Regulation (EU) 2021/557 and Regulation (EU) 2021/558 (together, the Regulations) were published in the Official Journal of the European Union on 6 April 2021 and came into force on 9 April 2021.
Regulation (EU) 2021/557 amended European Regulation 2017/2402 (EUSR)[i] extending the Simple, Transparent and Standardised (STS) framework to on-balance sheet synthetic securitisations (previously only available to “true sale” securitisations) and removing existing embedded regulatory constraints to the securitisation of non-performing exposures (NPEs).
Regulation (EU) 2021/558 makes concomitant changes to the Capital Requirements Regulation (CRR)[ii],
These measures have been in contemplation for some time, but the expected impact of the COVID-19 pandemic on the exposures held by EU banks has provided the impetus for them to be introduced now, notwithstanding that a comprehensive review of the EUSR is due by January 2022. The hope is that the immediate introduction of these measures will help institutions to reduce the impact of such exposures on their ability to lend.
The new amendments broadly follow with recommendations of the European Banking Authority (EBA) in the EBA’s report published 6 May 2020.
The economies of EU Member States have been adversely effected by the COVID -19 pandemic, with many still struggling to manage new COVID variants, further lockdowns and higher unemployment. These events have created or exacerbated pressure on borrowers’ ability to service their debt obligations and is expected to result in a growth in the volume of NPEs.
EU banks, in turn, are constrained in their ability to lend and support economic recovery by the increase in the regulatory capital they need to hold against the increasing levels of NPEs on their balance sheets.
Even pre-COVID, the issue of the regulatory costs of securitising NPEs had been under discussion in the EU. On 23 October 2019, the European Banking Authority (EBA) published its opinion on the regulatory treatment of NPE securitisations (NPE Opinion)[iii]. The EBA noted that the risks associated with NPE securitisations differ economically to securitisations of performing assets. In particular, the amount raised in a securitisation of an NPE portfolio is typically discounted relative to the face value of the NPEs being securitised. Amongst other things, the requirement to hold risk retention positions calculated by reference to the face value of the relevant NPE exposures can result in originators having to hold much more of the economic exposure to such securitised NPE portfolios than would be the case in an equivalent performing loan securitisation. In addition to the risk retention issue, the EUSR imposed other constraints on credit institutions using securitisation technology to dispose of NPE holdings, due to:
- very high capital requirements on investor credit institutions under the CRR: the pre-eminent securitisation capital methods (the SEC-IRBA and the SEC-SA) and the look-through approach lead to disproportionately high capital charges on NPE securitisation positions when compared to relevant benchmarks and, as a result, overstates the actual risk embedded in the portfolio; and
- Compliance challenges as regards certain due diligence requirements under the EUSR.
The EUSR risk retention and credit granting provisions did not previously recognise the differences inherent in NPE securitisations, e.g. in true-sale risk retention requirements align the interests of originators, sponsors and original lender with the investor. In NPE securitisations, however, servicers tend to have the greater interest in the performance of the assets and the associated recoveries made under them.
The following amendments have been made to the EUSR to try to alleviate these regulatory constraints on NPE securitisations.
Article 6 of the EUSR has been amended and introduces:
- a special regime for NPE securitisations regarding the fulfilment of the risk retention requirement. Now, the risk retention requirement for NPE securitisations shall be calculated on the basis of the discounted value of the exposures transferred to the securitisation special purpose vehicle; and
- an additional retention route, permitting the servicer to hold the risk retention position on the basis that the servicer will have a more substantive interest in the workout of an NPE portfolio and its recovery value.
In addition, the obligation on originators only to securitise loans using the same underwriting criteria as used to originate similar non-securitised loans failed to allow for situations where an originator purchased NPEs from a third party. In those cases, the criteria for the selection and pricing of such exposures at the time of that purchase would be of greater significance than the criteria applied at origination. Accordingly, Article 9(1) has been amended to permit purchasers of NPEs to apply sound standards to the selection and pricing of NPEs at the point of their acquisition (rather than at their point of creation).
This does however create an interesting dichotomy in the EUSR regime. An originator that acquires a portfolio of performing exposures may have difficulty establishing that the credit granting criteria for such loans are not different to those applied to similar non-securitised loans.
Similarly, an originator that has held a portfolio of NPEs since their initial creation (presumably as performing exposures initially) will still have to be able to demonstrate that any NPEs that it has securitised were originated using the same credit granting criteria as other similar loans. Accordingly, especially for more seasoned NPEs (where there may be gaps in the historical data relating to the circumstances applying at the time of origination), it may turn out to be easier to securitise after-acquired NPEs rather than NPEs that the original lender has held through their entire life. Could this lead to a “swapsies” market where banks trade each other’s NPE books in order to then securitise them?
The question could also be asked “why has the EU not considered applying similar rules in relation to performing exposures acquired after their creation?” It seems counterintuitive that the due diligence burden for an acquired portfolio of performing exposures might be more onerous than that for an acquired portfolio of non-performing exposures (and indeed for a “held for life” portfolio of non-performing exposures), but this does seem to be the effect of the amendment to Article 9.
STS on-balance sheet synthetic securitisations
A “synthetic securitisation” is a securitisation where the transfer of risk of a set of loans is achieved by the use of credit derivatives or guarantees. Ownership of the underlying exposures being securitised will not be transferred to the SSPE. In many synthetic securitisations, the underlying exposures will continue to be owned by the originator institution. Synthetic securitisations are more commonly associated with loans to corporate clients, as these are more likely to contain prohibitions on transfer than consumer loans. However, it is also possible to construct a synthetic securitisation of exposures which the originator does not own (or have direct exposure to).
“Aribtrage” synthetic securitisations (where the originator does not own the underlying exposures) will not qualify as for STS treatment. The objective of arbitrage synthetic securitisations is typically to profit from movements on the price of credit risk (either in relation to a specific obligor or generally), rather than to obtain credit risk protection in respect of actual exposures of the originator. The European Commission has determined that the nature of arbitrage synthetic securitisations means it is not appropriate to make them beneficiaries of STS treatment.
In deciding to extend the STS requirements to on-balance sheet synthetic securitisations, the Commission noted that certain requirements for STS traditional securitisations are not appropriate for STS on-balance-sheet securitisations. Regulation 2021/557 therefore introduces a set of new requirements, specific to synthetic securitisations, to ensure that the STS framework targets only on-balance-sheet synthetic securitisations and that the credit protection agreement is structured to adequately protect the position of both the originator and the investor. That new set of requirements should seek to address counterparty credit risk for both the originator and the investor. [iv]
Regulation 2021/577 introduces a new Section 2a to EUSR which extends the STS framework to on-balance-sheet synthetic securitisation. Synthetic securitisations that meet the requirements of Articles 26b to 26e shall be considered to be STS on-balance-sheet securitisations. It should be noted that such synthetic securitisations can only attract the STS label if carried out by EU banks. Synthetic securitisations originated by EU non-banks or non-EU banks will not be able to avail themselves of this treatment.
Simplicity –Article 26b sets out the requirements relating to simplicity. The underlying exposures must have been originated as part of the core business of the originator and at the closing of a transaction, the underlying exposures must be held on the balance sheet of the originator or a member of its group. The originator must not hedge its exposure to the credit risk beyond the protections obtained through the credit protection agreement forming part of the relevant synthetic securitisation. The originator shall also provide a number of representations and warranties the certain requirements relating to the originator and the underlying exposures as specified in Article 26b (6) have been met.
Standardisation –Article 26c sets out the requirements for standardisation. Disclosure of the interest rate and currency risks affecting payments along with measures taken to mitigate such risks are to be described in the transaction documents. Losses shall be allocated in order of seniority of the tranches with the first loss attributed to the most junior tranche. Sequential amortisation shall be applied. However, by way of derogation STS on-balance sheet securitisations may contain non-sequential amortisation so as to avoid disproportionate costs of protection as the portfolio pays down. Interestingly, however, no consequential change seems to have been made to Article 245 of the CRR in relation to SRT. While non-sequential amortisation does not automatically disqualify a securitisation from achieving SRT, it has been a feature that regulators have traditionally not regarded favourably when making SRT determinations. Additional regulatory guidance will be needed if originators seeking SRT are to routinely include non-sequential amortisation in new STS synthetic securitisations.
A reference register should be kept which clearly identifies the reference obligations on which the protection has been purchased i.e. the underlying exposures, the identity of underlying entities or obligors and a third party verification agent should be appointed to carry out a factual review of the correctness of the credit protection and loss following a credit event.
Transparency – Article 26d sets out the requirements for transparency. The originator is required to make available data on static and historical default and loss performance, including default and delinquency data and should cover a period of at least 5 years. A verification agent is to verify a sample of the underlying exposures to verify that such exposures are eligible for credit protection.
The originator will need to make available to potential investors, prior to pricing, a liability cash flow model representing the contractual relationship between the underlying exposures and the payment flows between the relevant parties and shall make the model available to investors after pricing and on an ongoing basis and to potential investors upon request.
Article 26e –new requirements concerning the credit protection agreement, the role of the third party verification agent and the synthetic excess spread. Credit events triggering payments should include at least those events referred to in Chapter 4 of Title II of Part 3 of Regulation (EU) No 575/2013.
The aim of these new provisions is to incentivise banks to use this type of securitisation tool to free up capital to allow further lending. Investors may be attracted to such securitisations as they may benefit from preferential regulatory capital treatment from the STS label. However, the benefit of preferential regulatory capital treatment is only available for the senior position held by the originator and not to investors holding other positions. This of itself may not be problematic, as the target investor base for the more junior positions should be non-banks (otherwise the NPE risk has merely been shuffled within the banking system rather than taken out of it). However, whether this creates problems indirectly (for instance if such non-banks try to use those more junior tranches to meet margin calls or as security for borrowings, in each case, with banks) remains to be seen.
STS Synthetic securitisations – collateralisation
We expect that the collateralisation requirements of Article 26(e) will attract a lot of attention from originators of synthetic securitisations. While the default position is that cash collateral has to be held with a third party bank having credit quality step 3 or above, originator banks in credit quality step 2 may be able to hold such cash collateral directly. Originator banks with credit quality step 3 will only be able to hold cash collateral directly if difficulties with holding collateral in other forms can be documented to the satisfaction of their local competent authority and the EBA. We expect originator banks to be quite keen to be able to hold cash collateral for STS synthetic securitisations, as the alternatives may present some difficulties. If collateral is held in the form of securities instead, then the relevant securities need to be (i) 0% risk weighted, (ii) have a maximum remaining maturity of three months or if less, the period to the next interest payment date, (iii) be capable of being redeemed into cash at an amount equal to the outstanding balance of the protected tranche and (iv) be held with a third party custodian.
This presents potentially two problems. The first is that many securities that attract a 0% risk weighting have, in recent times, carried negative yields. This means that the redemption value of the relevant security would likely be less than the price at which it could be acquired in the market – either obliging the originator to make up the difference when acquiring such collateral (potentially exposing investors to at least some originator credit risk) or requiring investors to accept collateral redemption value risk as well as the credit risk of the underlying reference obligations (unlikely to be an attractive proposition to investors).
The other issue is that if the securities providing the collateral are not permitted to have a maturity date longer than the next interest payment date of the relevant tranche of securities issued as part of the securitisation, then investors are going to be exposed to reinvestment risk on the collateral. If insufficient securities of the right type and maturity are available in the market at the time the relevant securitisation needs to “roll over” its collateral, then it will either have to switch to cash collateralisation (potentially tricky and expensive if not previously provided for in the documentation) or the whole transaction will have to be unwound (again, not attractive to investors looking for an investment to an expected term). How these potential issues are dealt with will be an interesting feature in the development of the STS synthetic securitisation market.
STS templates –interim measure
ESMA also published on 9th April 2021 interim STS templates on which notification to ESMA can be made where a synthetic securitisation is STS compliant. Use of these templates is voluntary but as originators are required to nevertheless provide information on the securitisation to ESMA, market participants may find it helpful to use these interim templates as the final templates (which will come in to force in due course) which are required to be developed by ESMA, will likely be based on these.
The following amendments have also been made to EUSR:
- Article 4 has been significantly re-written. Establishing an SSPE in a jurisdiction that FATF has declared “high risk and non-compliant” is no longer prohibited; but this prohibition has been replaced with one against establishing an SSPE in a “high-risk third country” that has strategic deficiencies in its regimes for anti-money laundering and anti-terrorist financing. In addition there is a new prohibition on establishing an SSPE in a jurisdiction that is an Annex 1 non-cooperative jurisdiction for tax purposes. There is also a new obligation on investors to inform the relevant Member States tax authorities if it has invested in securities issued by an SSPE established after 9 April 2021, in an Annex 2 jurisdiction (one that engages in harmful tax practices). In practice, it is highly unlikely that a securitisation of EU assets would involve an SSPE located in any of the jurisdictions caught by Article 4; and
- Article 22 has been modified such that, rather than reporting on the environmental performance of dwellings or vehicles financed by the underlying exposures in a residential mortgage backed securitisation or auto loan/lease securitisation, originators may (from 1 June 2021) instead report on the “principal adverse impacts of the assets financed by underlying exposures on sustainability factors.”. The relevant Regulatory Technical Standards for such reporting are to be produced by 10 July 2021.
Changes to CRR
The changes to CRR provide a new prudential treatment, including with regard to capital requirements, designed to underpin the changes introduced to the Securitisation Regulation. They extend the benefit of lower capital treatments to the senior tranche of balance-sheet synthetic securitisations that satisfy the STS framework; and (ii) provide for specific capital treatment for positions in NPE securitisations.
The changes include amendment to the CRR provision relating to the minimum credit rating requirement for almost all types of eligible providers of unfunded credit protection, including central governments.
Since 1 January 2021, the UK and the EU have separate (albeit largely identical) regulatory regimes for securitisation. As at the date of this blog, it remains to be seen if the UK parliament will follow suit and adopt similar amendments to the UK’s Securitisation Regulation and the UK CRR Regulation which, since 1st January 2021 , can only be amended, insofar as such laws apply in the UK, by UK legislation.
Unless and until the UK Parliament adopts the same or similar measures to the treatment of NPE and on-balance sheet synthetic securitisations as discussed above, market participants will have to contend with two separate regimes (UK and EU). Furthermore, while the UK will recognise EU STS securitisations which have been notified as being STS prior to 31 December 2022, it is not yet clear if this extends to on-balance sheet synthetic STS securitisations.
[i] Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 laying down a general framework for securitisation and creating a specific framework for simple, transparent and standardised securitisation, and amending Directives 2009/65/EC, 2009/138/EC and 2011/61/EU and Regulations (EC) No 1060/2009 and (EU) No 648/2012 – (OJ L 347/35, 28.12.2017
[ii] Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions
[iv] Recital (13) Regulation (EU) 2021/577