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Stephen Moller, head of the London finance department at K&L Gates, discusses the short- and long-term implications of Brexit on the securitisation market.
The uncertainty in the run-up to the Brexit vote on 23 June 2016 did not seem to hold the securitisation market back. In fact, according to the Association of Financial Markets in Europe, the volume of securitised products issued in Europe in Q2 2016 (€74.5bn) was almost 50%. This was higher than in the comparable period in 2015, the single most popular asset class being UK residential mortgage-backed securities (RMBS).
Looking forward, it is simply too early to tell whether the immediate shock of the result will damage the market, particularly given the difficulty in distinguishing the effect of Brexit and the general summer slowdown in European capital markets. However, from what we hear from clients and others, investors’ appetite for structured finance has not been diminished by the Brexit vote. From a legal perspective, any potential changes in the legal and regulatory landscape as a result of Brexit would affect investors planning to invest in securitisations in the short term. After all, it will take a number of years for the terms of the UK’s exit to be negotiated and for the UK to put in place replacement legislation to deal with the various regulatory issues relevant to securitisation which are now covered by European legislation.
Even once UK legislation is in place, we think it is likely to be very similar to current European requirements, at least initially. By the time the regulatory landscape for securitisation in the UK and the EU begins to diverge (if that happens at all), many of the securitisation transactions now being issued will have been redeemed.
Moving beyond the legal and regulatory issues, the macroeconomic uncertainty caused by Brexit could have implications for investors considering securitisation as against other investment classes, such as equities. Securitisation as a well-understood product with strong disclosure, and typically high credit quality characteristics may well make it an attractive investment in uncertain times.
The first thing to say is that the legal techniques which underpin securitisation transactions are very much a function of local domestic law. In England and Wales, the legal principles governing the true sale of assets and taking security over assets were in place long before the securitisation market started. In other European jurisdictions (eg, France, Italy, Spain and Portugal), there are specific legal frameworks for securitisation transactions. The point is that the laws and legal principles which form the basis for securitisation in the UK or any other European jurisdiction are unlikely to change in a material way as a result of Brexit.
What is governed by European legislation is the regulatory environment for securitisation—the regulatory capital charges applying to securitisations for credit institutions, the conditions upon which regulated entities can invest in securitisation and disclosure requirements. In particular, article 405 of the Capital Requirements Regulation (EU) 575/2013 (CRR) contains the so-called ‘skin in the game’ risk retention requirement for securitisations. This provides that European credit institutions can only invest in securitisation transactions in which the originator, sponsor or original lender holds a minimal economic exposure of 5% in the transaction. Similar requirements apply to insurance companies and to alternative investment funds managed by investment managers which are authorised or registered in the EU.
In theory, regulatory requirements in relation to securitisation in the UK and the EU could diverge in the future. In practice, even if that happens, UK originators may still end up having to comply with EU regulation in relation to securitisation. For example, it is common for US collateralised loan obligations managers to seek to comply with the requirements of CRR, art 405 in relation to risk retention even though the requirement is not directly binding on them. They comply voluntarily because they want to ensure that their transactions are eligible for purchase by European financial institutions. Similarly, it is difficult to see UK originators and arrangers wishing to shut themselves out of the wider European market.
Also, there is no particular reason for assuming that regulatory requirements in the UK and the EU will diverge materially in the long term. K&L Gates has a structured finance practice which spans Europe, the US, the Middle East and Asia and that gives us a global perspective. The general global trend is for regulatory convergence. After all, the US has its own securitisation risk retention regime under the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010. There is a similar convergence of regulatory principles in other areas too, for example, the requirements for the clearing of over-the-counter derivatives under the European Markets and Infrastructure Regulation and title VII of the Dodd-Frank Act. Even if the outcome of the Brexit negotiations enables the UK to establish an entirely different framework for securitisation regulation, it is not obvious that there would be an advantage to the UK in doing so.
European legislation relating to securitisation is in the process of change in any case, regardless of the Brexit vote. In September 2015, the European Commission issued a draft Regulation generally referred to as the Securitisation Regulation. The draft Securitisation Regulation provides for certain securitisation transactions which meet qualifying conditions to be classified as simple, transparent and standardised (STS) securitisations. Credit institutions and insurance companies buying STS securitisations would be eligible for favourable capital treatment. The draft Securitisation Regulation also modifies the risk retention regime and seeks to standardise regulatory requirements, particularly in relation to disclosure, across the range of European regulated entities—credit institutions, insurance companies and alternative investment funds.
Although not all of the changes contained in the draft Securitisation Regulation are necessarily favourable to the industry, the EU Commission has sought to engage with market participants and has recognised, in the words of the preamble to the draft Securitisation Regulation, that ‘securitisation is an important element of well-functioning capital markets’.
The draft Securitisation Regulation is in the process of being debated in the European Parliament, but it is fair to say that not everyone shares the Commission’s view of securitisation. Among some of the very material amendments that are being considered by the Parliament is the proposal that the required risk retention will increase from 5% to 20%, a change which many believe would have a very significant effect on the market.
So there is a very important debate ongoing within EU institutions which affects the viability of securitisation as an asset class. One of the consequences of Brexit is that the British voice in this debate is likely to have less weight. Given the undoubted expertise that UK regulators and market participants have in relation to finance, that is potentially damaging for the future development of legislation in this area.
There is a general desire in the market for simpler and clearer regulation in this area and for regulation to be more joined up. For example, the European Commission’s Capital Markets Plan identifies small and medium-sized enterprise (SME) lending as a key priority, but financial regulation across Europe could do more to encourage it. For example, in some jurisdictions alternative capital providers are prevented from making SME loans due to domestic licensing requirements, and the capital treatment of SME loan securitisations is also not particularly attractive. While we expect that these things will change over time, the process of financial reform within the EU can be slow.
If as a result of Brexit, securitisation regulation in the UK becomes simpler and more responsive to the needs of both market participants and the ‘real economy’, that might be a potential upside. However, for the reasons mentioned earlier, we do not see any divergence in the UK and European regulation happening quickly, if it happens at all. Generally, we would regard Brexit as being at best neutral for the market.
Interviewed by Duncan Wood.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.
First published on LexisPSL Banking & Finance. Click here for a free trial.
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