At a glance
A large number of legacy non-performing loan exposures (NPLs) continue to subsist on the balance sheets of banks. Portfolios of NPLs tie up huge amounts of regulatory capital which, in turn, limits the amount of capital that banks have available to lend to the real economy. The economic aftershocks of COVID-19 will not only increase the volume of NPL's but also bring into sharp focus the imperative for banks to offload these exposures from their balance sheets. It is highly likely that we will witness an uptick in the securitisation of NPLs in the post COVID-19 economy – but will the securitisation regulation and regulatory capital treatment of such transactions evolve to facilitate this trend? This blog explores the issues with regulatory capital treatment of NPL securitisations under the Capital Requirements Regulation (CRR) and the European Securitisation Regulation (ESR), as highlighted by the European Banking Authority (EBA). In addition, the Basel Committee has recently proposed technical amendments to its securitisations rules text, but will this stimulate the secondary market in NPLs?
European policy makers have looked favourably on the ability of securitisations to allow banks to move portfolios of NPLs off their balance sheets, freeing up regulatory capital reserves and increasing liquidity in the market.
According to the EBA, European banks have managed to halve balance sheet NPLs since 2015. However, despite this achievement, the volumes of NPL's have remained woefully high. Meanwhile, concerns have been raised about the drag in capital as a consequence of the higher 'provisioning' requirements for NPLs imposed by the European Central Bank and the recently approved 'prudential backstop' regulation. Indeed, the recent prudential backstop regulation has sought to introduce a harmonised 'minimum loss coverage' requirement for the amount of money banks need to set aside to cover losses caused by future loans that turn non-performing.
In an effort to boost the NPL securitisation market, the EBA released an opinion in October 2019 (the EBA Opinion) addressing the regulatory capital treatment of NPL securitisations and proposed that capital requirements for such securitisations should be adjusted in order to remove certain constraints on banks considering securitisation structures as a means to dispose of NPL stock.
Current issues under the CRR and ESR
The EBA Opinion identifies a number of impediments to the securitisation of NPLs under both the CRR and the ESR. It recognises that there are key distinctions to be made between the nature of the securitised risk of 'performing' and non-performing assets. 'Performing' exposures see investors bear the risk of borrowers defaulting on payments (i.e. credit risk), whereas NPLs are already in default and therefore priced on an entirely different basis. More specifically, NPLs are priced based on their outstanding amount and then applying a discount to reflect anticipated future losses and adjusting to take into account the outcome of a workout or enforcement process. In other words, the net value of the NPLs can be said to be the nominal or outstanding value minus the non-refundable purchase price discount (NRRPD). Accordingly, investors in NPL securitisations bear the risk that any workout or enforcement action is insufficient to cover the net value of the NPLs.
Treatment of NPL securitisations under the CRR
The EBA Opinion highlighted that the securitisation internal ratings based approach (SEC-IRBA) method may result in more favourable regulatory capital treatment at the mezzanine and junior tranche levels of NPL securitisations compared to the securitisation of 'performing assets'. However, when it comes to the most prevalent calculation methods used for regulatory capital requirements for credit risk to an underlying portfolio (i.e., the SEC-IRBA and the securitisation standardised approach (SEC-SA)), these methods produce significantly higher regulatory capital charges for NPL securitisations. In addition, the caps for securitisation capital weightings do not offset the NRPPD from expected losses and the exposure value of the portfolio of NPLs backing the securitisation, which results in disproportionately large capital charges.
In light of these inequitable positions, the EBA proposes a number of targeted amendments to the CRR including:
- Defining the scope of 'NPL securitisations' and including, in particular, a requirement that the securitised pool comprise a mandatory minimum level of NPLs from origination/inception.
- The desirable level of the (p)1 factor for NPL securitisations for the purposes of articles 259(1) and 261(1) of the CRR.
- The inputs to the formulaic approaches (SEC-IRBA and SEC-SA) to better reflect the loss-absorbing effect of the NRPPD in NPL securitisations.
- Using the net book value approach within the securitisation framework when determining attachment (A)2 and detachment (D)3 points for the setting of capital requirements for NPL securitisations.
- An appropriate prudential treatment for pools of securitised exposures comprising both performing and NPL's (mixed pools) for the purposes of the securitisation framework.
- The 'expected losses' and 'exposure value' under the SEC-IRBA should be calculated net of the NRPPDs and, where applicable, in the case of the originating institution, additional specific credit risk adjustments (SCRAs).
- Investor institutions be allowed to apply a 100 per cent risk weight cap for securitisations where the originator was permitted to apply the same, and the amount of NRPPD is at least equal to or larger than the SCRAs made by the originator.
Treatment of NPL securitisations under the ESR
The EBA opinion makes the following observations in relation to the operation of the ESR to NPL securitisations:
- As the risk retention amount (for most of the permitted methods) is calculated based on the nominal value of the NPLs, rather than a discounted value which takes account of the loss-absorbing effect of the NRRPD, this may result in an inflated risk retention amount being required to be retained for NPL securitisations.
- The list of permitted risk retention entities under the ESR is too narrow and focused on guarding against the 'originate to distribute' model which excludes other interested parties who may have an interest in the success or failure of a workout process for non-performing assets and so their interest are better aligned with the investors from acting as the risk retention entity.
- The prescriptive credit granting
requirements in article 9(3) of the ESR, which require the
purchaser of an NPL portfolio to verify that (a) 'sound'
and 'well-defined' criteria for credit granting were used
by the original lender, and (b) the original lender applied the
same criteria to the exposures to be securitised as it did to those
that will not be securitised raise particular practical challenges
for purchasers of NPL portfolios. For example:
- The ESR is unclear as to whether an NPL purchaser buying an entire loan book of NPLs is permitted to treat the requirements of article 9(3) as being met – due to no comparable exposures being available in order to assess the application of the 'sound' and 'well-defined' credit granting criteria.
- Loan books, especially 'performing' loan books, may have been subject to different credit granting criteria at the outset. In other words, a strict application of the article 9(3) requirements could mean that certain NPL portfolios are not capable of being securitised on the basis that no credit granting criteria have been applied to a comparable pool of loans by the original lender.
The EBA Opinion recommended the following targeted amendments to the ESR framework for NPL securitisations:
- A specific risk retention amount calculation method for NPL securitisations that takes into account the NRRPD on the assets' nominal value.
- An independent servicer qualifies to discharge the retention obligation where its interests in a successful workout or enforcement process are aligned with those of the investors.
- Article 9(1) and Article 9(3) verification and due diligence obligations are amended in respect of NPL securitisations (and other third party-originated assets securitisations).
The Basel Committee Technical Amendment on the capital treatment of NPL securitisations
On 23 June 2020, the Basel Committee published a consultation on its proposed technical amendments to the Basel Framework to address the capital treatment of NPL securitisations, recognising the "particular features that distinguish them from securitisations of performing assets" (the Technical Amendment).
The Technical Amendment establishes:
- A standardised definition of NPL securitisations – where there is a percentage of at least 90% of defaulted assets in the portfolio at the origination cut-off date and at any subsequent date on which assets are added or removed from the underlying pool due to replenishment, restructuring or other relevant reasons. The underlying pool may only comprise of loans, loans-equivalent financial instruments or tradable instruments used for the sole purpose of loan sub-participations. It is noted that national regulators may provide for a stricter definition of an NPL securitisation.
- The introduction of a risk weight floor of 100 per cent for all NPL securitisation exposures.
- The introduction of a fixed 100 per cent risk weight floor for the most senior tranches of non-performing loan securitisations, where the securitisation is a traditional securitisation, and the NRPPD is equal to or larger than 50 per cent of the outstanding amount of the NPLs. The risk weight applicable to other tranches/positions should be determined by the existing hierarchy approaches or the look-through approach.
- A ban on the use of foundation internal risk based approach parameters as inputs for the SEC-IRBA for all NPL securitisations.
- An originator or sponsor bank may apply the current capital requirement cap to the aggregated capital requirement for its exposures to the same NPL securitisation. The same applies to an investor bank, provided, that it is using the SEC-IRBA for an exposure to the NPL securitisation.
The consultation period ends on 23 August 2020, and the proposed amendments are expected to come into effect by no later than 1 January 2023.
The EBA Opinion was a much-welcomed first step in recognising certain legal impediments in the existing regulatory framework as they apply to NPL securitisations. The mantle has been taken up by the Basel Committee in relation to the securitisation rules, but work to address all legislative impediments to the securitisation of NPLs is still at a preliminary stage and much more work still needs to be done.
Please get in touch with your usual Reed Smith contact if you have any questions or concerns regarding the issues raised in this alert.
1 i.e. the supervisory parameter.
2 i.e. the input represents the threshold at which credit losses would first be allocated to the exposure.
3 i.e. the threshold at which credit losses of principal allocated to a securitisation exposure results in a total loss of principal.
Originally published 01 July, 2020
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