standardised approach by 50%, and the risk-weight floor on the senior retained tranche to 10%, improving the economics for banks under the standardised and IRB approach, and the increasing use of the STS framework on synthetic securitisations by EU banks since April 2021 is indicative of market support. As such, UK originator institutions are likely to be at a disadvantage compared to their EU peers.
Homogeneity. The FCA proposals broadly align with those of the EBA’s Final Report of 14 February 2023 (“Homogeneity RTS”).12 The FCA aims to clarify that as a condition for homogeneity, loans must be serviced in accordance with similar procedures for monitoring, collecting and administering cash receivables by the SSPE under UK Securitisation Regulations, and so as a policy matter the FCA will extend that so that loans serviced in such a manner by the originator will be included; this will cover situations where loans are kept on the balance sheet of the originators, and where there is no SSPE required for a true sale, but put in trust for the investors or a similar arrangement to achieve true sale. In those cases, the servicing would be done by the originator and a reference to the SSPE would be inappropriate. Also clarified is (i) the inclusion of part of recital 27 of the EUSR as an operative provision that corporate bonds (not listed on trading venue) may be included as underlying exposures; and (ii) clarity that mixed pools of buy-to-let an owner-occupied mortgages are generally not homogenous unless underwritten and serviced with similar standards. The FCA also proposes a clarification that where no homogeneity criteria are relevant for a particular securitisation, no homogeneity conditions should apply.
- Capital and liquidity treatment. The Policy Note highlights that the PRA may examine the capital and liquidity treatment of certain securitisations as noted in the HM Treasury Report. One particular area is in relation to “Basel IV”13 and the output floor. In response to the perceived weaknesses in the banking industry highlighted during the global financial crisis, the Basel III standards were introduced in an attempt, among other things, to reduce the excessive variability of risk-weighted assets ("RWAs") and to increase the comparability between the utilisation of supervisor-approved internal models and the standardised approach. One of the more far-reaching introductions was the implementation of an output floor, which is imposed as an internal rating model floor designed to limit the amount by which a bank’s internal models can reduce its overall capital requirement for credit risk compared with the requirement that would apply under the standardised approach. This supervisory parameter, seen by market participants as a premium charge payable for all securitisation transactions (regardless of their features) to address the modelling and agency risks prevalent in securitisations, plays a significant impact in the calculation of RWAs for securitisation positions, and is a key component for the calculation of securitisation RWAs.14 Securitisation industry participants called for halving the supervisory parameter for SEC-SA and lowering the floor for SEC-IRBA to 0.1 (for STS) and 0.25 (for non-STS), and in December 2022 the European Supervisory Authorities recommended a reduction in the risk weight floor applicable to senior tranches retained by originators. In February this year, the European Commission15 introduced transitional relief, agreement on which was reached with the European Parliament and the Council in 27 June 2023, by reducing the “p” factor in respect of the SEC-SA output floor by 50%, until 31 December 2032.
The final agreement provides that the prudential treatment of the securitisation framework is to be reviewed again, as part of the Capital Markets Union Action Plan, and a further reduction of the floor could be proposed as part of further legislative proposals before 31 December 2027. This may be particularly beneficial for SRT originators; sophisticated banks with internal models will have the requisite information to calculate the inputs required for the SEC-IRBA and may benefit from a lower capital floor and a lower RWA calculation under SEC-IRBA, and even new entrants or banks using SEC-SA will benefit from preferential treatment for the retained tranches. In the UK, although industry participants raised lowering the “p”-factor used to calibrate the capital requirements against securitised assets for all securitisations in the consultation process, the PRA has not yet made a similar adjustment in relation to the implementation of Basel IV in the UK, which would seem to leave UK originator institutions undertaking SRT transactions at a disadvantage, so this could be an area of future focus.
What will not change/minor changes?
Definitions and provisions as to the regulatory perimeter. These remain unchanged, though the PRA refers to originators and sponsors as “manufacturers”. Originators and sponsors, but not the SSPE, must be established in the UK. For EU securitisations, each of the originator, sponsor and SSPE must be established in the EU.
Securitisation repositories and third party verifiers (“TPVs”). The regime is the same but “authorisation” for TPVs is now called “registration” as TPVs as they are not authorised entities.
Credit-granting criteria for certain trade receivables. The Rules clarify that credit-granting criteria do not apply to trade receivables (unless originated in the form of a loan). This was previously included in recital 14 of the UKSR.
Currency references. These are now modified to reflect Sterling rather than Euro.
What is the impact for existing STS transactions in the UK and EU?
The Securitisation SI will not apply to securitisations issued before 1 January 2019 or, where there is no issue of securities, where the initial securitisation positions of the securitisations were created before 1 January 2019 and no new securitisations positions have been created on or after 1 January 2019.
Many firms will be familiar with the proposals discussed above as they reflect, in large part, market expectations. However, for post-1 January 2019 transactions, firms should consider each of the changes and to what extent their internal policies, procedures and systems and controls are in compliance with the new requirements. It is expected, however, that costs to firms of complying with the new Rules will relate more to familiarising themselves with the Rules, as opposed to material operational costs.
Any deal structured post-1 January 2019 may need to comply with the final Rules once they are adopted to the extent that the CRR RTS no longer apply or other changes impact any transactions. To the extent that a transaction is impacted by non-compliance with the Rules such transaction could theoretically need to be modified, save to the extent that the FCA or PRA, as the case may be, adopts a pragmatic approach and provides further guidance on this. Firms might consider it prudent to adopt any stricter interpretation of the rules for the time being.
For new transactions, market participants should consider the drafting of risk factors in prospectuses to highlight proposed changes to the securitisation framework and anticipate the impact of any changes in any legal memoranda. Existing transaction documentation is likely to provide for interpretative provisions which are broad enough to capture the change in legislation and/or devolution of powers to the FCA/PRA but it is worthwhile double-checking that this is the case.
The Securitisation SI is near-final but technical comments will be considered up to 21 August 2023 with the Securitisation SI expected to be laid in front of the UK Parliament by the end of this year and it will then be subject to review after 5 years. The FCA and PRA consultations run until 30 October 2023 and the FCA and PRA intend to publish their respective Rules in Q2 of 2024, subject to the progress of the Securitisation SI.
The proposals include some welcome elements to achieve a more flexible framework that can facilitate the growth of the UK market though, despite the regulators indicating the need to take into account international competitiveness, removal of barriers and growth of the market, there remains significant room for further improvement in some areas. There could of course be costs for firms in adapting to the new framework but in the long term a more principles-based system could prove more user-friendly and commercial for the UK market. Of course, in many instances additional flexibility under the UK rules may not result in the desired flexibility in practice due to the requirements of some investors and funders to invest in securitisations which comply with EU rules. Whilst the overall framework will remain substantially the same, under the current proposals, there are some areas of divergence and it is, of course, more than possible that there could be more divergence between the EU and UK regimes over time and which market participants which will need to continue to take into account for multi-jurisdictional transactions.
Please also see other Engage articles below for further information on some of the topics discussed above:
Edinburgh Reforms – quick guide and timeline
The Edinburgh Reforms: the next chapter for UK financial services regulation
UK: Financial Services and Markets Act 2023
If you have any questions on this topic please speak to your usual Structured Finance contact at Hogan Lovells.
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 Julian Craughan, Tauhid Ijaz and Jane Griffiths.
2 This follows HM Treasury’s Future Regulatory Framework Review that was concluded in July 2022. An illustrative statutory instrument for securitisation was published on 9 December 2022 as part of the UK government’s broader Edinburgh Reforms aimed at driving growth and competitiveness in the financial sector.
4 Information includes (i) quarterly disclosures of underlying exposures (non-ABCP only and for ABCP monthly information on underlying receivables or credit claims), (ii) investor reports on credit quality and performance, (iii) information about legal documentation (before pricing, 15 days after closing and on any material change), (iv) material events, (v) approved prospectus, (vi) offering or marketing document (before pricing and no later than 15 days after closing),and (v) any STS notification (before pricing and no later than 15 days after closing.
5 Pursuant to Regulation (EU) No 575/2013 (the “Capital Requirements Regulation”).
6 Following the end of the transition period on 31 December 2020, EU law is no longer directly applicable in the UK, save to the extent that it has been onshored by UK legislation. As the 2018 Risk Retention RTS had not been published in the Official Journal by the end of the transition period, the CRR RTS were the rules that were onshored in the UK (subject to changes made by the Prudential Regulation Authority as set out in Annex R of The Technical Standards (Capital Requirements) (EU Exit) (No. 3) Instrument 2019.
7 5 Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 Text with EEA relevance (as amended).
9 Articles 248 and 256 were amended by Regulation (EU) 2021/558.
10 Final Report and Draft Regulatory Technical Standards specifying the determination by originator institutions of the exposure value of synthetic excess spread pursuant to Article 248(4) of Regulation (EU) No 575/2013. Under the EU Final RTS synthetic excess spread recognised by the originator institution in its income statement, in previous or current periods that is still available to absorb losses should be considered in full for the determination of the exposure value, whereas for synthetic excess spread for future periods the exposure value will (after much consultation) be the synthetic excess spread for the upcoming period by the weighted average life of the reference portfolio (as at the calculation date) and a scalar factor representing the capacity of the synthetic excess spread to absorb losses (set at 0.6 if a “use-it-or-lose-it” operates) and at 1 otherwise.
11 This was introduced by FSMA 2023 which inserted article 28A into the UK Securitisation Regulation and which provides for changes to Capital Requirements Regulation, Solvency II, and the Money Market Funds Regulation. The Securitisation SI also amends the European Market Infrastructure Regulation to exempt STS-equivalent non-UK securitisations from the clearing obligation.
13 Between December 2017 to 2019, the Basel Committee on Banking Supervision ("Basel Committee"), through a series of amendments, finalised the third instalment of the Basel Accords creating a regulatory framework for bank capital adequacy, stress testing and market liquidity risk, known as "Basel III". This is sometimes referred to as "Basel 3.1", as they are amendments to the (original) Basel III agreed in 2010. Because of the magnitude of some of the changes, they have also been referred to as "Basel IV".
14 In the context of securitisation positions, the output floor would cap the minimum risk weighting under an internal model such as the Securitisation Internal Ratings Based Approach to 72.5% (following a transitional period) of the RWA under a counterfactual standardised approach. This means that banks' regulatory capital gains from the use of internal models such as SEC-IRBA cannot exceed 27.5% of what would have been required to be held in the context of a standardised approach.
15 See the ECON committee report in respect of the Commission’s CRR3 proposal dated 9 February 2023.