Documents leaked last week show the European Commission is serious about reforming its rules so as to liberate Europe's securitization market, squeezed in a regulatory headlock since the 2008 financial crisis.
Two draft proposals for policy reforms, addressing the Capital Requirements Regulation and the Securitization Regulation, were revealed by MLex, the regulatory news service, on May 28.
Most of the proposed reforms to the Sec Regs — concerning the disclosures issuers have to make and the due diligence required of investors — are fairly modest.
But the paper on the CRR shows genuine ambition. Some risk weight floors would be halved and there are reductions in the notorious 'p-factor', in exchange for additional safeguards.
As the Commission gives with one hand, the question will be: has it taken too much with the other?
To illustrate this, consider two examples.
Capital burden
First, the new capital rules for banks. One of the most inhibiting elements of the post-crisis regulatory regime for securitization is the risk weightings applied to securitization positions held by banks. These apply whether the bank is investing in a third party deal or retaining part of a securitization it has originated.
The calculations to assign these weightings can be fiendishly complicated, but in all cases the requirement for capital is higher than it would be if the bank simply owned the securitized assets outright.
The result has been to depress demand from banks as investors and to weaken incentives for banks to issue securitizations, by crimping the possibility of capital relief.
The Commission clearly wants to ease this straitjacket — for the deserving.
It proposes to create a new standard of ‘resilient’ securitization for senior tranches.
Tranches earning this moniker can qualify for the most favourable risk weightings, the CRR paper says.
When a bank is a third party investor, ‘resilient’ means the tranche must carry the Simple, Transparent and Standardised (STS) label — and comply with a maximum tranche thickness, calculated using new formulae.
Thickness refers to the percentage of the whole capital structure a tranche takes up.
For banks as originators or sponsors of deals, 'resilient' can include non-STS tranches, as long as they are thinner than the maximum thickness and meet three further conditions:
sequential amortisation or performance triggers for sequential amortisation
obligor concentration limit of 2%
the risk transfer in synthetic deals must be collateralised by 'high quality' assets or guarantees provided by sovereigns or supranationals
These rules are likely to be particularly relevant to significant risk transfer deals, in which banks seek capital relief by selling some or all tranches of a portfolio. Usually they like to retain the senior tranches, which then incur a capital charge.
Unfortunately, the Commission's scheme is an ugly fix for a more fundamental problem and adds yet another level of complexity, on top of the existing STS standard.
The maximum thickness is the main difference between STS and ‘resilient’.
The paper says it would be introduced to mitigate the “risk of regulatory arbitrage when the originator bank would be incentivised to structure an unduly thick senior position".
An originator might do this, the Commission thinks, to benefit from the lower p-factor and lower risk weights allowed by its proposed reform.
The p-factor is one of the thorniest issues in securitization regulation. It is a 'non-neutrality' factor, introduced "to capture the agency and model risks prevalent in securitizations", according to Clifford Chance, by making sure the risk weights of securitized positions are always higher than those for the underlying assets.
However, the Commission paper recognises industry concerns that the current calibration of the p-factor results in “levels [of non-neutrality that] are excessively high and lead to unjustified levels of overcapitalisation” for some deals. It therefore plans to reduce the p-factor.
However, setting the p-factor too low means a deterioration in performance of the securitized assets can lead to rapid increases in the amount of capital required.
Rather than grapple with the underlying issue, the Commission's solution is a maximum tranche thickness.
That could work, but it’s not clean and it will take careful analysis.
Unfund me, sir!
For the second example, consider the inclusion of unfunded SRT deals within the STS label, which the market has long been lobbying for.
Since 2021, synthetic SRT securitizations have been allowed to qualify for STS, as long as the investor taking the risk puts up cash to buy a note, and that money is invested in high quality collateral that would be used to compensate the ceding bank if losses in the portfolio reached the transferred tranche. This is known as a 'funded' structure.
Insurance companies like to take risk on SRT deals in unfunded form, by writing insurance contracts — up to now these have not been eligible for STS.
The leaked Sec Reg paper suggests the Commission is willing to allow this, subject to “certain robustness, solvency and diversification criteria”.
Those criteria are that the insurer must have:
the capacity for internal risk modelling
a credit quality step two rating or better
business activities in at least two classes of non-life insurance
at least Є20bn of assets under management
“Assets under management” is an odd way to refer to an insurer’s assets and has little bearing on its capital or solvency, which is presumably the reason to include that stipulation. But even beyond such pedantry, it’s a pretty restrictive list that again could limit the helpfulness of the measure.
Precision needed
These are perhaps the two most important cases of where the Commission's proposals could fall down on the details. But there are plenty of other niche points, and much more the market still needs to digest.
The leaked proposals give a strong sense that, although the Commission wants to make concessions to the market, for each one it feels the need to exact some fresh protection for the stability of the financial system — in spite of the already extensive protections in place.
Whether the authorities' risk-averse instincts ultimately limit the benefit of the reforms will come down to how they decide some very complicated details.