A review of the EBA’s guidelines on implicit support for securitisations under Article 248 of the CRR
Sponsors and originators may be tempted to give "implicit support" to issues which do not perform as expected, even when they are not legally obliged to - we saw this with some structured investment vehicles (SIV) after the 2008 financial crisis. Article 248 of the Capital Requirements Regulation (CRR) forbids implicit support, and an originator that provides it risks bringing assets it has securitised and removed from its balance sheet back on - because once implicit support has been given (unless in exceptional circumstances) there will be an expectation that it may be given again, and this is inconsistent with allowing off-balance sheet treatment.
As originally contemplated by Article 248, the European Banking Authority (EBA) has now issued related guidelines which apply from 1 March 2017. The guidelines include reasonably high-level principles and there is a severe sanction for non-compliance. Institutions are therefore likely to be cautious and may decide that it is safest to discuss and agree their approach with their regulator.
On 3 October 2016, the EBA published its final guidelines on implicit support for securitisation, as required by Article 248 of the CRR. They apply from 1 March 2017.
When the CRR and CRD IV replaced the Banking Consolidation Directive and the Capital Adequacy Directive, it retained two key requirements applicable to the treatment of securitisations where the originator wished to achieve off-balance sheet treatment:
- Articles 243-4 of the CRR, which require institutions wanting off-balance sheet treatment for securitised loans to achieve significant risk transfer (SRT); and
- Article 248, which forbids institutions from providing "implicit support".
The two provisions inevitably overlap: for example, Article 243(5) makes it a condition of SRT treatment that the documentation makes it clear that any purchase or repurchase of securitisation positions by the originator or sponsor beyond its contractual obligations (this being, of course, implicit support) is "exceptional and may only be made at arm's length", partly echoing the requirements of Article 248. The distinction is that Articles 243-4 look at the contractual arrangements put in place for the securitisation, whereas Article 248 looks at any actual arrangements which are subsequently entered into by the sponsor or the originator beyond its contractual obligations. Therefore, any support provided for in the initial documentation is not "implicit" for Article 248 purposes and falls to be considered only under the SRT provisions.
Implicit support was not an issue for the vast majority of securitisation asset classes, but it was encountered after the onset of the financial crisis for SIVs. The rationale for Article 248 is that implicit support signals to the market that some of the contractually transferred credit risk is still with the institution and has not really been transferred.
If an institution provides implicit support once, it creates an expectation that it may do again. This is also currently being considered in parallel by the Basel Committee on Banking Supervision. The consequence of breaching Article 248 is severe: the securitised assets in effect remain on the originator's regulatory balance sheet.
The CRR introduced an exclusion for transactions done at "arm's length", but did not explain what this meant. Article 248 contemplated that the EBA would publish guidelines about this. It now has.
What is "support"?
The guidelines explain that contractual support includes:
- credit derivatives;
- spread accounts;
- contractual recourse obligations;
- subordinated notes;
- credit risk mitigants provided to a specific tranche;
- the subordination of fee or interest income; and
- the deferral of margin income.
Implicit support includes:
- 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;
- buying exposures from the pool at above market price;
- ad hoc credit enhancements provided to one or more tranches; and
- agreeing to a larger first loss position.
1. A sponsor institution, or an originator institution which in respect of a securitisation has made use of Article 245(1) and (2) in the calculation of risk-weighted exposure amounts or has sold instruments from its trading book to the effect that it is no longer required to hold own funds for the risks of those instruments shall not, with a view to reducing potential or actual losses to investors, provide support to the securitisation beyond its contractual obligations. A transaction shall not be considered to provide support if it is executed at arm’s length and taken into account in the assessment of significant risk transfer. Any such transaction shall be, regardless of whether it provides support, notified to the competent authorities and subject to the institution’s credit review and approval process. The insitution shall, when assessing whether the transaction is not structured to provide support, adequately consider at least all the following:
(a) the price of the repurchase;
(b) the institution’s capital and liquidity position before and after repurchase;
(c) the performance of the securitised exposures;
(d) the performance of the securitisation positions;
(e) the impact of support on the losses expected to be incurred by the originator relative to investors.
This is perhaps the key principle in Article 248. The guidelines specify that “arm’s length” means that the terms of the transaction are as they would be in a normal commercial transaction. The guidelines helpfully emphasise that this will be judged only by reference to the information available to the parties at the time the transaction is entered into, and not with the benefit of hindsight. They elaborate that arm’s length means that:
- the parties had no relationship to each other (including, but not limited to, any special duty or obligation and any possibility to control or influence each other); and
- each party:
– acted independently;
– entered into the transaction of its own volition;
– acted in its own interests; and
– did not enter into the transaction on the basis of extraneous considerations not directly connected with the transaction in question (such as any reputational risk which might arise if it did not proceed with the transaction).
"Structured to provide support"?
This is a key phrase in Article 248, and the guidelines emphasise that a transaction will not be regarded as "structured to provide support" if:
- where carried out by a sponsor, it is on arm's length conditions or better; and
- where carried out by an originator which initially met the SRT conditions, it is on arm's length conditions or better, and either (i) the securitisation still meets the SRT conditions, or (ii) if not, the transaction was not done with a view to reducing potential or actual losses to investors.
When considering whether a transaction invalidates the SRT conditions (in which respect the EBA's guidelines on significant risk transfer, published in July 2014, also apply), the regulator should consider whether the initial reduced risk-weighted exposure of the originator remains appropriate, taking into account (a) its posttransaction credit risk, and (b) the extent to which its capital or liquidity position has been affected. The exception in (ii) above - that the transaction was not done with a view to reducing losses to investors - would exclude activities conducted by the originator concerning the continuation or liquidation of a transaction or of the issuer SPV.
The guidelines state that, to determine whether a transaction is "structured to provide support", all relevant factors must be considered, and the substance of the five factors mentioned in Article 248 in respect of repurchases should be applied:
- The price of the repurchase - whether or not any amounts payable or, as the case may be, receivable by the originator institution or by the sponsor institution, are materially different from the relevant market value (the EBA refused to elaborate on what constituted materiality). Measures of market value include quoted prices in active markets for similar transactions that the institution can access at the measurement date, if available. If not, inputs other than quoted prices that are directly or indirectly "observable" should be considered, failing which, then unobservable inputs should be (in which case the institution should provide evidence to its regulator of how the amounts have been valued and which inputs were used). The institution should demonstrate that its assessment is in line with its credit review and approval process.
- The institution's capital and liquidity position before and after repurchase - In considering whether the institution's capital and liquidity position is materially and adversely affected, directly or indirectly, by the transaction, the corresponding accounting entries that the participants make, and changes in their liquidity position, should be considered.
- The performance of the securitised exposures - If underlying exposures being repurchased have been underperforming relative to other securitised exposures or been reported as non-performing, the transaction is not at arm's length if the underperformance (or the foreseeable future performance of such exposures as a result of the circumstances having caused such underperformance) is not adequately reflected in the price.
- The performance of the securitisation positions - If the securitisation positions being subject to the transaction have been underperforming relative to other securitisation positions or have been reported as non-performing, it should be considered (i) whether the cost of measures taken to improve the performance of these securitisation positions has been fully borne by the relevant securitisation investors and (ii) whether the institution which participated in the transaction is negatively affected, directly or indirectly, by the transaction.
- The impact of support on the losses expected to be incurred by the originator relative to investors - It should be considered whether the expected losses of a securitisation position are materially increased or reduced, having regard, among other things, to changes in the market price of the position, in the riskweighted exposure amounts and in the ratings of securitisation positions.
If the originator or sponsor wishes to make a market in the securitisation bonds, these provisions directly impact it, and they will need to ensure their internal systems are adequate to demonstrate that purchases are made on arm's length terms.
Notification and documentation
The Article 248(1) notification requirement applies to transactions entered into by:
- the sponsor;
- the originator;
- entities in the same group as the originator (parents, subsidiaries and subsidiaries of parents); and
- by way of anti-avoidance, any entity to which the originator or an entity in its group provided, directly or indirectly, any financing, support or instructions or with which it entered into any arrangement in relation to the transaction, which would be subject to the guidelines if entered into by the originator (and where these conditions are met, the transaction should be assessed as if it had been entered into by the originator itself).
If the institution considers that a transaction does not constitute implicit support, it must provide its regulator with adequate evidence that it meets the relevant conditions set out in the guidelines.
The guidance goes beyond Article 248(1) itself, which applies the notification requirement only to the originator and sponsor. Article 248(1) is badly worded: it is clear that a transaction must be notified even if it does not provide support, but it is unclear if the apparently-wide term “transaction” is to be narrowed, or, if it is, how. It does not make much sense for a regulator to need to be told about every proposed arm’s length purchase of securities, and it seems unlikely that regulators would want to be told either, but Article 248 says what it says, and it is primary legislation, and the guidelines cannot alter it, and the sanction in Article 248(3) for failure to comply is severe. Weighing all this up, institutions are likely to want to be cautious and to try to establish a sensible balance by agreement with their regulator.
It is understandable that the EBA would not be more precise about what would be a “material” divergence from market price; and both this, and the actual methodology to be used by an institution when calculating the fair market price (when comparable market quotations are not available or are not reliable), will have to be determined with the regulator. Rating agency methodologies do not permit substitutions which cause any deterioration in the credit quality of the securitised pool, and institutions wishing to consider a substitution will need to ensure they can satisfy both the agencies and their regulator that the repurchase price and the substitution are neither overpriced nor under priced. Bearing in mind the Article 243(5) documentary requirement that any such ad hoc substitution should only be done exceptionally, institutions contemplating making a substitution may decide the only safe approach is to notify. As for market-making, it would be logical for the EBA not to want to know about arm’s length purchases of securities as part of normal market-making, but Article 248 is not well worded, and a conversation with the regulator and agreement on the approach to be followed seems wise.