On 13 November 2006, the Australian Prudential Regulatory Authority (APRA) released a discussion paper and accompanying draft prudential practice standard on securitisation in the form of a new draft (new APS 120) of the existing Prudential Standard APS 120 ‘Funds Management and Securitisation’ (current APS 120). The draft proposals can be found on APRA’s website.
APRA has stated that it intends the new APS 120 to reflect the Basel II capital adequacy regime.
Scope and Application
New APS 120 has been tailored specifically to securitisation and will not apply to funds management activities. APRA has stated that funds management activities will be covered in a separate prudential standard, a draft of which will be released at a future date. New APS 120 includes attachments A to G which are referred to throughout this article and roughly approximate to the various matters covered in the guidance notes to the current APS 120.
Like current APS 120, new APS 120 will apply to roles undertaken by, and investments of, authorised deposit-taking institutions (ADIs) in securitisation.
Foreign ADIs will not need to comply with new APS 120, other than the provisions relating to separation and disclosure. This is consistent with APRA’s current rationale that the capital adequacy regulation of foreign ADIs is a matter for the home country regulator of the foreign ADI.
However, unlike current APS 120, under new APS 120 a reference to an ADI is not taken to also include the subsidiaries of the ADI. Instead a reference to an ADI is taken to be a reference to:
- an ADI (or ADIs) on a stand-alone Level 1 basis, and
- an ADI (or ADIs) on a consolidated banking group Level 2 basis,
as set out in Prudential Standard APS 110 ‘Capital Adequacy’. Broadly, this means that a stand-alone ADI as a single entity and a consolidated banking group will each need to comply with the basic 1988 Basel Capital Accord (and revised Basel II) capital adequacy requirements. APS 110 reflects APRA’s tiered approach to the current Basel eight per cent capital requirement.
New APS 120 applies to ‘securitisation’ (as defined) and makes express provision for both ‘traditional securitisation’ and ‘synthetic securitisation’.
However, it does not extend to the issuance of covered bonds comprising full recourse debt instruments that are secured by a ‘cover’ pool (covered bonds). In fact new APS 120 specifically states that covered bonds are not permitted, or considered to be a securitisation (as defined in new APS 120) on the basis that they are inconsistent with the depositor preference provisions set out in the Banking Act 1959 (Cth).
Timing for Implementation
APRA has stated that the proposals form part of the Basel II capital adequacy regime for ADIs that will come into force on 1 January 2008.
APRA has invited submissions on new APS 120 to be provided to it by no later than 19 January 2007 and has stated that it expects that the full suite of Basel II prudential standards, including new APS 120, will be finalised in late 2007, ready for effectiveness on 1 January 2008.
In its discussion paper APRA has stated that ADIs are encouraged to detail the type of transitional arrangements they may need when making any submissions to APRA.
Furthermore, APRA has stated that it expects any new or modified securitisations undertaken subsequent to the release of new APS 120 to be ‘broadly in line with the proposed new requirements’. This will be of concern to ADIs, since it may result in structural or other changes to existing programs which ultimately may be relaxed or reversed once all submissions are in and the prudential standard is in final form.
New Definitions Introduced
Unlike the current APS 120, the new APS 120 contains a range of new definitions, including for ‘securitisation’, ‘traditional securitisation’, ‘synthetic securitisation’, ‘securitisation exposures’, ‘implicit support’, ‘originating ADI’, ‘indirect origination’, ‘servicing ADI’, ‘managing ADI’, ‘facility’, ‘service’, ‘funding facility’, ‘basis swap’ and ‘early amortisation clause’.
The definition of ‘securitisation’ is confined in that it refers to a structure where the cashflow from a pool is used to service obligations to at least two different tranches or classes of creditors with each class or tranche reflecting a different degree of credit risk. To the extent that an ADI’s structure does not fit this definition, but is similar, new APS 120 requires the ADI to apply to APRA for a written determination of its classification.
The definition of ‘originating ADI’ is quite broad as it includes an ADI in various capacities including as originator, sponsor, manager or servicer (originating ADI).
Self Assessment and Notification to APRA
In advance of undertaking a new securitisation, new APS 120 requires each originating ADI to provide a self-assessment to APRA evidencing compliance with the requirements of new APS 120 and also to obtain APRA’s prior written approval for the appropriate regulatory capital treatment to be applied.
Board and Senior Management Responsibilities
It is the responsibility of the board of directors and senior management of an ADI to put in place policies and procedures relating to securitisation. Under new APS 120 this requirement has been expanded and now includes an express obligation to have in place policies and procedures to monitor the effects of securitisation on the risk profile of the ADI.
An ADI must also assess the average asset quality of the exposures for which the ADI retains ownership (or the credit risk in the case of a synthetic securitisation) after a securitisation is completed.
The originating ADI must also consider any ‘residual risks’ arising from the exposures that have been securitised. There is no definition of ‘residential risks’ so this remains as an area for clarification by APRA.
APRA has stated that the nature and extent of relevant risks will depend upon the size of the ADI, the securitisation exposures, the role that the ADI assumes and the complexity of the securitisation business.
The new draft APS 120 expressly states that an ADI must obtain written advice from legal counsel with appropriate expertise in relation to the following issues:
- that certain of APRA’s separation requirements have been met for each securitisation
- that the ADI is protected from any legal liability from investors in the securitisation (apart from contracts into which the ADI has entered)
- in the case of a traditional securitisation, in relation to certain clean sale issues, and
- in the case of a synthetic securitisation, in relation to certain issues such as the transfer of credit risk.
The new draft APS 120 states that if any such opinions cannot be provided internally by the ADI, they must be given by external counsel. In addition, APRA may in any event seek an independent legal opinion on such matters at the expense of the ADI.
It is noteworthy that there will be a requirement that an opinion be obtained that the ADI is protected from any legal liability from investors in the securitisation (apart from contracts into which the ADI has entered). This proposal echoes some elements of the 10b5 opinions which are issued on some US issues but it seems to go further than the 10b5 ‘defence’ wording. It is unlikely that an external opinion could be given in the unqualified way described in new APS 120 and the scope of that opinion requirement appears to overlook some liabilities which could arise in tort, equity or under statute.
Disclosure and Separation for Originating ADIs: Attachment A
The disclosure and separation requirements for originating ADIs is set out in Attachment A of new APS 120. Some of the differences between current APS 120 and new APS 120 in relation to disclosure and separation requirements include:
- Under new APS 120 no member of the ADI’s group (as defined in the Australian accounting standards) can act as a trustee of an SPV. In addition, it appears that the intention is that the directors, officers or employees of an ADI must not act on behalf of the trustee of an SPV trust.
- New APS 120 expressly states that the SPV must be financially independent of the ADI and have separate personnel to the ADI.
- An originating ADI that does not comply with the requirements of Attachment A to new APS 120 will be considered to have provided ‘implicit support’ to a securitisation for capital adequacy purposes. Implicit support is provided to a securitisation by an ADI where the support provided is in excess of the ADI’s explicit contractual obligations (implicit support).
- The wording of the disclaimer language that investors receive in disclosure documentation in relation to an ADI has changed in a minor way so that it must state that an ADI does not ‘guarantee the capital value or performance of the issued securities or the performance of the exposures in the pool’.
- The express provisions in current APS 120 which allow for certain circumstances in which an ADI may used its logo, trade mark or name as a badge in marketing investment products, have not been included in new APS 120. These may yet be covered in the prudential standard on funds management (yet to be released). In relation to securitisation, it is possible that this has been removed from new APS 120 on the basis that APRA sees this as addressed by the more general requirement that marketing and promotions must ‘not give any impression contrary to the disclosure requirements’.
As regards separation between the ADI and the SPV, the new APS 120 will not permit an ADI to hold any share capital in a corporate trustee of a securitisation trust. This could pose issues for diverse ADIs which may operate investment/asset management divisions which invest in companies that act as securitisation trustees.
Capital Adequacy: Attachments B, C and D
New APS 120 sets out the circumstances in which APRA will allow an ADI to exclude a pool of underlying exposures from its balance sheet for regulatory capital purposes, including the requirements for transferring those exposures (either under a traditional securitisation or a synthetic securitisation).
A new requirement in relation to a traditional securitisation is that an ADI should not be required to make certain alterations to a pool of assets or credit enhancement after a pool has been securitised. This specifically includes any increase in the yield payable to parties such as investors and third party providers of credit enhancements in response to the deterioration in the credit quality of a pool.
In addition, new APS 120 directly incorporates the provisions relating to capital treatment of an ADIs ‘securitisation exposures’. Securitisation exposures are defined to include on- and off-balance sheet securitisation positions held by an ADI including:
- investments in securities issued by an SPV
- retention of a subordinated tranche of securities issued by an SPV
- credit enhancements, such as guarantee and reserve accounts provided in relation to a securitisation
- extension of funding or liquidity facilities, and
- exposures arising from derivative transactions with an SPV, (securitisation exposures).
For an on-balance sheet securitisation exposure, the risk-weighted asset amount of that exposure must be calculated by multiplying the ‘exposure value’ by the relevant risk weight. The relevant risk weight is determined using one of two broad approaches—the standardised approach or the internal ratings based (IRB) approach.
For off-balance sheet exposures, an ADI must also apply a credit conversion factor (CCF) to the securitisation exposure.
An ADI that adopts the standardised approach to determine the regulatory capital charge for the exposures in a pool (see APS 112) must use the standardised approach for the calculation of its regulatory capital charge for securitisation exposures. The detailed requirements of the standardised approach for securitisation exposures are set out in Attachment C.
Alternatively, where an ADI has approval from APRA to use the IRB approach to determine the regulatory capital charge for the exposures in a pool (see APS 113), the ADI must use the IRB approach in relation to the calculation of its regulatory capital charge for securitisation exposures. The detailed requirements of the IRB approach for securitisation exposures are set out in Attachment D.
Further, where an ADI has obtained approval from APRA to use the IRB approach for determining the regulatory capital charge for some exposures in a pool and it uses the standardised approach to determine the regulatory capital charge for other exposures in the pool, the ADI must obtain written approval from APRA regarding the approach to be taken in relation to securitisation exposures.
Where overlapping securitisation exposures occur (for example, an ADI provides several types of facilities such as credit enhancements and liquidity facilities in respect of the same pool of exposures), then to the extent that the facilities overlap, the ADI must adopt the securitisation exposure that produces the highest regulatory capital charge.
Importantly, new APS 120 now requires that start up costs of a securitisation must be deducted from an ADI’s Tier 1 capital as capitalised expenses.
In addition, an ADI that provides implicit support to a securitisation must at a minimum hold regulatory capital against all of the issued securities relevant to the SPV.
Facilities and Services: Attachment E
An ADI may provide ‘facilities’ and ‘services’ to a securitisation provided that the requirements of Attachment E are satisfied and the ADI holds regulatory capital against the securitisation exposures arising from the facilities provided.
Facilities are defined to include credit enhancements (including spread accounts), liquidity and funding facilities, underwriting of securities issued by an SPV and derivative transactions with an SPV (facilities).
Attachment E sets out certain common criteria that apply to all facilities provided by an ADI to a securitisation. Where liquidity, underwriting and funding facilities comply with the specified common criteria and other relevant criteria in Attachment E, they will be considered to be eligible facilities for capital adequacy purposes. Such eligible facilities will be treated accordingly under Attachment C (in relation to the standardised approach) and Attachment D (in relation to the IRB approach), with specific CCFs being prescribed.
One notable component of these common criteria is that an ADI must be able to withdraw from its commitments under a facility at any time and at its absolute discretion following a reasonable period of notice (being not longer than 90 days). While this may be applicable to undrawn lending commitments because ‘facility’ (as defined) includes derivatives, some clarification may be needed to deal with a provider of a derivative to a SPV.
New APS 120 refers to a number of arrangements which constitute spread accounts similar to the current APS 120.
Importantly it provides that an ADI must deduct directly from its Tier 1 capital any expected future income from a securitisation exposure that it has reported as an on-balance sheet asset.
Funding of an SPV
New APS 120 replaces the concept of ‘lending to SPVs’ with the concept of a ‘funding facility’. That is defined to mean a facility provided by an ADI to an SPV for the purchase of exposures (not being provided through the ordinary purchase of securities issued by the SPV) (funding facility). Funding facilities that are used for:
- the acquisition of additional exposures
- the refinancing of an existing loan used to fund the acquisition of additional exposures of the SPV, or
- redraws on exiting exposures in the pool,
must not be used to fund more than 20 per cent of the pool of the SPV at any time during the life of the securitisation unless approved in writing by APRA.
New APS 120 includes a new provision in relation to basis swaps. Basis swaps are often used in securitisation transactions to hedge the mismatch that arises from amounts determined under two different floating rate benchmarks. For example, the floating rate benchmark applicable to underlying exposures may be different from the floating rate benchmark applicable to the interest paid on securities that have been issued.
New APS 120 states that an ADI entering into a basis swap must be able to demonstrate to APRA that the basis swap is constructed with sufficient margin so that the ADI is not expected to be a net payer during the life of the transaction. Where the ADI is or expects to be a net payer in a derivative transaction for ‘significant periods’ (as detailed in New APS 120) it may be required to report to APRA if those derivative transactions do not comply with certain arm’s length criteria or requirements in relation to a maximum principal amount.
Services provided by an ADI are defined to include the offering of advice to investors or an SPV, servicing a pool and managing a securitisation (services). Attachment E specifically states that an ADI that provides services to a securitisation must ensure that its operational risk capital requirement (as determined by APS 114 or APS 115) adequately covers the operational risk of providing such services.
Furthermore, an ADI providing services to a securitisation must not subordinate, defer or waive the receipt of fees or other income for its role as a servicer provider as APRA considers this to be the provision of implicit support for capital adequacy purposes.
This is arguably a wider concept than under current APS 120 which only relates to services provided to the SPV, whereas the new requirement is in relation to services provided to a ‘securitisation’.
An ADI may now undertake the role of manager to a securitisation provided certain requirements are met (which, as is the case under current APS 120, also apply equally to a servicer to a securitisation). While the requirements are similar to those under current APS 120, they go further by expressly requiring that the servicer or manager must comply with APRA’s separation and disclosure requirements as detailed in Attachment A.
Acquisition of Exposures out of a Pool and Acquisition of Securities by Originating ADIs: Attachment F
New APS 120 specifically states that an originating ADI may acquire the underlying exposures pursuant to:
- the exercise of a clean-up call, or
- the granting of a further advance when the originating ADI is acting in the capacity as a servicer,
if in both cases, the detailed requirements in Attachment F are satisfied.
New APS 120 also allows for an originating ADI to acquire underlying exposures under an early redemption of a securitisation pool.
Under an early redemption or clean-up call the originating ADI will only be allowed to acquire the underlying exposures where that call option relates to 10 per cent or less of the original balance of the pool of assets.
Where an ADI is acting in the capacity of servicing a pool of assets, the ADI will be permitted to repurchase or replace pool assets but the 10 per cent limit will not apply.
However, any such repurchase or replacement must only apply to non-defaulted assets and must be for the purpose of providing further finance to the borrower. If this and other specified criteria are not complied with, the ADI will be taken to have provided implicit support.
Revolving Structures and Early Amortisation Clauses: Attachment G
New APS 120 now sets out specific requirements in relation to the transfer by an ADI of underlying exposures that consist of revolving facilities including, for example, certain types of loans, trade receivables accounts or credit cards.
The criteria for capital relief includes a requirement that the ADI retains the right to cancel without notice any undrawn exposures on revolving facilities whose drawn exposures have been transferred.
New APS 120 also includes specific provisions dealing with early amortisation clauses. An early amortisation clause is defined and refers to a contractual clause that, when triggered, will result in security holders in a securitisation being paid out, in full or in part, prior to the originally stated maturity of the issued securities. In certain circumstances revolving facilities that include early amortisation provisions will incur an additional regulatory capital charge.
Consequences of Noncompliance
APRA’s powers remain under new APS 120 in relation to its oversight of securitisation arrangements involving ADIs.
Under new APS 120:
- where APRA determines an ADI’s regulatory capital requirement is not commensurate with its overall risk from securitisation, or
- the ADI does not comply with the requirements of new APS 120,
APRA can require an ADI to:
- hold additional regulatory capital above its minimum requirement, or
- hold regulatory capital against the relevant pool or the full value of securities issued by the SPV.
Where an ADI provides implicit support it will be required at a minimum to hold regulatory capital against the full value of all securities issued by the SPV.
Where APRA assesses the risk of an ADIs exposure to securitisation as not having been adequately addressed by regulatory capital requirements, APRA can:
- impose limits on the extent of additional securitisation exposures of the ADI, or
- in exceptional circumstances:
- prevent the ADI from continuing to undertake securitisation, or
- require the ADI to transfer its securitisation exposures to a third party.
Comments and Submissions
New APS 120 contains a range of new or reworked concepts which may have broader regulatory consequences for ADIs involved in securitisation than is the case under current APS 120. While some streamlining has occurred (for example, the ability of an ADI to be a manager or servicer of an SPV and no longer through a stand-alone subsidiary), additional requirements have also been added (for example, the inability to own or hold a beneficial interest in any share capital in a corporate trustee of an SPV).
There is a degree of detail in new APS 120 which will unravel as it is applied to existing securitisation programs. The full implications are yet to be seen. If new APS 120 remains in its current form, it is possible that some existing programs will need to be amended in certain respects to avoid the potentially serious consequences of noncompliance with new APS 120.
Submissions on new APS 120 were required to be made to APRA by no later than 19 January 2007. We understand that a number of industry participants as well as the Australian Securitisation Forum have made submissions.
We anticipate that APRA will release a further draft once it has considered the submissions on the first draft. It is not clear whether APRA will seek further submissions on any revised draft, but given the significance of this Prudential Standard for ADIs and other regulated financial institutions, it is hoped that APRA will invite further submissions on any revised draft.
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