Written by Bogdan Pavliuk, Senior Consultant.
Introduction
Effective as of January 1st, 2019, the EU securitisation market has undergone a substantial overhaul in terms of the overall regulatory framework that governs the securitisation activities of the different players in Member States (i.e., the “EU Securitisation Framework”). The overhaul represents a major milestone in the EU’s Capital Markets Union (CMU) agenda and includes several interrelated and complementary regulations. At its core lie the following texts:
- Reg. EU 2017/2402: A product-specific regulation that includes general rules for securitisation activities and is applicable to all market participants.
- Reg. EU 2017/2401: Amendments to the Capital Requirements Regulation (CRR) (Reg. EU 575/2013), where the latter covers the prudential framework for credit institutions. The main changes focus on the regulatory capital calculation rules for securitisation exposures.
- Reg. EU 2018/1221: Amendments to Solvency II (Reg. EU 2015/35), where the latter covers the prudential framework for insurance and reinsurance undertakings. The main changes focus on the regulatory capital calculation rules for securitisation exposures.
This article aims to provide a general overview of each of the abovementioned regulations, highlighting the key components and considerations from the perspective of banks and (re)insurers subject to the new requirements.
The EU Securitisation Regulation
Known as the “EU Securitisation Regulation”, Reg. EU 2017/2402 is an overarching regulatory text that is applicable to all participants in the EU’s securitisation market, including institutional investors, originators, sponsors, original lenders, and securitisation special purpose vehicles (SSPEs). Central to the regulation is the definition of a “securitisation”, which is a scheme where the underlying credit exposures are “pooled” and the associated credit risk is subsequently “tranched”, encouraging a more efficient distribution of risks and rewards across the market. More specifically, the following two characteristics are fundamental to the definition of a securitisation:
- Payments in the transaction or scheme are driven by the performance of the underlying exposures.
- The subordination of the tranches determines the distribution of losses during the life of the transaction or scheme (i.e., the cashflow “waterfall”).
Although the EU Securitisation Regulation has introduced a number of different elements and technicalities that the participants to a securitisation transaction must take into consideration, the noteworthy aspects can be summarised in terms of four fundamental areas.
Due diligence requirements:
Article 5 requires institutional investors (e.g., credit institutions, (re)insurance undertakings, investment firms, UCITS, etc.) to verify, among other things:
- The processes and procedures of the originator or original lender for granting the credits that underly the securitisation transaction.
- The retention by the originator, sponsor or original lender of a material net economic interest in the securitisation of at least 5% as per the risk retention requirements (see below).
- The disclosure by the originator, sponsor or original lender of all required information as per the transparency requirements (see below).
- The existence of written policies and procedures that are proportionate to the complexity and risk profile of the securitisation position being held.
Risk retention requirements:
Article 6 seeks to align some of the conflicts of interest between the different parties to a securitisation transaction, specifically through the “skin in the game” concept:
- The originator, sponsor or original lender must maintain a material net economic interest in the securitisation of at least 5%, which cannot be hedged or transferred via credit risk mitigation.
- The retention must be held by either one of the abovementioned parties and cannot be shared.
- If the abovementioned parties are unable to reach an agreement as to who shall retain the risk, the retention must be borne by the originator.
Transparency requirements:
Article 7 lays down the disclosure requirements for originators, sponsors and SPPEs, including:
- Information on the underlying exposures (to be provided to investors and competent authorities).
- Documentation on the securitisation that is essential for understanding the transaction.
- Data disclosures via standardised templates (i.e., the ESMA reporting requirements) to a centralised securitisation repository, intended to facilitate the investor due diligence process.
Criteria for STS securitisations:
On top of the requirements outlined above, the EU Securitisation Regulation has introduced the concept of “simple, transparent and standardised” (STS) securitisations, aimed at establishing a more risk-sensitive prudential framework for securitisation transactions. A given securitisation may achieve the “STS” designation, subject to meeting the following two requirements:
- Complying with the extensive criteria under Chapter 4 related to
- simplicity (w.r.t. portfolio and cashflows),
- transparency (w.r.t. data availability) and
- standardisation (w.r.t. structural features, roles and responsibilities, etc.).
- Notifying ESMA as per Article 27(1) for inclusion of the securitisation in ESMA’s database of STS securitisations.
In addition to providing prospective investors with a degree of confidence as to the securitisation transaction, the STS classification allows for a preferential regulatory capital treatment by banks and (re)insurers with exposure to such transactions (discussed in the next two sections).
Revisions under the CRR
The “New Securitisation Framework” (Reg. EU 2017/2401) has replaced in its entirety the prior securitisation framework for regulatory capital under the CRR (Reg. EU 575/2013, Chapter 5, Title II, Part Three). The groundwork for the revised framework has been laid down by the Basel Committee on Banking Supervision (BCBS) in its “Revisions to the securitisation framework” publication.
With regard to its scope, the New Securitisation Framework applies to all banks subject to minimum capital requirements for securitisation positions, whether as originators, sponsors or investors, as well as in the role of transaction parties that assume credit risk on securitised exposures (e.g., as credit support or swap providers).
The ultimate objective of the New Securitisation Framework is to “address the shortcomings which became apparent during the financial crisis, namely mechanistic reliance of external ratings, excessively low risk weights for highly-rated securitisation tranches and, conversely, excessively high risk weights for low-rated tranches, and low risk sensitivity.” In this context, the New Securitisation Framework has defined a revised and simplified hierarchy of approaches for the calculation of capital requirements, in the following order (subject to a few nuances):
- The Securitisation Internal Ratings Based Approach (SEC-IRBA).
- The Securitisation Standardised Approach (SEC-SA).
- The Securitisation External Ratings Based Approach (SEC-ERBA).
Additional notable aspects of the New Securitisation Framework include caps on capital charges (driven by the capital requirements that would be applied to the underlying exposures had they not been securitised), a “look-through” treatment for senior securitisation positions, and the introduction of a favourable capital treatment for STS securitisations.
SEC-IRBA:
The SEC-IRBA must be applied by all institutions when:
- The securitisation position consists of a pool of exposures that is an “IRB pool” (i.e., a pool of exposures for which the institution has permission to use the credit risk IRB Approach.
- Sufficient information is available to calculate the total capital charge on the underlying pool (i.e., “KIRB”).
- The competent authority has not prohibited the institution from using the SEC-IRBA (the former has the power to do so on a case-by-case basis).
Under the SEC-IRBA, the risk-weighted exposure amount (RWA) for a securitisation position is computed based on a number of inputs: KIRB, the attachment/detachment points of the tranche, the effective number of exposures in the pool, and the weighted-average LGD of the pool. Additionally, the model incorporates a “supervisory parameter” that operates as a capital surcharge based on the maturity and seniority of the tranche, as well as the granularity of the pool.
For tranches that absorb losses up to the IRB Approach capital requirement of the underlying pool, the assigned risk weight is 1250% (the maximum possible). For tranches above the pool capital requirement, a risk weight of 12.5 x KSSFA(KIRB) is applied. If the tranche straddles the level of the pool capital requirement, a weighted-average blend of the two measures is used.
Lastly, the risk weight under the SEC-IRBA is subject to a floor of 15%, unless the securitisation position meets the STS criteria, in which case the capital surcharge is halved and the risk weight floor is set at 10%.
SEC-SA:
If the SEC-IRBA cannot be used, the institution must apply the SEC-SA. The latter is based on the pool capital requirement calculated under the credit risk Standardised Approach (i.e., “KSA”), where the inputs include the attachment/detachment points of the tranche and the ratio of the exposure in default to the total exposure of the underlying pool. The supervisory parameter is fixed at 1, with the resulting capital surcharge being higher than that under the SEC-IRBA.
In line with the SEC-IRBA, the tranches below the Standardised Approach capital requirement of the underlying pool will assume a risk weight of 1250%, while those above will attract as risk weight of 12.5 x KSSFA(KA), with a weighted-average risk weight being used for tranches that straddle the level of the pool capital requirement. If the delinquency status of 5% or less of the exposures in the pool is unknown, the SEC-SA may still be used, but a standard adjustment must be made to the pool capital requirement. If the delinquency status of more than 5% of the exposures in the pool is unknown, the securitisation position assumes a risk weight of 1250%.
Once again, the risk-weight floor under the SEC-SA is 15%, with the exception of STS securitisations for which the capital surcharge is halved and the risk weight is floored at 10%.
SEC-ERBA:
The institution must use the SEC-ERBA for externally rated positions (or positions for which an inferred rating may be derived) when:
- The SEC-SA would result in a risk weight that us higher than 25% for STS securitisations.
- The SEC-SA would result in a risk weight that is higher than 25% or the SEC-ERBA would result in a risk weight that is higher than 75% for non-STS securitisations.
- The securitisation is backed by a pool of auto loans, auto leases or equipment leases.
Under the SEC-ERBA, the pre-defined risk weights (between 15% and 1250%) are allocated in accordance with the securitisation position’s rating, seniority and maturity (1-5 years based on linear interpolation), with an adjustment made for tranche thickness. Naturally, senior tranches assume a lower risk weight than non-senior tranches of the same rating and maturity.
Once again, there is an embedded overall floor of 15% on the applicable risk weight, and the risk weight for a non-senior tranche cannot be lower than that of a hypothetical senior tranche in the same securitisation (assuming equivalence of rating and maturity). STS securitisations are also subject to preferential risk weights under the SEC-ERBA, with 10% being the floor.
As a special subset of the SEC-ERBA, the Internal Assessment Approach (IAA) may be applied to unrated positions (e.g., liquidity lines) in asset-backed commercial paper (ABCP) programmes, subject to complying with a list of extensive requirements. This component of the New Securitisation Framework is largely in line with the previous version.
Revisions under Solvency II
In the spirit of the revamp in the banking context and to harmonise the EU securitisation market, Solvency II (Reg. EU 2015/35) has undergone material updates through the roll-out of the “Amended Securitisation Framework” (Reg. EU 2018/1221). The latter defines the updated solvency capital requirement (SCR) calculation rules for securitisation exposures held by insurance and reinsurance entities, effectively replacing Article 178 in the original Solvency II text. It has also introduced dedicated rules for the SCR treatment of securitisation exposures that benefit from the STS classification.
While the CRR is a credit risk-centric framework (i.e., with a focus on default risk), Solvency II is predominantly concerned with market risk and in particular spread risk when it comes to investments in securitisations. The Amended Securitisation Framework has recalibrated the SCR calculation rules to provide the right stimuli for the different types of securitisation investments and to better reflect the risk sensitivity proportionate to the characteristics of these investments. As a result, a new set of classifications for securitisation exposures has been introduced, with each subject to different “stress factors” that ultimately define the level of SCR consumption.
In this context, securitisation investments by (re)insurance undertakings should fall under one of four categories:
- Senior STS securitisation positions (further split into those with and without a credit rating from a nominated ECAI).
- Non-senior STS securitisation positions (further split into those with and without a credit rating from a nominated ECAI).
- Re-securitisation positions (with a credit rating from a nominated ECAI).
- All other securitisation positions (further split into those with and without a credit rating from a nominated ECAI).
In addition to the classification, the stress factor and final SCR charge are driven by the credit rating and duration of the securitisation position (i.e., the lower the rating and the higher the duration, the more penalising the capital consumption). In terms of impacts, senior STS securitisation investments are afforded the lowest stress factors, placing them in a favourable position to the previous “type 1” classification. Conversely, non-STS securitisation positions are allocated the same stress factors as under the former “type 2” classification. The SCR impact of the STS vs. non-STS classification can be as high as ×10, ceteris paribus, discouraging (re)insurers from investing in non-STS securitisations.
Concluding Remarks
This article provides a general overview of the EU Securitisation Framework, highlighting its most important elements from the standpoint of Member State bank and (re)insurance companies engaged in securitisation activities. Structured finance and in particular securitisation are, by definition, complex and technically intensive, with the regulatory framework governing such activities being reflective of this fact. Despite the EU Securitisation Framework being in force since January 2019, it remains relatively new and continues to pose significant challenges in terms of its implementation for all impacted institutions, both from the operational and strategic perspectives.
In the future, we will provide a blog post which will explore the key findings of the regulatory authorities regarding the current status of the EU Securitisation Framework’s implementation (more specifically the EU Securitisation Regulation). The reports, to be consulted, will include the “Joint committee report on the implementation and functioning of the securitisation regulation” (published in May 2021 through the combined effort of the EBA, EIOPA and ESMA) and the “Targeted consultation on the functioning of the EU securitisation framework” (with the final report to be published by the European Commission).