Tuesday’s approval by the Committee on Economic and Monetary Affairs of the proposed Basel 3 reforms was good news regarding securitisation.
As our client-facing commentary, “Securitisation capital requirements under Basel and the CRR”, explains, a lot of the Basel III reforms have been implemented by the EU and the UK, and the remaining reforms (known as “Basel IV” or sometimes “Basel 3.1”) are in the process of being legislated. In the EU, this will be by amending the EU CRR, and in the UK it will be by amending the UK CRR.
At present, regulated banks may choose to calculate their capital using the “standardised approach” (or the “SA”), which uses a simplistic methodology, having been calibrated on a cautious basis using global data, including a lot from the USA. However, any bank wanting to optimise its capital, and which has the data history to do it, can choose to develop a model showing how risky or non-risky its assets actually are, and if that model is approved, the bank can use it to calculate the amount of capital it needs. This is called the ”internal rating-based approach”, or “IRB”, and it leads to lower capital being required because it is more precise: it is based the bank’s own actual experience and data, reflecting its particular credit underwriting standards and the culture and practices of the market in which it operates, which may well be much more conservative than those which fed into the data used to set the SA numbers (which include US sub-prime pre-GFC data).
The Basel Committee nevertheless came to the conclusion that the IRB might underestimate risk, and so it proposed the now-notorious “output floor”, which is part of Basel IV, and so is in the process of being introduced in the EU and UK. When the output floor comes fully into force (which Basel had said should be by 2028, but in the EU and the UK, 1 January 2030 is currently envisaged) it will mean that, if the IRB would lead to the required capital being less than 72.5% of what the SA would require it to be, then that 72.5% figure will apply. This is the output floor, and it will have huge ramifications for banks which use the IRB.
Securitisations have their own capital regime in the CRR because they are regarded as being inherently risky (over and above the credit risk) because of agency and model risk. In the CRR formulae, this is addressed by including a factor known as “the ‘p’ factor", which penalises securitisations, because it ensures that if (for example) an EU bank securitises a pool of loans that were on its balance sheet, retaining some of the securitised notes and selling the rest to other regulated EU banks, the aggregate capital charge will be more than the originator EU bank had to bear when the assets were on its balance sheet. This is known as “non-neutrality” and it is generally regarded as being excessive, taking into account the actual experience in the UK and EU of defaults and losses following the GFC – which is very different from the USA experience.
In November 2022, a paper, “Impact of the SA Output Floor on the European Securitisation Market” demonstrated the seriousness of the problem that the output floor would cause:
“Corporate securitisations, both for large corporates and SME portfolios, will be largely eliminated by the introduction of the Basel SA Output Floor as currently envisaged. This could contribute to a significant reduction in the availability of bank funding to European firms…
Existing transactions done for risk management purpose, especially corporate ones, are likely to fail the EU Significant Risk Transfer (SRT) test applied by supervisors and, hence, will have to be terminated...
… the SA Output Floors regime will encourage greater securitisation activity in residential mortgage and other retail loan portfolios because the increase in capital for loans held on balance sheet will exceed, sometimes disproportionately, that of securitised assets...
The floor will affect both the capital (under IRBA and SA rules) that the bank must hold if it retains the risks on the loans, as well as the required capital (again under IRBA and SA securitisation rules) for retained tranches of securitisations… In effect, the impact on securitisations is a ‘horse race’ between the increase in capital for on-balance-sheet loans and the capital increase for retained securitisation positions. How this ‘horse race’ turns out for a particular sub-category of loans depends crucially on the risk parameters of the loans involved, namely the PDs and LGDs. These risk parameters are specific to asset classes and countries because the loan markets in given countries have generic characteristics (high or low PDs or high or low LGDs). They are also bank specific as each IRB bank has its own IRB models…
… few participants in the public debate on CMU appear to understand the likely consequences of SA Output Floors… the implementation of the SA Output Floors will disfavour one asset class substantially while benefiting another asset class with no clear rationale policy priorities. This is a consequence of adopting regulatory rules that are not soundly rooted in an understanding of the relatively riskiness of different asset classes”.
Meanwhile, MEP Gilles Boyer had (according to the official record) no less than 48 meetings with interested market participants during 2022 on this topic, and this led to his proposal of amendment 1388 to the draft CRR amendment regulation which had been proposed by the European Commission, in order to reduce the effect of the output floor pending a “comprehensive review of the EU securitisation framework”. His work was supported by sustained industry lobbying, including a letter of 3 November 2022 co-signed by AFME, the EBF, and several other industry bodies.
The Tuesday vote
And so to this Tuesday, when the Boyer amendments were approved by the Euro Parl ECON committee, as a result of which the ECON-approved draft wording now provides that, pending the completion of the comprehensive review by the EBA and ESMA (which the ECON wording proposes should be done by 31 December 2026), the ‘p’ factor which applies under the SEC-SA (and which therefore is the one which would apply when and if the output floor kicked in) will be cut. To be precise:
- For STS securitisations, 0.25 rather than 0.5;
- For non-STS securitisations, 0.5 rather than 1
This is not a panacea as regards the output floor or its consequences, but – assuming it is eventually enacted – it will tend to counteract some of the adverse effects of the output floor, and it holds out the hope that the comprehensive review which is now envisaged will come to a sensible conclusion, with obvious beneficial consequences for the capital markets. It now goes into trilogue, where it might not be entirely plain sailing: readers will remember that only last month the ESA’s “Joint Committee advice on the review of the securitisation prudential framework” (this is the 13 December 2022 EBA press release and these links are to the ESA’s advice about insurers and about banks) came to a different and disappointing conclusion. Still, the vote this week is cause for encouragement.