Securitisation and the SRT Regime

In response to continued increases in regulatory capital requirements, banks and other institutions are looking to securitisation as a capital relief tool. ‘Significant risk transfer’ (SRT) transactions have the potential to help firms manage their balance sheets in a sensible manner. The transfer of risk is subject to strict regulatory requirements and supervision, and there are other factors to take into account beyond the tests set down in the governing legislation. Francesca Segurini and Joy Amis, who specialise in securitisation at Herbert Smith Freehills, answer some questions regarding the regime.

What is the SRT regime?

In broad terms, where originator institutions (ie banks) transfer credit risk in relation to an asset or portfolio of assets to a securitisation vehicle (or, in the case of some synthetic transactions, directly to a counterparty via a derivative), they may achieve a reduction in their regulatory capital requirement in relation to the loans they securitised. With the transfer of such credit risk, originator institutions are able to redeploy the capital released. SRT requirements, associated guidance and supervisory process exist to ensure that the reduction in the capital requirement achieved by the relevant institution is commensurate with the risk transferred.

It is worth noting that although the transfer of risk to third parties is recognised by regulators as a legitimate means of risk mitigation and consequentially of reducing capital requirements, the securitisation framework includes a requirement that there is no arbitrage in relation to the treatment of securitised assets as off-balance sheet. The European Banking Authority (EBA) has published guidelines in relation to SRT as part of its focus on the creation of a European Single Rulebook, which highlight the importance for national competent authorities and originator institutions of considering a broad range of factors in determining whether SRT has been achieved.

How are SRT transactions regulated?

SRT is regulated through the Capital Requirements Regulation (EU) 575/2013 (the CRR). In particular, CRR, Articles 243 and 244 of the CRR set out the key requirements for institutions undertaking SRT transactions, with associated provisions of the CRR and the CRD IV Directive 2013/36/EU being relevant to, for example:

  • risk-weighting for retained positions
  • risk retention and investor due diligence
  • implicit support

Institutions must make their own determinations as to whether SRT requirements are satisfied, but the national competent authorities have ultimate authority to determine whether the reduction in capital is justified. Institutions seeking to achieve SRT for a transaction have three options to choose from under the framework:

Option 1

The originator does not retain more than 50% of the risk-weighted exposure amounts of mezzanine securitisation positions, where these are:

  • positions to which a risk weight lower than 1,250% applies
  • more junior than the most senior position in the securitisation and more junior than any position in the securitisation rated credit quality step one or two (as determined in accordance with Article 136 of the CRR)

Option 2

Where there is no mezzanine position, but the originator does not hold more than 20% of the exposure values of securitisation positions that are subject to a deduction or 1,250% risk weight, and the originator can demonstrate that the exposure value of such securitisation positions exceeds a reasoned estimate of the expected loss on the securitised exposures by a substantial margin.

Option 3

Subject to the discretion of the national competent authorities, permission may be granted by the relevant competent authority to an originator to make its own assessment if the competent authority is satisfied that the originator can meet certain requirements. In the UK, the Prudential Regulation Authority (PRA) will grant such permission subject to satisfaction of certain conditions.

In the case of Option 1 and Option 2, where the possible reduction in risk-weighted exposure amount, which the originator institution would achieve by the securitisation is not justified by a commensurate transfer of credit risk to third parties, competent authorities may decide on a case-by-case basis that significant credit risk shall not be considered to have been transferred.

In addition to the core regulatory framework set out above, there are a number of statements and guidance which are relevant to potential SRT transactions. In particular, the EBA has issued relevant guidelines, and in the UK PRA supervisory statement (SS9/13) sets out relevant information regarding SRT notifications and permissions (see further below).

The EBA guidelines recognise the potential for capital arbitrage in particular:

  • when the costs of protection are not adequately recognised
  • where capital relief is being claimed even when there is no meaningful transfer of risk

The former might relate to, for example, where the premium payable over the life of a transaction is equal to 100% of the protection amount. This could leave the protection buyer in a position over the life of the transaction that is no better than if protection had not been purchased. In the case of the latter, the guidelines provide an indication of transaction features that constitute contractual support including:

  • providing over-collateralisation
  • credit derivatives
  • contractual recourse obligations
  • subordinated notes or credit risk mitigants,
  • subordinating fees or interest
  • deferring interest

They also include implicit support including:

  • buying deteriorating credit-risk exposures from a securitised pool
  • substituting higher-quality risk exposures into the pool
  • selling exposures into the pool at a discount
  • purchasing exposures from the pool at above market price
  • providing ad hoc credit enhancement

National competent authorities are expected to place considerable emphasis on governance and risk assessment. For example, originator institutions must be able to demonstrate a careful assessment of the expected loss of the securitised exposures as compared to the expected loss on the securitisation positions. Where the thickness of the most subordinated tranche, of which a proportion is retained by the originator, does not exceed the expected level of losses on the portfolio by a sufficient margin, then significant risk will not be deemed to have been transferred. This encourages institutions to be cautious and thorough, and to establish a sensible and transparent dialogue with their regulator.

How is the UK implementing the SRT requirements?

The CRR provides competent authorities with certain discretions. In the UK, the PRA’s implementation of the SRT regime is widely perceived to be among some of the most robust of European regulatory authorities. The PRA has made clear that it expects institutions to take a ‘substance over form’ approach to assessing SRT.

UK institutions seeking capital relief will be subject to CRR and PRA Rulebook requirements, which include the following:

Notification

The PRA must be notified no later than one month after the date of the transfer, and the notification must include sufficient information to allow the PRA to assess the purported transfer (including copies of the SRT policy applied, details of the economic substance of the transaction, reliance on ECAIs, description of risks retained, key transaction documents, investor presentations, connected parties involved in the transaction, details of the rationale for the transaction, etc).

Re-characterisation

Where the PRA considers that the reduction in the risk-weighted exposure achieved via the securitisation is not justified by a commensurate transfer of credit risk to third parties, SRT will not be considered to have been achieved and the relevant institution will not be able to recognise any reduction in risk-weighted capital. Furthermore, as SRT is a continuing obligation, the PRA may reassess its judgement in the event that the terms of a transaction change materially.

Pre-approval

Although the PRA does not operate a formal pre-approval process for securitisation transactions, it does expect to provide a view on whether it considers a commensurate risk transfer to have been achieved. In practice, this may mean that originator institutions choose to maintain a dialogue with the PRA throughout the structuring process, in order to ensure that the transaction can achieve the desired relief.

Disclosure

Where a firm claims a regulatory capital reduction in relation to a securitisation transaction in its disclosures to the market, the PRA will expect the firm to assess the risk of re-characterisation and, if relevant, disclose such risk where this is material in light of the PRA’s stated policy.

Monitoring

Where an institution achieves SRT for a particular transaction, the PRA expects it to continue to monitor risks related to the transaction.

Calculation methodology

The PRA expects an institution to inform it of the methodology used to calculate the capital requirements, and will be more sceptical of the achievement of SRT where the regulatory capital calculation used produces very low capital requirements.

Implicit support

The PRA will monitor support provided to securitisation transactions, in line with EBA guidance.

In relation to institutions seeking to rely on Option 3, the following will also be relevant:

Conditions

The PRA will only grant permission for an originator to make its own assessment of SRT where it is satisfied that all of the relevant conditions have been met, these particularly relate to a firm’s ability and experience, systems and controls in assessing risk in relation to relevant securitisation structures and asset classes.

Waiver

A firm may only use Option 3 where it has first obtained a waiver from the PRA, which will be limited in scope to a certain time period or number of transactions. There are also materiality limits relating to the amount of the reduction as a proportion of the firm’s aggregate risk weighted exposure amount.

Notification of changes

Any changes in circumstances from those under which the permission was granted must be notified to the PRA. As with any area which is currently regulated at EU level, it remains to be seen whether the SRT regime will change as a result of Brexit, and whether UK regulatory requirements will continue to match those set out in the CRR, even after Brexit. It is worth noting that the European capital framework derives from international Basel accords, and so while implementation may differ somewhat, the guiding principle behind the regulation should remain the same. From the tone of the PRA’s supervisory statements to date, it seems likely that the UK’s SRT regime will continue with minimal changes.

How is the market implementing the SRT requirements?

Use of public market securitisation as a capital relief tool became less common in Europe following the financial crisis, with issuers finding it difficult to sell the more subordinated tranches of asset-backed transactions. However, in recent years with risk appetite starting to return it has been possible for some institutions to place mezzanine and junior tranches of their transactions with third parties and therefore to avail themselves of the SRT regime. It is increasingly appealing for institutions to seek to structure securitisation transactions for this purpose, as ever-increasing capital requirements push banks to shrink their balance sheets.

Recent proposed changes to the CRR suggest that, at least for traditional (as opposed to synthetic) securitisations, assets in respect of which the conditions for significant risk transfer are met may be excluded from the calculation of the exposure measure for the purpose of the leverage ratio. If these changes are implemented as proposed, we would expect this to be a material additional incentive for banks to pursue this kind of trade.

2016 and early 2017 also saw a significant volume of synthetic capital relief transactions, again in response to increasing risk-weights attaching to debt portfolios held on balance sheet, and the imposition of risk-weight floors. Many of these deals are public, but more are privately placed, with concerns expressed by commentators at the lack of transparency in this growing market. We expect continued regulatory focus in this area.

Francesca Segurini is of counsel with Herbert Smith Freehills, specialising in securitisation and structured finance products, and has extensive experience of acting on a wide range of securitisation, covered bond and structured finance transactions for leading financial institutions.

Joy Amis is a senior associate solicitor in the debt capital markets group at Herbert Smith Freehills, specialising in securitisation and structured finance. Joy’s practice also touches on derivatives, investment funds and financial services regulation.

Interviewed by Janine Isenegger.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

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