CMU-securitisation – the real challenges of legislative proposals
At the end of 2015, the European Council agreed on its negotiating stance on the securitisation legislative proposals put forward by the Commission as part of its Capital Markets Union initiative. The package consists of a draft securitisation regulation and a draft amendment to the Capital Requirement Regulation (CRR) and seeks to harmonise and revise the current EU regulatory framework for securitisation.1
Why is this taking place now?
To shed some light on this, the comparison with the U.S. market situation is useful. Market conditions in Europe and in the U.S. are fundamentally different. The U.S. securitisation market witnessed a clear rebound after the peak of the global financial crisis while European volumes are obviously very far from that stage2. This illustrates two things: first that securitisation is a live market generally which, when structured properly and where trust is there, contributes materially to the financing of the dynamic U.S. economy; and second that the room for improvement in Europe is significant. Obviously, the disintermediation of the U.S. economy is not a new phenomenon and largely explains that, today as before, capital markets are tapped by way of ABS or otherwise. But even more in the European environment where 75-80% of the financing is provided by the banking system, the availability of the securitisation instruments is essential to ensure that banks will benefit from necessary resources to fully contribute to the financing of the economy.
The problem is that, in an environment where the Central bank provides unlimited funding to the banking system, unbalances do not appear as obvious. Central bank money in such quantity is like a snow cover, the landscape looks nice, quiet and uniformed, while the reality is that some hidden cracks exist underneath. To fill in these cracks, the European economy needs well-functioning capital markets, and access to the capital markets for banks means a well-functioning securitisation market. As such, securitisation is not a financial product but rather an essential pillar of the European banking economy.
The European Commission is clearly concerned by that situation. It is remarkable that it has picked up securitisation (along with prospectus matters) as the very first initiative to implement the Capital Market Union, one of the highest political priorities of the Juncker's Commission programme. The Commission notes in the draft securitisation explanatory memorandum that "a high-quality framework for EU securitisation can promote integration of EU financial markets, help diversify funding sources and unlock capital, making it easier for credit institutions and lenders to lend to households and businesses".
For an industry which still suffers from a reputation of being a risky instrument, this is a very welcome and encouraging message. It also demonstrates a vision which cuts through a rhetoric which mixes up geographies, products and fundamental issues. As noted by the Commission "the worst-performing EU securitisation products rated AAA defaulted in only 0.1% of the cases at the heights of the crisis. In comparison, their U.S. equivalent defaulted in 16% of cases".3 It is a paradox that most defaulting securitisations have been non- European while it is the European market which is struggling to recover and is now moving towards identifying certain qualifying arrangements to restore investor confidence.
Regulatory uncertainties also appeared to be one of the main obstacles to the recovery of a wellfunctioning securitisation market. Looking backwards, the proliferation of regulations and initiatives affecting the market over the past few years has been considerable. Among other things, such initiatives have set new standards with respect to regulatory capital, liquid asset holdings, risk retention, investor due diligence, disclosure and transparency, rating agency arrangements, and securitisation investment exposure limits. Inevitably, this revised regulatory landscape has given rise to issues related to overlap and consistency and presented challenges to the ability of market participants to efficiently assess, and respond to, the new requirements.
In that context, the Commission's package, by creating the concept of simple, transparent and standardised (STS) securitisation, aims to reduce the stigma faced by securitisation and bring greater consistency in regulation. Through this, it is hoped that the conditions for the growth of the securitisation market will be reestablished. But to achieve these goals, the regulator must establish the appropriate balance in defining the STS criteria.
To define STS securitisation, the draft regulation includes detailed criteria for traditional true sale transactions and ABCP conduits which are, in each case, aimed at ensuring that qualifying arrangements are sufficiently simple, transparency and standardised. Certain transactions would not be eligible for STS status, including CMBS, managed CLOs and synthetic transactions.4 This outcome seems to reflect the policy intention of the authorities notwithstanding concerns raised by market participants about the status of these arrangements. However, concerns have been raised that a much wider range of transactions may not be able to satisfy the proposed criteria, which then risks defeating the market revival goal underlying the revised regime. For example, significant issues have been identified under the proposed ABCP criteria and indeed it is not clear that any existing arrangements would comply with the proposals.
While it is not possible to describe all of the proposed changes in this high-level commentary, we wish to flag two substantial criticisms brought by market participants. First, certain proposed requirements (eg the proposed STS verification route of self-attestation) are arguably insufficiently clear for originators or sponsors to comply and the proposed corresponding penalties for "getting it wrong" (which include possible criminal sanctions) may operate to discourage (rather than encourage) originators from relying on the STS provisions and from using securitisation more generally. Second, certain other proposed requirements (including the investor due diligence obligations related to the verification of a transaction's STS status) are arguably too onerous, which may again function to discourage investors from investing in securitisations, particularly relative to other products.
It is intended that transactions which satisfy the STS criteria will benefit from improved regulatory capital treatment under the amended CRR; however, it is still unclear as to what extent treatment will be improved under the Liquidity Coverage Ratio and/or under Solvency II. As a result, not only are there concerns that few transactions will be able to satisfy the criteria as noted above, there is uncertainty with respect to what the upside will be to the extent that compliance is able to be achieved in respect of a transaction.
The regulations will now be debated before the European Parliament and are subject to negotiation between the Parliament and Council. The regulations are unlikely to be adopted before the end of 2016, although it is clear that the EU authorities are keen to push the initiative ahead as quickly as possible.
Significant changes may be made through the negotiation process and we consider it to be essential that the proposals are improved within that process. It is hoped that the coming Parliament debates will reflect the systemic importance of securitisation and not be unduly influenced by reputational issues largely based on the U.S. sub-prime market and not reflective of the performance of the EU market to date.
It is critical that some consideration be given to the market-shaping impact of the STS proposals. Given this, one must then be absolutely certain that non-qualifying transactions would not make an effective and – on balance – a generally positive contribution to the financing of the European economy. This is the fundamental challenge that the lawmakers will need to address when shaping the securitisation regulations in the coming months.
1 Proposal for a Regulation of the European Parliament and of the Council laying down common rules on securitisation and creating a European framework for simple, transparent and standardised securitisation and amending Directives 2009/65/EC, 2009/138/EC, 2011/61/EU and Regulations (EC) No 1060/2009 and (EU) No 648/2012; Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 575/213 on prudential requirements for credit institutions and investment firms.
2 See AFME securitisation Data Report Q2 2015, http://www.afme.eu; Standard & Poor's "The U.S. leads the global securitization rebound, but interest rate hikes could threaten that trend", http://www.standardandpoors.com/ratings direct.
3 http://europa.eu/rapid/pressrelease_ MEMO-15- 5733_en.htm?locale=en.
4 See Allen & Overy LLP's bulletin "Capital Markets Union: Securitisation proposals come closer but risk missing the mark".