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Proposed changes to eligibility requirements for guarantee CRM

A UK Prudential Regulation Authority (PRA) consultation paper, published on 16 February 2018, on the eligibility of guarantees as unfunded credit risk mitigation (CRM) contains some significant points, concerning eligibility of guarantees as unfunded CRM, for UK-regulated banks and investment firms within the scope of the Capital Requirements Regulation (CRR) that make use of unfunded CRM. It will also be relevant to unfunded CRM providers to those entities, wherever located and whether or not subject to the CRR themselves.

Scope of consultation

The consultation paper relates to the requirements for guarantees as CRM under the Standardised Approach and Foundation Internal Ratings Based Approach (the Chapter 4 Requirements). The requirements of the Advanced Internal Ratings Based (AIRB) approach are not affected. However, for a variety of reasons (large exposures requirements, double default rules, absence of approved models for a particular obligor or guarantor, underlying exposures that are securitisation positions), AIRB institutions often, in fact, seek to satisfy the Chapter 4 Requirements.

The consultation paper guidance is expressed to relate to “guarantees”. However, certain of the CRR provisions addressed (“timeliness” of protection payments, the requirement for protection to be “incontrovertible”, the substantive and geographic scope of Article 194(1) legal opinions) apply both to guarantees and credit derivatives. It is unclear whether the consultation paper guidance in this respect should be read as affecting both types of unfunded CRM.

No grandfathering provisions are envisaged in the consultation paper in relation to existing arrangements.

Changes to eligibility assessment of guarantees as unfunded CRM

The consultation indicates that the PRA expects the eligibility assessment of guarantees as unfunded CRM to meet the following:

Scope of Article 194(1) legal opinions may be expanded

Article 194(1) CRR requires “independent, written and reasoned” legal opinions confirming that a guarantee is “legally effective and enforceable” in all relevant jurisdictions. There is no requirement in the CRR, or related EBA Q&A guidance, for legal opinion comfort in respect of the CRR eligibility criteria themselves. In fact, a large number of the criteria relate to matters of fact rather than matters of law. In practice, firms typically look to standard transaction enforceability opinions to satisfy the Article 194(1) opinion requirement. Legal advice may or may not be taken in relation to satisfaction of the CRR eligibility criteria and, if taken, is unlikely to take the form of a legal opinion. However, in the consultation paper, the PRA indicate that they expect the “eligibility criteria” for a guarantee to be covered by “independent legal opinion”. This is a potentially significant development in terms of feasibility, cost and process.

The PRA also expand on their understanding of the requirement that legal opinions cover “all relevant jurisdictions”. The PRA indicate that “relevant jurisdictions” include the governing law of the guarantee, and the protection provider’s jurisdiction of incorporation, but “could well include other jurisdictions where enforcement action may be taken”. Presumably, the PRA have in mind jurisdictions such as branch jurisdiction, where the protection provider acts through a branch, and the jurisdiction of a protection provider’s material assets if this is different from its jurisdiction of incorporation/branch (eg where the protection provider is a securitisation special purpose entity). It is to be hoped that the PRA do not expect additional opinion cover in respect of a jurisdiction that may be associated with the underlying exposure(s), or the protection purchaser but further clarity in this respect would be welcome. Again, this is a potentially significant development in terms of cost and process.

Quantitative guidance on “timeliness” of protection payments

The consultation paper proposes quantitative guidance on the requirement for “timeliness” in protection payments. The PRA indicate that they generally regard the concept of timeliness as requiring a pay-out “without delay” and within “days ... not weeks or months”. This is at odds with market practice and with established EBA guidance; in particular in the context of insurance/insurance-like CRM and unfunded CRM provided by multilateral development banks, where payment periods can be much longer (without involving initial payment and subsequent true-up structure).

By way of exception, the PRA indicate that guarantees in respect of residential mortgage exposures continue to benefit from their statutory 24-month maximum payment period. Mutual guarantee schemes and public sector bodies will also continue to be able to make timely provisional payments. It would be helpful to clarify that the PRA do not mean to preclude other protection providers from making timely initial payments, with subsequent adjustments to reflect the actual outcome of workout processes. Such practice is common and in line with guarantor subrogation rights as a matter of English law.

The PRA also expressly disapply the proposed guidance on timeliness in the context of securitisation positions. It is unclear whether the PRA are referring to CRM written on existing securitisation positions, to CRM written on non-securitisation exposures that itself constitutes a securitisation (ie synthetic securitisations) or both. The EBA has indicated that an interim credit protection payment within a year following reporting of a credit event “is a desirable feature from the perspective of the originator’s capital position”, given that the full work-out of the losses can be a lengthy process. If the PRA were mindful of this when carving out securitisations, it might be presumed that they intend both synthetic securitisations and CRM on existing securitisations to be covered.

The PRA further indicate that they read certain words, occurring in Article 215(1)(a) CRR, into Article 213(1)(c)(3) CRR. More specifically, the PRA state that the requirement that a guarantee must not contain a clause that prevents the guarantor from being obliged to pay out in a timely manner “would be expected to be read with the further condition that” the firm must have the right to pursue the guarantor for any monies due under the guarantee without having to first pursue the defaulting obligor. In effect, this means that guarantees benefitting from the somewhat relaxed requirements around pay-out quantum under Article 215(2) (ie guarantees provided in the context of mutual guarantee schemes, or provided/counter-guaranteed by public sector bodies benefitting from the possibility of provisional payments based on robust estimates/pay-outs otherwise satisfactory to regulators) are nevertheless subject to a requirement for the protection purchaser to be able to pursue the guarantor without first pursuing the underlying obligor.

Guidance on exclusions in respect of a “quantifiable portion of the exposure” relating to a particular “type of payment”

The CRR permits institutions to exclude “certain types of payment” from the cover of a guarantee, and to adjust the value of the guarantee to reflect that “limited coverage”. This has sometimes been used as the basis for arguments that exclusions in insurance/insurance-like contracts (nuclear carve-outs etc) are not incompatible with guarantee analysis. The PRA’s proposed interpretation would prevent this: the exclusion must, it indicates, be not merely a “quantifiable portion of the exposure” but also relate to a “type of payment”, which the PRA interprets as meaning “different sums the obligor may be required to pay to the firm under the contract, such as the principal, interest, margin payments, fees and charges”.

Guidance on the requirement for protection to be “incontrovertible”

The PRA indicate that they interpret the CRR requirement for credit protection to be “incontrovertible” as requiring “the wording of a guarantee [to] be clear and unambiguous”, leaving “no practical scope for the guarantor to dispute, contest, and challenge or otherwise seek to be released from, or reduce, their liability”. The PRA indicate that they expect firms to consider the terms of the guarantee itself, the remedies available under the law that applies to that guarantee, and whether there are scenarios in which the guarantor could in practice successfully seek to reduce or be released from liability under the guarantee.

Next steps

Given the absence of grandfathering, affected parties will need to consider the impact of the proposed guidance as regards their existing unfunded CRM, as well as in relation to future protection.

Further information

This article is part of the Allen & Overy Legal & Regulatory Risk Note, a quarterly publication. For more information please contact Karen Birch –, or tel +44 20 3088 3710.
Legal and Regulatory Risk Note
United Kingdom