This Update considers the impact on securitisation transactions of significant regulatory changes that will take effect from 1 January, 2011. The changes include new requirements in respect of originator risk retention, additional disclosure, investor due diligence requirements and resecuritisation.

The changes are being introduced through amendments to the Basel II framework (Basel II)1 and the EU Capital Requirements Directive (CRD).2 As Basel II and the CRD have no direct effect in and of themselves, the changes will need to be implemented into the national law of each country applying Basel II or the CRD. In the case of the United Kingdom (UK), changes will be made to the prudential rules of the Financial Services Authority (FSA).

As a preliminary matter, it should be noted that not all of the changes to the CRD and Basel II mirror each other; for example, the Basel II changes do not include a 5% originator risk retention requirement.

In addition, although the Basel II changes have been finalised, that is not the case with the amendments to the CRD, so there may be further changes in the detail before they are formally adopted by national regulators.

In this Update,“bank” and “credit institution” are used interchangeably for ease of reference.

Where the changes are set out

The changes to the securitisation framework that are discussed in this Update are found principally in the following documents.

International – Basel II:3

  • “Enhancements to the Basel II framework”, July 2009 (the Basel Enhancements Paper)4 – this contains the new guidelines for resecuritisation, liquidity facilities and Pillar 3 disclosures; and
  • “Revisions to the Basel II market risk framework”, July 2009 (the Basel Market Risk Paper)5 – this deals, amongst other things, with trading book capital charges for securitisation positions.

EU – CRD:6

  • an amending Directive referred to as “CRD II”7 – this contains the 5% retention requirement, additional disclosure and investor due diligence requirements and changes to the large exposure rules;8
  • an amending Directive referred to as “CRD III” – this contains new rules on resecuritisations, Pillar 3 disclosure and capital requirements for trading book exposures.9 CRD III is not yet finalised, although a “Presidency Text” dated 28 October, 2009 is available and forms the basis for the discussion below;10 and
  • an amending Directive which contains a definition of “significant risk transfer” and new credit conversion factors for liquidity facilities (the Technical Changes Directive).11


In the UK, the FSA published its consultation paper CP 09/29 Strengthening Capital Standards (the “FSA Consultation Paper”) on 10 December, 2009 on the changes brought about by CRD II and CRD III (although it acknowledges that the CRD III text is not yet final).12 We make reference to the FSA Consultation Paper where it would be helpful to illustrate how one of the EU’s major financial ser vices regulators is approaching the relevant issues. As currently drafted, the FSA has applied its usual “intelligent copy-out” approach to implementing EU legislation. That is, the FSA has tried as far as possible to copy the exact words from CRD II and CRD III into the FSA rules, principally Chapter 9 (Securitisation) of the Prudential Sourcebook for Banks, Building Societies and Investment Firms (BIPRU).

5% Originator Risk Retention

This risk retention requirement will apply to new securitisations issued on or from 1 January, 2011 and, in relation to existing securitisations, from 31 December, 2014 if there is a substitution or addition of assets. This risk retention requirement affects the CRD only, it is notably absent from the Basel II changes (although as noted below, the United States is proposing its own originator retention rules).

One objective of the CRD II amendments is to address a “misalignment” perceived to have arisen in certain securitisation transactions as between the interests of originators and the interests of investors. Such a misalignment of interests is considered to have been one of the issues underlying the financial crisis. It has been perceived by regulators that an originator which proposes to transfer all of its risk through a securitisation (i.e. “originate to distribute”) might apply lower standards in its origination and monitoring of the relevant assets than it otherwise would – to the detriment of investors in the securitised assets.

The CRD II amendments, which are reflected in a new Article 122a in the CRD, introduce a new requirement intended to ensure that the originator, the original lender or the sponsor13 will retain a 5% economic interest in respect of the assets being securitised (or in related assets). This is the “skin-in-the-game” rule that sparked considerable controversy when first mooted in early 2008 (at which time the proposed level of retention was 15%).

Article 122a provides for such retention to be effected by only one of the relevant parties and not by all of them. For ease of reference, we use “originator” in this Update to refer to the originator, the original lender or the sponsor, as applicable.

Article 122a(1) provides that no bank is allowed to be “exposed” to a securitisation position unless the originator retains, on an ongoing basis, a “material net economic interest” of at least 5%. It is important to note that, because the rule refers to a bank being “exposed” to a securitisation, the rule appears to apply not only to banks which are direct investors (noteholders) in a securitisation, but also other banks who have exposures to the securitisation by way of being liquidity providers or swap counterparties. This may have to be clarified further because the corresponding requirement in Article 122a(7) for the or ig inator to disclose the level of its commitment/retention under Article 122a(1) refers to the originator making the disclosure to “investors”.

Article 122a(1) prescribes four alternative methods by which an originator might retain the requisite interest:

  • vertical slice – retain at least 5% of the nominal value of each of the tranches acquired by investors;
  • originator’s share – in a securitisation of revolving exposures (e.g. credit card receivables), retain at least 5% of the nominal value of the securitised exposures;
  • random selection – in a transaction in which a pool of at least 100 exposures is potentially to be securitised, retain from that pool exposures that have been randomly selected and which have a nominal value equivalent to at least 5% of the nominal value of the securitised exposures; or
  • first loss piece – retain such amount of the first loss tranche as equates to at least 5% of the nominal value of the securitised exposures.14

Whichever method is used, the prescribed net economic interest must be maintained on an ongoing basis. In addition, the retained interest must not be sold or hedged and must not be subject to any credit risk mitigation – but it is not clear to what extent this would preclude indirect hedging (or other protection) arrangements (e.g. a derivative on a relevant index), as opposed to a direct hedge (e.g. a credit default swap) on the 5% exposure itself.

There are certain exceptions to the retention requirement; for example, there is an exemption for certain index-based transactions; and for syndicated loans, purchased receivables and credit default swaps which (in each case) are not used to package and/or hedge a relevant securitisation.

Article 122a(1) establishes certain anti-avoidance measures: the retention rule applies to any arrangement having the economic substance of a “securitisation” (as defined in the CRD15), regardless of the structure and documentation involved; and parties must not try to negate the economic impact of the requirement by, for example, introducing a fee arrangement for that purpose. As a result, it will be important for originators as well as investors and other counterparties (e.g. swap and liquidity providers) carefully to analyse any particular financing transaction to consider whether it is a “securitisation” as to which the 5% retention requirement will apply.

Article 122a does not provide for any specific sanction where a bank fails to comply with Article 122a; that is, where a bank invests in a securitisation in circumstances where the originatorfails to retain 5% of the material net economic interest in the transaction. Article 122a(9) merely provides that regulators will monitor compliance and will “impose measures for noncompliance”, thus leaving the individual EU regulator to impose the appropriate sanction at its discretion (although the wording suggests some sanction must be imposed).

Commentary on 5% Originator Risk Retention

The 5% retention requirement is not a requirement on the originator as such, but rather on the investing bank or other bank with an exposure to the securitisation (e.g. swap or liquidity provider). It provides that such bank must not have an exposure to the credit risk of a securitisation position unless the originator has explicitly disclosed to the bank that it will retain the requisite interest. There is no express requirement upon the originator actually to comply with its undertaking and there is no direct monitoring by the regulator of compliance by the originator (as opposed to by the investor bank). By prohibiting banks investing in securitisations where there is no such undertaking as to retention, the objective is to ensure that the retention will be made even in securitisations of assets of non-EU originators.

The approach taken is therefore different to that being proposed in the United States. On 11 December, 2009 the United States House of Representatives passed the proposed “Wall Street Reform and Consumer Protection Act of 2009”; like CRD II, this proposed legislation includes a 5% risk retention requirement and enhanced disclosure requirements; however, the requirement there is for the originator to retain the risk, rather than for the investor not to invest unless the originator retains the risk.16

Because the 5% risk retention requirement is drafted as a requirement on the investing bank rather than on the originator per se, securitisations of assets of non-EU originators which hope to attract EU bank investors will have to comply with the requirement so that EU banks can invest.

Again, because the obligation is on the bank with the exposure (i.e. investor, swap or liquidity provider, etc.), rather than the originator itself, to comply with Article 122a(1), it is not clear what happens if the retained interest falls below 5%, for example where the originator retains 5% of the risk exposure on the closing date of the transaction but then sells the 5% exposure shortly thereafter. In this regard, the FSA Consultation Paper notes:

“[W]e would expect investors to consider the strength of an originator’s disclosure before investing and if based on experience an investor had doubts about whether the originator would retain the interest they should take this into consideration when determining whether or not to invest.”17

This places the onus on the investor to have a clear internal audit trail which demonstrates how the investor has got comfortable with any particular originator’s disclosure.

It should be noted that, because of changes being made to other EU Directives, it is not only bank investors who may be required to insist that originators retain 5% of the exposure. In the proposed EU Directive on Alternative Investment Fund Managers, there is a requirement that alternative investment funds (which includes all manner of investment funds, not only hedge funds) may not invest in securitisations unless the originator complies with the 5% retention requirement set out in CRD II.18

In addition, it seems likely that Solvency II (which will govern regulatory requirements for EU insurance companies from October 2012 and which is sometimes called “Basel II for insurers”) will also contain a similar requirement so that EU insurance companies will likewise be restricted from investing in securitisations unless the originator complies with the 5% retention requirement set out in CRD II.

The risk retention requirement is also likely to have less of an impact on certain asset classes than others. For example, it has historically been fairly common for originators in residential mortgage backed securitisation (RMBS) transactions to retain the first loss tranche, although it is also the case that in some cases, such first loss tranche was then sold (either on a cash or synthetic basis).

In addition, it is as yet unclear what asset backed commercial paper (ABCP) programme sponsors will be doing to comply with the retention requirement; since ABCP programmes are treated as securitisation transactions, investing banks will need to comply with Article 122a(1). In this regard, the drafting of the exemptions (for syndicated loans and receivables) is unclear; for example, does it exempt from the retention requirement securitisations of lease receivables, or whole business securitisations?

Finally, it remains to be seen how the risk retention requirement will be applied in practice and what its impact will be on the securitisation market. For example, the economic effect of choosing a vertical slice of the securitisation notes being issued may be very different from choosing the first loss tranche.

The European Commission was supposed to report at the end of 2009 as to whether to leave the retention requirement at 5% or potentially to increase it; a report has yet to be published at the time of writing. The Commission is supposed to consider the advice of the Committee of European Banking Supervisors (CEBS) on the retention issue; CEBS published its advice on 30 October, 2009 and recommended no change from the 5% level.19 CEBS also suggested that an exemption from the originator retention requirement be made available where the underlying exposures of the securitisation are liabilities (including covered bonds) issued by the originator.

New Disclosure Requirements

Transaction level disclosure

The new disclosure requirements will apply to new securitisations issued on or from 1 January, 2011 and, in relation to existing securitisations, from 31 December, 2014 if there is a substitution or addition of assets.

CRD II (Article 122a(7)) imposes two separate disclosure requirements on sponsors and originators which are banks.

First, sponsor and originator banks must disclose to investors the level of their retention of exposures under Article 122a(1) (discussed above).

Secondly, sponsor and originator banks must ensure that “investors and prospective investors” have “readily available access” to:

  • “all materially relevant data” on:
    • credit quality and performance of the individual underlying exposures; and
    • cashflows and collateral supporting the underlying exposures, and
  • such information as is necessary to conduct comprehensive and well-informed stress tests on the cashflows and collateral values supporting the underlying exposures.

There is an ongoing obligation to deliver all such information “as appropriate due to the nature of the securitisation”. It should be noted that no express provision has been included in the Basel II changes to impose a disclosure obligation of this type (although the Basel II changes do include Pillar 3 disclosure requirements as discussed below).

The penalty for any material breach of the CRD II disclosure obligation is that the regulator will apply to the relevant securitisation exposure an additional risk weight of no less than 250% of the risk weight that would otherwise have applied to the securitisation position; with the penalty risk weight increasing for each subsequent breach. This is subject to a maximum risk weight of 1,250% (i.e. a deduction from capital).

As a general comment, there is no detail at all in Article 122a as to the obligation to disclose “all materially relevant data”. The requirement contains subjective concepts (e.g. “readily available access”,“material” and “as appropriate”). In particular, the wording of this disclosure obligation (what an originator must disclose) does not tie in with the wording of the due diligence obligation (what a bank as investor must look at). One assumes that there must be an implied obligation on originators to disclose whatever is required to be reviewed by investors under the due diligence obligation. In certain cases – particularly in relation to RMBS or consumer loan securitisations – a question is raised as to whether the originator may be able to comply with the disclosure requirement as to “individual underlying exposures” given its obligation to comply with data protection/privacy or bank secrecy laws. However, given that Article 122(7) refers to the provision of information that would allow the investors to conduct stress tests, and stress tests for very granular transactions (like RMBS) are unlikely to be carried out an individual loan basis, it would appear that an originator ought not to have to provide personal data about individual borrowers.

Separately, however, the obligation to provide information on an ongoing basis raises an interesting question as to how the obligation will be met in a situation where the originator has sold to a secur itisation issuer all of the assets. In such a situation, the originating bank may no longer have any right to receive ongoing information about the performance of those assets. This is particularly the case where the originating bank is not also the servicer of the assets in the securitisation transaction.

It should be noted that, in relation to RMBS transactions, the European Securitisation Forum (ESF) (which from 1 November, 2009 became part of the Association for Financial Markets in Europe (AFME)) published in 2008 a set of voluntary guidelines for issuers of European RMBS, as to disclosure of information to investors both pre-issuance and on an ongoing basis – the RMBS Issuer Principles for Transparency and Disclosure (the “Principles”).20 Issuers which have agreed to abide by the Principles will apply them to all RMBS issued from 1 January, 2010. The Principles make provision both as to the nature of the information to be disclosed, and as to the standardisation of the format of disclosures. The ESF/AFME is currently working on Version 2 of the Principles, which will include changes necessary to deal with the new disclosure requirements introduced by CRD II.

Finally, on 23 December, 2009, the European Central Bank (ECB) published its consultation paper Public consultation on the provision of ABS loan-level information in the Eurosystem collateral framework.21 The ECB intends to take into account loan level data in its eligibility criteria used to determine whether to accept ABS as collateral in its credit operations. The submission of such data would be done using standardised templates, which will differ depending on the types of underlying assets.

Pillar 3 disclosures

Article 122(7) as discussed above relates to disclosure by the originator for individual securitisation transactions. However, the Basel Enhancements Paper and CRD III significantly increase the disclosure requirements at a general level in relation to a particular bank’s activities in relation to securitisation; this general disclosure requirement falls under Pillar 3 (which relates to market discipline and disclosure) of the Basel II framework. Some of the new information that must be disclosed by originators under Pillar 3 includes:

  • a description of the types of assets securitised;
  • a description of the processes in place to monitor changes in the credit and market risk of securitisation exposures, including how the behaviour of the underlying assets impacts securitisation exposures and a description of how those processes differ for resecuritisation exposures;
  • a description of the bank’s hedging policy in respect of retained securitisation and resecuritisation exposures,
  • including identification of material hedge counterparties;
  • the aggregate amount of assets awaiting securitisation;
  • a detailed description of how the bank applies the internal assessment approach (IAA) (if any);
  • the aggregate amount of securitisation exposures retained or purchased and the associated capital requirements, broken down between securitisation and resecuritisation exposures and further broken down into a meaningful number of risk-weight or capital requirement bands; and
  • specific information as to securitisation exposures held by the bank.

Because of the increased focus on the trading books of banks, the above infor mation will be required to be disclosed separately for a bank’s non-trading (i.e. banking) book as well as for its trading book.

One question raised by the requirement to disclose the aggregate amount of assets awaiting securitisation is to how practicable it might be to have to make such a disclosure where assets are being warehoused only for a short time by a bank.

Investor Due Diligence Requirements

The new investor due diligence requirements will apply to new securitisations issued on or from 1 January, 2011 and, in relation to existing securitisations, from 31 December, 2014 if there is a substitution or addition of assets.

General requirement

CRD II imposes new and extensive due diligence obligations on banks investing in securitisations. The obligations apply both before making an investment and during the life of that investment. Such due diligence obligations are also set out in the Basel Enhancements Paper.

Article 122a(4) provides that an investing bank must be able to demonstrate to its regulator, in respect of each securitisation position it holds, that it has “a comprehensive and thorough understanding” of each of a range of specified matters (see below); and that it has implemented formal policies and procedures “commensurate with the risk profile of its securitisation investments” for analysing and recording such matters. The following are specified for this purpose:

  • information disclosed to it as regards the originator’s retained interest in the securitisation (see above as to the
  • 5% risk retention requirement);
  • the risk characteristics of the securitisation position;
  • the risk characteristics of the underlying exposures;
  • if the originator or sponsor has been involved in any other securitisation of assets of the same class as those underlying the relevant exposures, their reputation and loss experience in that other securitisation;
  • the statements and disclosures made by the originator or sponsor (or by their agents or advisers) as to their due diligence on the securitised exposures and any supporting collateral;
  • the methodologies and concepts on which the valuation of supporting collateral is based, and the policies adopted by the originator or sponsor to ensure the independence of the valuer; and
  • all the structural features of the securitisation that can materially impact the perfor mance of the bank’s securitisation position – these are stated to include the contractual waterfall and waterfall-related triggers, credit enhancements, liquidity enhancements, market-value triggers and any deal-specific definitions of default.

This general due diligence requirement is expressed to be an ongoing obligation, although aspects of it are likely to be of greater relevance at the outset, rather than once the investment has been made.There are other specific requirements which are continuing obligations, as discussed below.

Stress tests

Investing banks must regularly perform stress tests appropriate to their securitisation positions. For this purpose, they can rely on a credit rating agency’s financial model, but only if the bank can demonstrate that it has conducted appropriate due diligence on the rating agency’s own methodology and assumptions.


Banks must have formal procedures commensurate with the risk profile of their investments in securitised positions to monitor on an ongoing basis, and in a timely manner, performance information on the underlying exposures. Article 122a(5) prescribes the following as a non-exhaustive list of factors to be monitored:

  • exposure type;
  • percentage of loans more than 30/60/90 days past due;
  • default rates;
  • prepayment rates;
  • loans in foreclosure;
  • collateral type and occupancy;
  • frequency distribution of credit scores;
  • industry and geographical diversification; and
  • frequency distribution of LTV ratios.

Where the underlying asset of the securitisation is itself a securitisation position (i.e. it is a resecuritisation), the investing bank must obtain all relevant information in respect of both the original secur itisation and the assets underlying that securitisation.


The penalty for non-compliance with any of the above due diligence provisions is the same as that which applies in the case of the new disclosure obligation (see above). That is, in the event of any material breach of these requirements that arises from the bank’s negligence or omission, the regulator will apply to the relevant securitisation position an additional risk weight of no less than 250% of the risk weight that would otherwise have applied; with the penalty risk weight increasing for each subsequent breach. This is subject to a maximum risk weight of 1,250% (i.e. a deduction from capital).

Commentary on investor due diligence requirements

One clear effect of the heightened due diligence requirements introduced by Articles 122(4) and (5) is that investing banks will need to have properly established systems and controls in order to demonstrate that the proper amount and type of due diligence has been carried out in relation to any particular transaction. It is quite clear from the tenor of the rules that a “box-ticking” exercise will not be sufficient. All this will in turn have time and cost implications which may result in higher funding costs all round. Resecuritisations which are CDOs of ABS may in particular be prohibitively expensive or simply impractical to put together given that underlying loan level data of the original ABS will need to be provided to the CDO investors.

As an ancillary matter, the proposed Directive on Alternative Investment Fund Managers (in relation to investment funds) and Solvency II (in relation to insurers) may apply similar due diligence requirements on funds and insurers, respectively. If so, then the majority of investors in securitisations will be affected by this new requirement in the same manner as the 5% retention requirement.

Requirement to Apply a Common Approach to Origination and Monitoring

There is one further new measure under CRD II which – like the obligations on disclosure, due diligence and risk-retention – aims to align the interests of originators/sponsors and investors. Article 122(6) provides that an originator “shall apply the same sound and well-defined criteria for credit-granting” to assets, regardless of whether the assets are to be securitised or are to be held on its own book. This is to prevent originators from applying more lax credit underwriting standards to assets which they are originating primarily to securitise (although the 5% risk retention requirement should also encourage more consistent standards). If the originator fails to comply with this requirement, it will not be able to treat the securitised exposures as removed from its regulatory balance sheet.

This additional requirement does not feature in the Basel II changes.

“Resecuritisation”: New Risk-weighting Requirement

The new requirement relating to resecuritisation is expected to apply from 1 January, 2011.

Both CRD III and the Basel Enhancements Paper set out a new risk-weighting framework for “resecuritisations”. A position in a resecuritisation would previously have been treated in the same way as a securitisation, but there are now two separate regimes.

CRD III defines resecuritisation to mean “a securitisation [as defined in the CRD22] where the risk associated with an underlying pool of exposures is tranched and at least one of the underlying exposures is a securitisation position”. It would also be a resecuritisation where the underlying exposure was itself a resecuritisation (i.e. a re-resecuritisation). So, for example, both a CDO of ABS and a CDO of a CDO of ABS would be within the definition of resecuritisation. It is important to note that a single securitisation (or resecuritisation) exposure in a pool of many exposures will suffice for the arrangement to constitute a resecuritisation.

As in the case of a securitisation, the risk weighting of a resecuritisation exposure under the standardised approach, or when using the internal ratings based (IRB) method, is determined by reference to the applicable credit rating (if any – an unrated exposure being deducted from capital).

In each case under the standardised approach, the risk weight associated with each level of rating is significantly higher for a resecuritisation than for a securitisation. Subject to a ceiling of a 1,250% risk weight, which is applicable both to securitisations and resecuritisations, the risk weights for resecuritisations range from 40% (for “AAA” to “AA-” exposures) to 650% (for “BB+” to “BB-” exposures) as opposed to the equivalent 20% to 350% range for securitisations.23

Similarly, under the IRB method, the risk weighting in respect of any particular level of rating is generally substantially higher for a resecuritisation exposure than for a securitisation exposure.

For banks applying the supervisory formula method, there is a minimum risk weighting for resecuritisations of 20%, as opposed to a 7% minimum for securitisations.

Commentary on resecuritisation

Because the resecuritisation rules will apply whenever there is an underlying securitisation exposure, it is extremely important for banks to have clear internal policies and procedures to identify when particular balance sheet positions may be “securitisation positions”, and thus potentially “resecuritisation positions” for the purposes of Basel II and the CRD.

The CRD has been in force in the EU since 1 January 2007 and EU member state regulators have recently begun to focus on how banks have been treating exposures on their balance sheets. It would not be sufficient for a bank simply to analyse a position from the pure credit risk perspective; it must be clear that the legal definitions and requirements set out in the applicable legislation have been analysed and satisfied. For example, because the definition of “securitisation” is very widely drafted in the CRD, and would capture many situations where there is simple tranching, a bank might not realise that a particular position is in fact a “securitisation position” within the meaning of the CRD.

Banks will thus have to assess carefully whether any current transaction structures which might be commonly used might be characterised as resecuritisations from 1 January, 2011 onwards. For example, might the practice in CMBS transactions of splitting a particular loan into two tranches, and securitising one of the tranches, result in the issuer SPV’s (tranched) notes being considered to be resecuritisation positions?

The analysis may also be complicated in relation to ABCP programmes, which are assumed under Basel II and the CRD to be securitisation transactions.24 An ABCP programme sponsor bank will need to consider whether liquidity facilities and programme-wide credit enhancement facilities provided by it would be considered to be resecuritisation exposures. The Basel Enhancements Paper and CRD III each provides some guidance on this matter as follows:

  • a liquidity facility should generally not be considered to be a resecuritisation position where it covers 100% of the assets (such that the liquidity facility is a single tranche) and none of the assets within the ABCP conduit is a resecuritisation position; and
  • a programme-wide credit enhancement facility which covers only some of the losses above the seller-provided protection across the various pools of assets in the programme would constitute a tranching of risk and so would be a resecuritisation position.

Further, ABCP programme sponsor banks will need to consider whether the commercial paper (CP) issued by the ABCP conduit is itself a resecuritisation position. The Basel Enhancements Paper and CRD III generally provide that such CP would not be a resecuritisation position provided that there is only one class of CP and either:

  • the programme-wide credit enhancement is not a resecuritisation; or
  • the CP is fully supported by the sponsor bank, such that the CP investors are effectively exposed to the default risk of the sponsor bank instead of the assets within the ABCP programme and so that the external rating of the CP is based primarily on the credit quality of the bank sponsor.  

Ancillary Matters

Aside from the measures described above, it is worth setting out some other matters covered by CRD II and CRD III and the Basel II changes.

The following changes all take effect from 1 January, 2011.

Large exposures

The large exposures regime aims to limit the extent to which a bank’s credit risk can become concentrated. Under the EU large exposure rules, a bank’s aggregate exposure to any one client, or to any “group of connected clients”,must not exceed 25% of its own funds; and the aggregate of all its individual large exposures is limited to 800% of its own funds.

CRD II amends the definition of “group of connected clients” in Article 4(45)(b) of the CRD. This amendment could have an impact on bank sponsors' exposures to their ABCP conduits. The Basel II changes do not introduce a similar amendment.

Under the revised CRD definition, a group of connected clients exists where, amongst other things, two or more clients “are to be regarded as constituting a single risk because they are so interconnected that, if one of them were to experience financial problems, in particular funding or repayment difficulties, the other(s) would be likely to encounter funding or repayment difficulties.” The words in bold italics highlight the language that has been added by CRD II.

The amendment has been introduced because of the view of the EU that, under the old definition, the focus on the likelihood of repayment difficulties, without considering also funding difficulties,was unduly narrow.

On 11 December, 2009, CEBS published its guidelines on the amendments to the large exposures rules, including the amended definition of “group of connected clients”.25 The guidelines provide that the relevant degree of interconnectedness is likely to be present where the clients to which the bank is exposed share a common dependence on a single source of funding that is not easily replaceable. The guidelines provide an illustration of such a scenario: a bank which provides liquidity facilities to more than one asset purchasing vehicle, each of which is funded by an ABCP issuer under an ABCP programme, might find that all such liquidity facilities are drawn at the same time in a situation where funding by the ABCP issuer is not forthcoming. That is, all of the asset purchasing vehicles depend for their primary source of funding on the proceeds of CP issued by a single vehicle. In that circumstance, the liquidity bank should consider treating all of the asset purchasing vehicles as a group of connected clients for purposes of the large exposures analysis (i.e. aggregating all of the liquidity facilities and treating them as a single facility to a single client).

The effect of this amendment to the definition of “group of connected clients” is that bank sponsors of multi-seller ABCP programmes, who typically provide liquidity facilities to the relevant asset purchasing vehicles, will need to consider whether all those liquidity facilities should be aggregated so as to form a single exposure, and whether such aggregation might cause the bank to breach its large exposure limits. If so, such banks will need to explore ways of managing such large exposures.

Significant credit risk transfer

The CRD (as well as Basel II) requires that, in order for an originator to treat securitised assets as having been moved off its regulatory balance sheet,“significant credit risk” in those assets must have been transferred under the securitisation transaction. However, the CRD has not previously provided any guidance as to what amounts to a significant transfer of credit risk. The result is that the expression of the requirement is inconsistent across the EU since individual member state regulators apply their own tests of when “significant” risk transfer has been achieved.

For example, in the UK the current requirement under the FSA rules is that credit risk transfer is only considered to be “significant” where the proportion transferred is commensurate with, or exceeds, the proportion by which risk weighted exposure amounts are reduced. On the other hand, in Germany the BaFin requires that a bank must show that it has transferred 50% or more of the mezzanine risk (which is in fact one of the options now set out under the new definition discussed below).

The CRD is now being amended under the Technical Changes Directive so as to provide a much more detailed provision. In essence, significant credit risk will be deemed to have transferred in any given transaction where any of the following is present:

  • the originator applies a 1,250% risk weight to all securitisation positions it holds in the relevant securitisation (or deducts such retained positions from its capital); or
  • the originator does not retain more than 50% of all mezzanine positions; or
  • where there is no mezzanine position, the originator does not hold more than 20% of the first loss piece (which is risk weighted at 1, 250%); or
  • the originator makes its own assessment where the regulator has permitted it to do so (such permission being granted only if the regulator is satisfied that the originator can meet certain requirements).

In relation to the second and third options above, the FSA has said in the FSA Consultation Paper that it will override those options where it decides that the reduction in risk weighted exposure amounts is not justified by a commensurate transfer of credit risk to third parties.26 The Directive text allows for a regulator to take such an approach.

This new definition of significant risk transfer will take effect from 31 December, 2010.

No amendment is made to Basel II with regard to the elements of an effective risk transfer; Basel II has never clearly set out what is meant by “significant risk transfer”, instead leaving that to implementing regulators.

Risk weighting: liquidity facilities

For banks applying the standardised approach, the CRD currently provides for a range of three credit conversion factors (CCFs) to be applied to securitisation liquidity facilities which are unrated and which satisfy certain prescribed conditions as to their purpose, availability, repayment terms and documentation:

  • 0% for a facility that can be drawn only in the event of general market disruption;
  • 20% for a facility of one year or less; and
  • 50% in other cases.

Pursuant to the Technical Changes Directive, as well as the Basel Enhancements Paper, the 0% and 20% CCFs will no longer be available from 1 January, 2011. The CCF for an unrated liquidity facility satisfying the prescribed conditions (which are unchanged) is now 50%, even if it is available only for general market disruption or has a maturity of 364 days or less.

The 20% CCF previously applicable under the IRB method to market disruption facilities has also now been deleted.

Risk weighting: self-guaranteed exposures

CRD III and the Basel Enhancements Paper each provides that a bank's regulatory capital requirements in respect of any particular exposure cannot be determined by reference to a rating agency's credit rating if that rating is based, or partly based, on a guarantee (or other support) provided by the bank itself. For example, if a bank holds ABCP issued by a conduit to which the bank provides a liquidity facility, and the rating of the ABCP is influenced by its provision of that facility, the ABCP position must be treated for regulatory capital purposes as if it were unrated.

Trading book treatment

CRD III and the Basel Market Risk Paper provide that the capital requirement in respect of a securitisation position held in the trading book will be calculated by reference to the risk weighted exposure amount that would have been relevant if the position had been held in the banking book. The objective is to eliminate opportunities for arbitrage between trading and banking books.


There has been much focus at an international level as to how to deal with the perceived systemic risks that can be caused by securitisation. Apart from the issues discussed in this Update, IOSCO published a significant report in September 200927 which discussed how the perceived failings of securitisation might be addressed. At the same time, the Basel Committee is undertaking a more fundamental review of the securitisation framework, which may lead to a recalibration of the capital charges under the Supervisory Formula Approach and the Ratings Based Approach (RBA), as well as the necessity of the hierarchy rule which requires the use of the RBA if an external rating exists.28 As part of the same consultation, the Basel Committee is also considering applying large haircuts to securitisations exposures used as collateral to hedge counterparty risk (as compared, say, with government bonds). It is clear that, while the changes discussed in this Update will shape the way securitisation is carried out in countries which implement Basel II or the CRD, the story is not quite over.