The European Banking Authority (EBA) has published a Consultation Paper setting out draft Guidelines on "implicit support" in securitisation transactions under Article 248(2) of the Capital Requirements Regulation (CRR). As you may be aware, Article 248(1) of the CRR restricts originators or sponsors from providing "support" to a securitisation (with a view to reducing potential or actual losses to investors) beyond their contractual obligations. The provision of implicit support is seen by regulators as raising significant supervisory concerns, not least because it undermines the achievement of "significant risk transfer" (SRT, which it is necessary to establish in order to achieve the proper regulatory treatment of securitised exposures - i.e. their exclusion from an originator's calculation of regulatory capital). The legislative provisions in CRR clarify that, if a transaction is executed at "arm's length" and is taken into account in the assessment of SRT, it will not be considered to provide support to a securitisation. Such a transaction must also be notified to the relevant supervisor, whether or not it actually provides support. If implicit support is found to have been provided to a securitisation, the penalties are severe - the originator or sponsor must (at a minimum) hold regulatory capital against all of the securitised exposures as if they had not been securitised. Examples of implicit support include the purchase of deteriorating exposures from the underlying pool, adding higher quality exposures to the pool, providing ad-hoc (not contractual) credit enhancement and selling discounted exposures into the securitised pool. Examples of the types of "transaction" contemplated include amendments to the transaction documentation or changes to coupons, yields or other features, which the originator/sponsor is not contractually obligated to enter into. Article 248(2) of CRR requires the EBA to issue guidance on the CRR's restriction on the provision of implicit support. The EBA's draft Guidelines provide an objective test to determine whether a transaction takes place at "arm's length", set out proposed guidelines in respect of the five factors which the originator/sponsor must take into account when assessing whether a transaction is not structured to provide support (the price of the repurchase (of e.g. deteriorating exposures from a pool), the institutions' capital and liquidity position before and after repurchase, the performance of the securitised exposures, the performance of the securitised positions, and the impact of support on the losses expected to be incurred by the originator relative to the investors), and provide guidance on the notification requirements applicable to such transactions. The proposed Guidelines may be summarised as follows:
- Transaction "not" structured to provide support: a transaction is not structured to provide support if it is executed: (i) at arm's length conditions; or (ii) on conditions which are more favourable to the originator/sponsor than arm's length conditions. The Guidelines note that, since the SRT provisions in CRR only apply to originators (not sponsors), the second limb of the test applies only to originators, and requires that the securitisation continues to meet the conditions for SRT and complies with the EBA's Guidelines on SRT (see Edition 11 of this SCM Briefing for details of the EBA's SRT Guidelines). The "relevant factors for assessment" in assessing whether a transaction is structured to provide support are set out in the final bullet point below.
- Notification and documentation: originators should notify supervisors of any transactions entered into by an entity other than the originator (but which may undermine SRT as a result of that entity's connection with the originator), and the supervisor should assess the transaction as if it had been entered into by the originator (and the supervisor should also consider any relevant connection between third parties or the sponsor with the originator, including any financing provided by the originator). Where an originator (or sponsor) notifies the supervisor of a transaction (and claims that the transaction does not constitute implicit support), it must provide evidence that the relevant conditions in paragraph 10 of the Guidelines (see the above bullet point) are met. If the transaction is undertaken by a sponsor or other entity (which is not the originator) but: (i) with which the originator has an existing relationship; (ii) to which the originator provided any support; or (iii) with which the originator entered into any transaction in relation to the transaction being notified, the originator/sponsor should include details of the type of relationship between the originator and sponsor (or third party), or of the support provided by the originator to the sponsor (or third party), in the evidence provided.
- Arm's length conditions: a transaction is executed at "arm's length" if the terms are as they would be in a normal commercial transaction if the parties had no relationship to each other and each party acted independently, of its own volition, in its own interests and did not take into account any extraneous considerations which are not directly connected with the transaction in question (including, but not limited to, reputational risk in respect of the originator or sponsor should either party not proceed with the transaction). In assessing arm's length, all parties should have regard to the information available at the time the transaction was entered into, and not to information that becomes available thereafter.
- Significant Risk Transfer: the separate EBA Guidelines on SRT should be taken into account in assessing whether the conditions for SRT are (and continue to be) met. The conditions for SRT would be deemed to be invalidated by a transaction if: (i) the credit risk of the originator after the transaction materially increases; or (ii) the capital or liquidity position of the originator is (directly or indirectly) materially affected by the transaction. To assess whether a "material increase" has occurred, all relevant factors should be considered, including material changes in the market price of the securitisation positions, material changes in the total risk-weighted exposure amounts of the position-holders, and changes in the ratings assigned to the securitisation positions.
- Relevant factors for assessment: all relevant factors should be considered in assessing whether a transaction is not structured to provide support, including (relating to the five factors (a) to (e) set out in Article 248(1) CRR):
- The price of the repurchase: an assessment should be made of the amounts payable or receivable, measures of market value should be considered (e.g. quoted prices or other unobservable inputs), and it should be demonstrated that the assessment is in line with its (the originator or sponsor's) credit review and approval process. A transaction will not be at arm's length if the amounts receivable by the originator or sponsor are materially lower than (or amounts payable are materially higher than) the relevant market value.
- The institution's capital and liquidity position before and after purchase: the conditions for SRT will no longer be satisfied if the originator's capital or liquidity positon is materially affected and, as a result, the reduction in the risk-weighted exposure amount achieved by the originator is no longer justified by a commensurate transfer of risk to third parties (with supervisors to consider the accounting entries made by the transaction parties).
- The performance of the securitised exposures: where the underlying exposures have been underperforming relative to other exposures (or have been reported as non-performing), the transaction should not be considered to have been executed at arm's length if the underperformance (or foreseeable future performance) of the exposures is not adequately reflected in the price of the purchase or repurchase.
- The performance of the securitised positions: where the securitisation positions have been underperforming relative to other positions (or have been reported as non-performing), parties should consider: (i) whether the cost of measures taken to improve the performance has been fully borne by the 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: parties should consider whether the expected losses of a securitisation position are materially increased or reduced having regard to (amongst other things) changes in the market price of the position, in the risk-weighted exposure amounts and in the ratings assigned to the securitisation positions.
Responses to the Consultation Paper were requested by 20 April 2016, and a public hearing was held at the EBA's offices earlier in 2016 to discuss the proposed Guidelines. The Guidelines appear to be overly complex for what they aim to achieve, and could perhaps benefit from being split into Guidelines applicable to originators, and Guidelines applicable to sponsors/other entities. In addition, they are fairly disjointed, wordy and overly complex in terms of their language, which does not make for an easy-to-read document. Industry feedback has focused on the need to provide clearly that actions contemplated by the transaction documentation would not constitute implicit support (this would be "explicit support"), and that recent and ongoing regulatory efforts (many of which are discussed elsewhere in this Briefing) largely deal with the issue of implicit support such that only a narrow set of issues need be covered by the EBA's Guidance.
European Banking Authority Consultation Paper