European Union: Credit Risk Mitigation And Legal Opinions

Last Updated: 19 April 2016
Article by Azad Ali and Oliver Abel Smith

Background

The Capital Requirements Regulation (EU Regulation No. 575/2013) ("CRR") is part of the EU's legislative package to implement regulatory capital standards issued by the Basel Committee.  The CRR consolidates standards arising from the Basel III package with preceding standards from the Basel II Accord that remained unchanged under the Basel III standards.  Rules relating to eligible credit risk mitigation ("CRM") were largely unchanged under Basel III although the Basel Committee may in due course tighten the CRM regime.

CRM is important for many banking institutions as it reduces credit risk-weighted assets, and therefore the amount of credit risk capital required.  Leverage ratio requirements have to a degree undermined this driver as the calculation of the exposure measure in the leverage ratio ignores any CRM associated with any given credit asset.  More recently, the European Central Bank, in its new guise as the prudential supervisor for significant banking institutions within the Single Supervisory Mechanism, has carried out examinations of the balance sheets of banks within its supervisory purview, which has included reviewing the documentation and legal opinions related to the use of CRM.  This process is prompting many such institutions to make documentary and procedural changes to ensure that their use of CRM is robust and subject to proper due-diligence from a legal perspective.

The CRR is directly applicable to financial institutions in the EU and came into force on 1 January 2014.  This note serves as a reminder of the types of credit risk mitigants that are contemplated under CRR and of the specific requirement for legal opinions introduced by the CRR.

Unfunded Credit Protection

Unfunded CRM includes uncollateralised guarantees (and, by analogy, risk participations) and credit derivatives, in each case provided by eligible protection providers and satisfying certain conditions.  Eligible protection providers include sovereigns, local governments, banks, investment firms and other rated entities (whether rated externally or ascribed an internal rating (in the case of banks using the Internal Ratings Based (IRB) approach to credit risk)). Additional conditions apply to IRB banks.  Other requirements address the legal enforceability of the credit protection in all relevant jurisdictions and, in the case of credit derivatives, to the scope of the credit event and settlement provisions.  Guarantees are also subject to specific eligibility conditions.

Funded Credit Protection

One method for a bank to ensure that loans are pre-funded or are derecognised as credit assets from its balance sheet under IAS 39 is to enter into funded participations. The participant provides the funds for the loan by way of a settlement payment rather than by way of cash collateral. In turn, the loan exposure comes off the balance sheet of the lending bank (the grantor of the participation) for both accounting and regulatory capital purposes and is assumed by the participant instead.  The participant also assumes an exposure to the lending bank as it relies on that bank to pass on loan repayments to it. As this type of participation does not generate a credit exposure for the lending bank, it does not fall to be considered within the CRM provisions in the CRR.  Funded participations are typically documented under an English-law governed template agreement prepared by the Loan Market Association or, for trade finance transactions, under the BAFT-IFSA master participation agreement (although the latter would not necessarily allow de-recognition under IAS 39 without amendment).

Funded credit protection, as envisaged in the CRR, typically takes place by way of on-balance sheet netting or the provision of collateral.  On-balance sheet netting is permissible typically in relation to loans and deposits involving the same counterparty where there is an agreement between the bank and the counterparty to provide for the loan exposure to be offset by the deposit liability.  On-balance sheet netting can also apply in relation to repo transactions and securities or commodities lending or borrowing transactions.

Other types of funded credit protection could involve a credit-linked note (provided the embedded credit default swap itself qualifies as eligible unfunded credit protection) or collateral that supports a guarantee, a credit derivative or other economically equivalent arrangements such as risk participations.  There are additional rules determining which types of collateral are eligible and what haircuts are to be applied to the collateral including in the case where there is a currency mismatch between the loan and the collateral.  Wrong way risk, where there is a material positive correlation between the credit quality of the obligor and the value of the collateral, is also addressed in terms of limits on eligible collateral.  These are supplemented by operational requirements in respect of collateral management.  Additional rules address the minimum maturity for credit protection and limits on the recognition of CRM where the maturity of the protection is shorter than that of the underlying loan.

Requirement for Legal Opinion(s)

The key change introduced by CRR in respect of CRM - both funded and unfunded - is set out at Article 194(1) CRR.  This provides that "the lending institution shall provide, upon request of the competent authority, the most recent version of the independent, written and reasoned legal opinion or opinions that it used to establish whether its credit protection arrangement or arrangements meet the condition [that such arrangements are effective and enforceable in all relevant jurisdictions]".   This marks a significant departure from the position pre-CRR, where financial institutions may not as a matter of course have obtained legal opinions in relation to CRM - instead relying on internal legal review, analogous opinions, individual experience and market practice.

Specific to funded credit protection, Article 194(4) CRR requires that "institutions may recognise funded credit protection in the calculation of the effect of credit risk mitigation only where the lending institution has the right to liquidate or retain, in a timely manner, the assets from which the protection derives in the event of a default, insolvency or bankruptcy....of the obligor and, where applicable, of the custodian holding the collateral."  It would seem necessary therefore to include reasoned insolvency analysis in the opinion(s) provided under the relevant Articles of CRR.

In addition, the requirement for legal review under the CRR extends additionally to the issue of enforceability of collateral arrangements in all relevant jurisdictions (Article 207(3) in relation to financial collateral and gold and Article 209(2)(c) CRR in relation to receivables) and also to the enforceability of guarantees and credit derivatives (Article 213(3) CRR) – all of which supplement the obligations in Article 194.

As to how the requirement for a legal opinion should be interpreted, the EBA has stated1 that "Article 194(1)....requires that credit protection is legally effective and enforceable in all relevant jurisdictions.  This condition must be met before the credit protection can be considered as an eligible credit risk mitigation technique.  The only way for an institution to establish whether this condition is met is to obtain a legal opinion".  The EBA goes on to say that such opinion need not be obtained from external legal counsel but that, as long as it is "independent, written and reasoned", it may also be provided by internal legal counsel.

On the question of whether generic opinions are acceptable, the EBA states "On the issue of whether an opinion must be specific to the relevant transaction covered and the technique employed by the institution or whether it can be a generic one, it depends mainly on the nature of the two.  If an institution engages in the same type of transaction, with counterparties located in the same jurisdiction and uses the same credit risk mitigation technique, then it can rely on the same opinion.  For example, if an institution uses a master netting agreement for which a generic opinion exists, it can use that opinion as long as the latter clearly indicates that the agreement is legally effective and enforceable in all the jurisdictions relevant to the transactions covered by that agreement".

A good example of the type of master netting agreement under contemplation is the International Deposit Netting Agreement sponsored by the BBA, in respect of which legal opinions as to enforceability have been obtained in multiple jurisdictions.  By contrast, ISDA-commissioned close-out netting opinions may not pass muster, since they are concerned generally with the efficacy of close-out netting provisions across multiple derivative transaction types – they do not attest to the enforceability of bespoke credit default swap transactions employed as CRM for individual exposures.  In other words, a top-up opinion may be required2.  Similarly, opinions for repeat deals are likely also to require top-ups, issued by internal if not external legal counsel.

One important point to note is that the relevant netting agreement should not contain a walk away clause3.  There has been debate about whether flawed asset provisions - such as section 2(a)(iii) of the ISDA Master Agreement - constitute a type of walk away provision that falls foul of CRR, but that debate is beyond the scope of this note.

Conclusions

The onus is on relevant institutions seeking to reduce risk capital requirements against credit assets to ensure that they have the requisite legal opinions in place and, if not, to consider what opinions need to be obtained.  Where opinions are required, thought should be given as to whether these can be tailored for repeat deals - with or without top-ups - or whether reliance can be placed upon generic and/or in-house opinions.

Footnotes

1 Question and answer 2013_23 dated 29 July 2013.

2 This is likely to allude, among other things, to the well-known Potts opinion, which helpfully concludes that credit default swap transactions are not insurance as a matter of English law. The Potts opinion is not without its critics, however, although the market operates in reliance upon it.  See additionally in this regard Article 213(3) CRR concerning the requirement for legal review of unfunded credit protection arrangements generally (Including credit derivatives).

3 Article 296.2(d) CRR

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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