UK: Qualifying Securitisation | What Is It And What Does It Mean For The Market?

Last Updated: 3 July 2015
Article by Clifford Smout and Natalie Berkecz

In September 2015 the EU Commission is expected to bring forward a legislative proposal in on 'high-quality' securitisation as part of the Capital Markets Union. The Commission suggests it may be possible to incentivise the issuance of high quality securitisation through a differentiated capital charge relative to standard securitisation. This in turn could re-invigorate the European securitisation market.

Securitisation potentially brings real market benefits, such as being able to match the maturity of assets to liabilities, and deepening and diversifying sources of finance. A robust, well-functioning securitisation market would bring stable market-based funding, to complement bank lending as a source of finance for the economy. This could benefit under-financed SME markets and generate long-term sustainable financing for mortgage portfolios.

Developing the criteria for qualification will be challenging and regulators need to be cautious in their approach in setting the boundaries, considering the potential for causing market fragmentation and tarnishing the reputation of non-qualifying securitisation. Set the boundaries too wide and you risk devaluing the qualification; however, excessively narrow definitions could be at the detriment of currently well-functioning areas of the market.

What might qualifying securitisation look like?

The Commission's proposal will be the latest in a long list of similar attempts to define high-quality securitisation. Tables 1 and 2 below provide a high-level view of what the criteria for qualifying securitisation may look like.

The rationale for differentiated capital charges (and potentially lower haircuts when held as collateral), is that qualifying securitisations are perceived to pose a lower risk by providing sufficient transparency to investors, in part by being more easily comparable. Furthermore, some authorities have also suggested exempting qualifying securitisation structures from the non-cleared derivatives margining rules. Investors would still need to undertake due diligence on the underlying risks, as qualification is not intended to be a benchmark for product risk, but instead may reduce the overall burden of due diligence for investors as a result of reduced complexity and standardisation of the structure, rights and underlying assets. What remains unclear is whether the regulators will look to increase capital charges for non-qualifying securitisation or instead set lower numbers for the qualifying instruments, and their ability to do so in the absence of a global agreement.

The proposed qualifying framework maintains the distinction between securitisations that meet the base criteria (Table 1) and the credit risk of the underlying assets (Table 2). Therefore the underlying assets would also have to meet minimum credit quality floors. A theme across consultations has been to base the credit criteria, or "additional risk features", on those used for the Liquidity Coverage Ratio.

Impact

Uncertainty

The qualifying criteria aim to bring clarity and simplicity on the one hand, but may have the effect of increasing uncertainty in other respects.

Certainty as to whether a securitisation is qualifying or not will be key for investors. The Commission addressed this to some extent in the consultation by suggesting that a "monitoring/verification" mechanism could be introduced; either by the respective regulator or potentially through a third party assurance opinion. The costs of such verification will presumably be borne by the issuer. If the verification mechanism is implemented ex ante to pricing, and combined with the Joint Associations' suggestion for a public register of qualifying securitisations, this would go a long way to tackling certainty over a qualifying instrument.

Ongoing Compliance

The consultations do not address the issue of ongoing compliance with the qualifying criteria. Logic suggests that the criteria apply throughout the life of the securitisation, but the consequences of a securitisation ceasing to qualify are unclear. For example, what happens when the quality of the underlying assets deteriorates to a point where they no longer meet the credit criteria? Would this result in the securitisation having to be re-categorised on the investor's balance sheet, recalibrating to the non-qualifying risk weight, or potentially the sale of the instrument by a fund whose investment criteria do not allow investment in non-qualifying securitisations?

Detailed criteria vs principles

The market has expressed concerns over the very prescriptive and detailed qualifying criteria as opposed to a principles-based approach. The latter approach may align more closely to the intentions behind the policy by capturing only the desired transactions, focusing on the risk profile and transparency of the structure, rather than excluding transactions due to non-compliance with one or more technical criteria, e.g. the potential for managed CLOs to fall foul of the active management criteria. However, the principles would have to be clearly articulated to avoid regulatory arbitrage or uncertainty and reduce the risk of re-characterisation for originators/sponsors structuring the qualifying securitisation.

Fragmented market

Creating qualifying securitisations that benefit from differentiated capital treatment and that are potentially excluded from derivatives margining requirements raises the prospect of the market splitting between qualifying and non-qualifying securitisations and creates the possibility for 'gaming' the market. Authorities have expressed the view that qualifying and non-qualifying securitisations should co-exist but there is likely to be a divergence in the structures, risks and pricing between the two.

International convergence

BCBS and IOSCO have not yet completed their work on criteria for simple, transparent and comparable securitisations and it will be important to ensure that any EU regulation aligns with the international frameworks, with consistent implementation between jurisdictions. However in the absence of any indicators of support from elsewhere (e.g the US) this also opens the possibility that qualifying securitisations may remain an EU only concept. If these efforts sufficiently stimulate the market in Europe, issuances globally may look to structure to the qualified securitisation standard in order to remain attractive to a European investor base, although what other regulators' reaction would be to this remains unclear.

Standard structure

The Commission proposed the development of an optional harmonised structure for EU securitisations. This structure would standardise i) the legal form of the SPV, ii) the mode of transfer of the underlying assets, and iii) the rights and subordination rules of noteholders. This will potentially to save time and costs in negotiating the structure and terms, and reduce the necessary due diligence of investors on the structure, allowing focus to be given to the underlying assets, although there are doubts over whether this achievable, particularly in respect of ii).

The responses

The industry has generally welcomed the EU Commission's proposals. Consultation responses suggest that extending the qualifying criteria to synthetic structures and also to ABCP-transactions is appropriate and that consistency with the broader EU regulatory framework is essential. However there is a strong indication from authorities that qualifying securitisations will not include synthetic structures.

Another suggestion is that loan by loan data should be provided to investors and that investors should be empowered to conduct their own stress tests; the joint ECB and Bank of England response took this a step further and stated that there was an urgent need to improve the availability of SME credit data in the EU. This forms a separate initiative under the Capital Markets Union.

Next steps

Legislation is expected in September 2015 and the EBA is expected to publish its opinion on the criteria and capital treatment in July. It is expected to answer calibration questions; as to whether isolation of the underlying assets is sufficient or if a true sale would be required; and how a homogeneous pool of assets is defined. However, it is possible to start to draw an understanding of which types of securitisation would qualify, as set out in Tables 1 and 2.

Table 1: Overview of the criteria suggested for qualifying securitisations

Source: EBA Discussion Paper on 'Simple, standard and transparent securitisations' (October 2014); joint response to EBA Discussion Paper from AFME, BBA, ICMA and ISDA (January 2015); joint Bank of England and European Central Bank discussion paper, 'The case for a better functioning securitisation market in the European Union' (May 2014); BCBS and IOSCO consultative document on 'Criteria for identifying simple, transparent and comparable securitisations' (December 2014); European Commission consultation document 'An EU framework for simple, transparent and standard securitisation' (February 2014).

Table 2: Overview of credit quality criteria for the additional risk features.

Source: EBA Discussion Paper on 'Simple, standard and transparent securitisations' (October 2014); joint Bank of England and European Central Bank discussion paper, The case for a better functioning securitisation market in the European Union (May 2014); European Commission consultation document 'An EU framework for simple, transparent and standard securitisation' (February 2014).

Footnotes

1. Such securitisation has also been referred to as simple, transparent and standardised securitisation (STSS or qualifying securitisation)

2. It should be noted that the criteria discussed below would only apply to medium to long term securitisations; criteria for Asset Backed Commercial Paper are to be developed at a later stage.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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