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Securitisation and the EBA's implicit support rules

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The proposed guidelines on implicit support for securitisation provide useful focus, but they should be more limited in scope

The EBA’s proposed guidelines on implicit support for securitisation provide useful focus, but they should be more limited in scope

Earlier this year the European Banking Authority (EBA) published a consultation paper on proposed guidelines for the assessment and regulation of implicit support given by EU-regulated banks in securitisation transactions. Issued on January 20, with comments due by April 20, the proposed guidelines seem well considered, not too prescriptive, and add some clarity to what has been a murky subject. But, they could be improved by limiting the scope of subject transactions.

Rule on implicit support

Article 248 of the Capital Requirements Regulation (CRR) prohibits banks (and investment firms regulated under CRR), when acting as originators or sponsors of securitisation transactions, from providing support to those transactions beyond their contractual obligations [when such support is provided] 'with a view to reducing potential or actual losses to investors'. Known as the rule against implicit support, it applies where the originator or sponsor bank has treated loans or other financial assets as securitised for the purpose of its credit risk capital requirements. When it treats assets as securitised, the bank holds capital against its exposures to the securitisation transaction (such as an investment or commitment to provide funds) but not against the securitised assets.

For a bank acting as an originator – meaning it was involved in creating the securitised assets or had bought those assets for its own account – to treat assets as securitised for capital requirements purposes it must show that it has transferred significant credit risk to third parties. This can be done either by transferring the assets via traditional securitisation, or by means of guarantees or credit derivatives, creating a synthetic securitisation. A bank acting as sponsor – by establishing and managing a programme that purchases assets from third parties – would also hold capital against its exposures according to the securitisation framework, unless it treats the programme's assets as its own.

Providing implicit support raises regulatory concerns, because it means the bank's capital requirement may not fully reflect its credit risk in relation to the assets. A bank originator or sponsor that provides implicit support to a securitisation must, at a minimum, hold capital against the securitised assets as if they had not been securitised.

A transaction will not be treated as implicit support 'if it is executed at arm's length and taken into account in the assessment of significant risk transfer'. Even so, the transaction must be notified to the bank's regulators and it must be subject to the bank's credit review and approval process.

Examples of implicit support include the bank's purchase of higher-risk assets from the securitisation at prices above market value, adding higher quality assets without full compensation, and providing guarantees of securitised assets or securitisation positions. Some instances of implicit support occurred during the financial crisis, for example, when bank sponsors provided backstop facilities for structured investment vehicles.

When banks originate securitisations for funding purposes, retain higher-risk tranches and don't claim reduction of capital requirements, the rule against implicit support does not apply.

The prohibition against implicit support has long been part of the securitisation capital framework. It appeared in the 2004 Basel II Accord, in the former Capital Requirements Directive that implemented Basel II in Europe and, before that, in the UK bank regulator's policy on securitisation. However, to date neither the EBA nor its predecessor, the Committee of European Banking Supervisors, had published detailed guidelines on how to determine when implicit support has occurred. The guidance proposed by the EBA earlier this year could help the securitisation market by promoting common standards for application of this rule by banks and their regulators in different member states.

Scope of the guidelines

Article 248(2) CRR requires that the EBA issue guidelines on (i) what constitute arm's length conditions and (ii) when a transaction is not structured to provide support. The January consultation paper sets out a draft of those guidelines. These do not address banks' provision of support for securitisations pursuant to contractual obligations; instead, such contractual support is assessed under the EBA's July 2014 guidelines on significant risk transfer.

The draft guidelines start by specifying the type of transaction to which they apply; namely, any entered into by an originator or sponsor bank in relation to a securitisation transaction or securitisation positions as to which the bank has no obligation to enter into the transaction at all, or on those specific terms. This includes 'any amendments to the securitisation transaction' as well as 'changes to the coupons, yields or other features of the securitisation positions'. This scope is very broad and could pick up, for example, minor amendments to securitisation documents to correct mistakes or deal with changes in law or regulation.

Under article 248(1) CRR, a bank must notify its regulator of any 'such transaction … regardless of whether it provides support'. Under the proposed guidelines, when notifying the regulator of a transaction, if the bank claims it does not constitute implicit support, it must provide evidence that the transaction satisfies the applicable conditions set out in the guidelines. These notification and evidence requirements could be burdensome given the broad scope of subject transactions. It would be useful, and consistent with the purpose of the rule, to limit its scope to transactions that materially change the amount or nature of risks borne by the bank in relation to the assets.

The notification requirement also applies to transactions carried out by parties other than the originator bank where it 'is entered into by an [other] entity which is connected to the [bank] in a manner that might undermine the credit risk transfer'. The bank's regulator must then assess the transaction as if it was entered into by the bank. Banks and regulators must consider 'any relevant connection' including whether the bank provides the entity 'with financing or with support or instructions for the purposes of undertaking the relevant transaction. Market participants may ask the EBA for further guidance on the application of this concept. The EBA has also asked market participants to comment on whether the assessment factors (discussed below) should apply equally, or with modification, to connected entities.

Arm's length conditions

To address the first part of its mandate, the EBA has proposed an objective test for assessing whether a transaction is entered into on 'arm's length conditions'. This means banks and regulators must be satisfied that, based on information available to the parties at the time of the transaction, the terms are as they would be in a 'normal commercial transaction', in which the parties had no pre-existing relationship and in which each party acted independently according to its own interests, without taking account of extraneous considerations such as risks to the bank's reputation from not proceeding with the transaction. While this definition is generally consistent with other concepts of arm's length transactions, the final guidelines should make clearer that the 'no pre-exiting relationship' reference describes the hypothetical 'normal commercial transaction' and need not be true for the subject transaction. The exclusion of reputational risk should also be made clearer. While a party to a 'normal commercial transaction' could and should consider reputational risks stemming from the deal, what makes that consideration suspect is the bank being connected to the securitisation issuer, such that default by the issuer would damage the bank's reputation.

EBA guidance on support factors

Support factor

(Article 248(1) CRR)

Factors for assessment

(Draft EBA guidelines)

Repurchase price

Consider measures of market value, including quoted prices in active markets for identical transactions, where available

Where quoted prices not available, consider other ‘observable inputs’

If no observable inputs, consider ‘unobservable inputs’ and provide evidence to regulator

Show that assessment is in line with bank's credit review and approval process

Regulators to consider transaction not arm's length if amounts receivable by bank are lower or amounts payable are higher than market value

Capital and liquidity position before and after repurchase

Consider whether bank's capital and liquidity position is materially affected

Consider participants' accounting entries and changes in liquidity position

Significant risk transfer condition no longer satisfied if, as a result of transaction, reduction in risk-weighted exposure amounts no longer justified by commensurate transfer of credit risk to third parties

Performance of securitised exposures

Consider whether underperformance or foreseeable future performance is adequately reflected in price of purchase or repurchase

Performance of securitisation positions

Consider whether cost of measures to improve performance is fully borne by relevant investors, and whether bank is negatively affected by transaction

Effect on losses expected to be incurred by originator relative to investors

Consider whether expected losses of positions are materially increased or reduced, considering changes in positions' market prices, risk-weighted exposure amounts and credit ratings

Not structured to provide support

For the second part of its mandate, the EBA sets out conditions to decide when a relevant transaction is 'not structured to provide support'. For a sponsor bank, these will be satisfied if the support is executed at arm's length conditions or on conditions that are more favourable to the sponsor than arm's length conditions. For an originator bank the same test applies and, in addition, following the transaction the conditions for significant risk transfer must continue to be met.

Significant risk transfer is determined in accordance with article 243 or article 244 CRR (for traditional and synthetic securitisations, respectively). Under the guidelines, a transaction will be deemed to invalidate significant risk transfer if, as a result of the transaction: the bank's credit risk materially increases or the bank's capital or liquidity position is materially affected; and the reduction in required capital resulting from the securitisation is no longer justified by a commensurate transfer of credit risk to third parties.

In assessing whether credit risk has materially increased, all relevant factors should be considered, including changes in the market price of the securitisation positions, the total risk-weighted exposure amounts and the securitisation position ratings.

Article 248(1) CRR sets out five factors which institutions must consider when assessing whether a transaction is not structured to provide support. The EBA's January consultation paper sets out further guidance for banks and regulators applying these factors when assessing transaction structure (see table above). While two of the five factors in CRR refer to asset repurchase transactions, the guidance makes clear they should also be adapted to other forms of support. Like the rest of the CP, this guidance does not draw bright lines or mandate specific results in particular cases, but seeks to steer analysis according to principles.

Step-in risk

Before and during EBA consultation period, the Basel Committee on Banking Supervision (BCBS) carried out a separate consultation on a similar concept, but with much wider scope. Ending in March 2016, the BCBS consulted on establishing a regulatory framework to identify, measure and regulate a newly identified type of risk called step-in risk. This is defined as 'the risk that banks would provide financial support to certain shadow banking or other non-bank financial entities in times of market stress, beyond or in the absence of any contractual obligations to do so.'

Step-in risk is not limited to securitisation, but covers a much wider range of potential transactions. The BCBS may seek to introduce a broad framework that requires additional capital or consolidation to address this type of risk. If introduced, this regime may overlap with and prompt change to the CRR treatment of implicit support.

Direction where needed

While the scope of the BCBS's step-in risk consultation is very broad, the EBA's proposed guidelines seem carefully devised to address the points required by the regulatory mandate. No doubt industry participants will have comments and questions about possible applications of the proposed guidelines, and in particular the broad scope of transactions that require consideration and must be notified to regulators. However, on the whole, the proposed guidelines should be useful in clarifying the application of a rule whose subject matter by definition is obscure.

By Mayer Brown partner Kevin Hawken and associate Bourn Collier in London