The last 18 months has seen a welcome return of a number of ADIs to the Australian Securitisation market. However market conditions have forced many ADIs to retain some or all of the subordinated notes in their transactions. The ongoing ability of ADIs to continue to hold subordinated notes in these transactions and the resulting capital consequences will be dependent on APRA’s regulatory approach under the Enhancements to the BASEL II Framework in Australia.
The industry therefore watched with interest as APRA published on 23 May 2011 substantial revisions to APS 120 Securitisation Prudential Standard (“APS 120”) and APG 120 - Securitisation Prudential Practice Guide (“APG 120”) designed to come into effect on 1 January 2012. Concerns have been raised that the revised APS 120 and APG 120 will hinder the market by not explicitly permitting ADIs to hold subordinated notes in their transactions and specifying the regulatory capital implications. These concerns were not eased by the letter sent by APRA to local ADIs on 20 July 2011 which reinforced this stance.
However, it should be noted that rather than prohibiting the holding of subordinated notes, ADIs will be required to consult with APRA before conducting any such transaction. Given current market conditions, a high level of certainty is required as to how APRA will implement the new rules in practice.
Significant credit risk transfer is key
Consultation is necessary for transactions where ADIs hold subordinated notes on the basis that APRA has confirmed its view that an originating ADI holding the most subordinated tranche(s) of a securitisation will be taken to have retained a substantial majority of the credit risk in the transaction. A significant transfer of credit risk is now a core requirement of APS 120. APRA has also confirmed that it will not take a favourable view of ADIs circumventing these requirements by entering into bilateral or multilateral arrangements to purchase the subordinated tranches of other securitisations.
This is particularly relevant as:
- current market conditions continue to create challenges for ADIs placing subordinated tranches with third party investors at an economical price; and
- other regulatory measures, such as the “skin in the game” regulations in Australia, Europe and the United States, contemplate that originators will need to retain an exposure to their securitisation transactions. The operation of APS 120 will limit the options available to ADIs in complying with those ”skin in the game” requirements.
Consultative Self Assessment
However, APRA has held out some hope to those ADIs wanting to continue to conduct transactions where they plan to hold the subordinated Notes. Paragraph 8(a)(i) of APS 120 suggests that transactions may be permitted where an ADI consults with APRA, the transaction is structured as an on balance sheet arrangement and provided that it otherwise complies with APS 120.
An immediate concern is whether or not APRA considers that compliance for APS 120 for these purposes includes the “significant transfer of credit risk” requirement outlined in paragraph 18 of APS 120. If so, paragraph 8(a)(i) seems to provide little hope for ADIs seeking to conduct funding trades in the absence of “exceptional circumstances” given paragraph 8(a)(i) requires full compliance with the terms of APS 120. Yet this would be an odd interpretation - as a fully complying transaction already has the option of effectively not seeking capital relief by applying the maximum capital rule under paragraph 26 of Attachment B. Thus, there is room for optimism that APRA intends to apply paragraph 8(a)(i) to transactions which comply in all respects other than achieving a significant credit risk transfer. Provided that transactions are not covered bonds in disguise, ADIs may have more confidence in approaching APRA to continue to hold subordinated notes if they do not seek any capital relief from the transaction.
Alternative Capital Treatment
However, it is less clear what ADIs who adopted the “alternative capital treatment” will be able to do going forward. The “alternative capital treatment”, outlined in APRA’s 10 December 2010 letter to ADIs, allowed ADIs to claim capital relief for securitised mortgages but required any subordinated notes to be deducted from Tier 1 capital. In the absence of any ongoing relief, given paragraph 8 of APS 120, it appears that APRA will only permit such a treatment under “exceptional circumstances”. In its letter dated 20 July 2011, APRA noted that the current arrangements for the alternative capital treatment expire on 1 January 2012 and APRA will provide further guidance closer to 1 January 2012. This position should be finalised as soon as possible to provide the requisite degree of certainty to the market. As certain ADIs are reliant on securitisation for both funding and capital purposes, participants are hopeful some relief will be forthcoming so that securitisation is able to be used going forward as a capital management technique in markets where subordinated notes cannot be sold to third parties.