Bank of England wades in on securitisation capital framework: not all that glitters is gold-plating

Output Floor

As expected, the Discussion Paper sets out the full incorporation of the output floor, which broadly ensures that the total risk-weighted assets (i.e. the value of an asset held by the bank multiplied by a risk-weighting commensurate with its level of creditworthiness, with higher risk categories carrying a higher risk-weighting, or "RWA") calculated by firms using internal regulatory-approved ("IRB") models would not fall below 72.5% of the RWA under the standardised ("SA") approach. This sets a minimum floor to RWAs, and was highly controversial given the data received to date, which suggests that a lot of IRB positions are well below the 72.5% mark and would therefore be impacted by having to hold additional capital as a result.  

The impact of the output floor would also be applicable to investors in securitisation positions (when using the Securitisation Internal Ratings-Based Approach ("SEC-IRBA"), which would be capped at 72.5% of the Securitisation Standardised Approach ("SEC-SA")). This exacerbates a pre-existing constraint flagged by market participants, which is the relatively conservative parameters used to calculate RWAs under the SEC-SA. Some of the larger and more sophisticated banks could previously avail themselves to the IRB approach and therefore obtain more favourable capital treatment which was seen as more proportionate to the level of risk they were exposed to (and hence were not as concerned with the SEC-SA calculations). The position is now different, as notwithstanding the SEC-IRBA approach, IRB banks may nevertheless find themselves stifled by the imposition of the output floor as a result of conservative SEC-SA RWAs. This may put renewed focus on the SEC-SA approach, even from IRB banks.   

Although the output floor itself will be incorporated, as per the position of the EU in CRR3, there will be a phased-in implementation of the output floor, starting at 50% and then moving up by 5% increments, with the final 72.5% reached on 1 January 2030. However, given that the UK implementation is expected to become effective 6 months later than the EU, the overall transitional period for the output floor in the UK will be 4.5 years (rather than 5 years). It is unlikely that this will generate significant pushback, as most large banks (using the IRB methodology) will already have factored in the EU regime in their capital planning.   

The PRA has also recognised from prior feedback that the imposition of the output floor may have significant negative consequences on significant risk transfer transactions – in particular on-balance sheet synthetic securitisations ("SRT Transactions"). SRT Transactions are frequently used by banks as an effective capital management tool to ensure that credit risk is transferred to an investor and/or a guarantor (which itself may not be subject to capital requirements). This has been seen by a number of regulators as a prudentially advantageous position to ensure that banks are able to manage their risk without having to liquidate and/or exit capital-intensive product lines. Unfortunately, one of the common structures of SRT Transactions involves the originating bank retaining a thick senior tranche position which, although in theory could have a relatively low RWA if using the SEC-IRBA approach (given the higher amount of principal losses which need to accrue before the senior tranche starts absorbing losses, being determined by the tranche attachment and detachment points), the imposition of the output floor would mean that the originating bank may be subject to holding a significantly higher amount of capital as a result of the SEC-SA floor. This is even in scenarios where such originating bank may have significant knowledge of the reference portfolio in question, and may have a substantial amount of historic data (including delinquencies) which would allow them to properly assess the actual credit risk under the SEC-IRBA approach. Even though the output floor is applied at a consolidated aggregated level across the entire portfolio, evidence in the Basel and EBA monitoring reports suggests that there will be material increases in RWAs for SRT Transactions. The Discussion Paper has asked for feedback from industry participants in respect of the perceived costs and benefits for SRT Transactions.  

The PRA has acknowledged the difficulties with the imposition of the output floor and invites feedback in respect of a (potentially) permanent recalibration of the output floor. The PRA has also gone further than the CRR3 on the recalibration of the supervisory parameter (including in the context of SRT Transactions) by suggesting potential avenues where a more proportionate and potentially risk-adjusted non-neutrality factor could be applied (see below).

The securitisation capital surcharge  

The Discussion Paper has also noted industry concern relating to the non-neutrality factor (or the supervisory parameter p), which is a capital surcharge applied to securitisation positions to address what the regulators perceive as modelling and agency risk (broadly, that the interests of the originator and the investor do not align). Clearly for the purposes of retained senior tranches of SRT Transactions (i.e. where the originator and the investor are the same entity) these perceived costs would not arise. However, under the proposed regime (and under the EU CRR3 approach) this would not be relevant and the originator would be subject to the full supervisory parameter (being 1 (for non-STS)² and 0.5 (for STS) under SEC-SA and a minimum of 0.3 (regardless of STS / non-STS) under the SEC-IRBA). Although the supervisory parameter can be much lower under the SEC-IRBA approach, given the imposition of the output floor, it is likely that the supervisory parameter embedded in the SEC-SA approach would be determinative and result in the minimum floor being higher. The CRR3 included a temporary halving of the supervisory parameter in the SEC-SA approach for the purposes of calculating the output floor, but this remains temporary (until 31 December 2032) and does not assist banks using the SA model more generally (which remain disadvantaged by the conservative non-neutrality factor). The Discussion Paper does not seem to envisage a temporary relief against the supervisory parameter, although this may be raised in the feedback.

The Discussion Paper has, however, gone further than the CRR3 in outlining potential options for recalibrating the supervisory parameter on a more permanent basis (this is somewhat alluded to in Article 506ca of the CRR3 which requires a report by the EBA on potential prudential treatment of synthetic securitisations, but the implementation timing is expected to be no earlier than 2028). The Discussion Paper outlines three potential options:

1. Option 1: implementation of the output floor as is (i.e. no changes to supervisory parameter);
2. Option 2: implementation of the output floor with targeted and data-based adjustments, including to the supervisory parameter; or
3. Option 3: implementation of carve-outs from (or other qualifications to) some or all securitisation exposures.

Option 1, whilst aligning with the current proposals, is acknowledged by the PRA to be constraining for firms subject to the output floor and queries whether it adversely affects UK bank SRT originators, is proportionate and advances the PRA’s objectives to achieve competitiveness and growth.

Option 2 would seem to be a more permanent variation of the EU CRR3's transitional output floor relief for supervisory parameters and is seen by the PRA as being a persuasive alternative to Option 1 as benefiting PRA firms and facilitating SRT transactions; however, whilst advancing the PRA’s objectives it does not align entirely with the Basel framework. The PRA analysis suggests that there is scope to reduce the supervisory parameter for SEC-SA, although there was reluctance to significantly reduce it so as to create parity with STS and non-STS positions (which the PRA wants to avoid). The PRA also considers having a risk-based approach to calculating the supervisory parameter, where different factors and structural features of a securitisation could result in a different supervisory parameter. This is currently not the case for SEC-SA, and would address one of the biggest issues with the imposition of a one-size-fits-all surcharge on all SEC-SA positions. It would also mean that senior tranches of SRT Transactions could get more favourable treatment under the output floor where they could demonstrate they meet some of the criteria (which could be based on variables such as delinquency rates and pool granularity) as a result of their deep knowledge of the underlying assets in question.

Option 3 seems to go much further than the current CRR3 approach and is most in line with feedback from the industry suggesting the creation of "resilient" securitisations which would grant capital relief to, among other "safe" securitisations, senior retained tranche of SRT Transactions. Although the PRA invited feedback on Option 3, they have made clear that it raises prudential concerns, is not in line with Basel standards and they are currently not minded to adopt this approach. It remains to be seen what the feedback to this will be, although it is possible that market participants will focus their feedback on optimising the non-neutrality factor under Option 2.