From Basel (III) to Brussels: no direct train service for securitisation capital requirements

How did we get here?

Finalised Basel III implementation   

The Basel Committee on Banking Supervision (the "Basel Committee") finalised the third instalment of the Basel Accords creating a regulatory framework for bank capital adequacy, stress testing and market liquidity risk in 2017 ("Basel III"). Although not directly applicable or legally binding on banks, member states of the Basel Committee (including the US, the UK, the EU, Hong Kong, Russia, Singapore and a number of other countries) agreed to implement and apply the Basel rules in their jurisdictions within the time frame established by the Basel Committee. On 27 March 2020, the Basel Committee's oversight body, the Group of Central Bank Governors and Heads of Supervisors agreed to delay the implementation date of Basel III until 1 January 2023 (with accompanying transitional arrangements for the output floor).

EU response to Basel III  

On 27 October 2021, the European Commission published legislative proposals for amendments to Regulation 575/2013 (the "Capital Requirements Regulation") and Directive 2013/36/EU (the "Capital Requirements Directive IV"), in order to implement the updated final Basel III standards (such proposals being the "EU Banking Package 2021").

Approach in the UK and the US

Unlike the EU, the US and the UK have not yet put forward concrete plans on implementing Basel III, although the UK has already put in place legislation granting HM Treasury the power to make consequential provisions or other regulations to incorporate Basel III. The Bank of England confirmed in a press release of March 2021 that it intends to publish a consultation paper on the subject in the fourth quarter of 2022. It is expected that the US will similarly delay implementation until 2025, and that the Bank of England may take into account the US Federal Reserve's approach given the number of US investment banks operating in London.    

Market response to Basel III and the EU Banking Package 2021

The general consensus amongst a large number of market participants and industry bodies was that EU banks were significantly better capitalised and more prudentially resilient as a result of the post financial crisis Basel standards. This was evidenced with banks' performance during exceptionally stressed scenarios, such as COVID and the cost of living crisis. In its impact assessment of the EU Banking Package 2021, the Association for Financial Markets in Europe ("AFME") noted that some of the proposed amendments would result in material increases in capital requirements, when all the various buffers were aggregated, for banks, which may lead to negative consequences for lending and the wider economic activity. AFME also supported a 5-year transitional imposition of the output floor, to minimise cliff effects and to take into account the fact that banks were already subject to the leverage ratio minimum requirements as a further buffer to the internal models.

European banks have slowly been growing their common equity tier capital to sustain larger shocks and have therefore significantly enhanced their capital strength over the last couple of years, as illustrated by the below table:

In a joint stakeholder letter relating to the securitisation framework dated 3 November 2022, signed by multiple market bodies (including AFME, PCS and True Sale International) and addressed to the European Commission, European Parliament and the Council of the EU, a number of concerns were raised in respect of the Basel III implementation. The role of securitisation in financing SMEs and the economy more generally, as well as financing essential "green" assets was highlighted. Indeed, the European Commission itself acknowledged the benefit of securitisation to the wider economy in its recent Report on the functioning of the Securitisation Regulation. The letter stressed how the EU's securitisation market continued to decline, notwithstanding the US recording its highest ever issuance levels in 2020 and again in 2021. One of the main reasons for this was the perceived disconnect between the aims of the capital markets union and the regulatory capital framework which, albeit applied on a more general level to banks and credit institutions, posed particular capital hurdles on securitisations making them less attractive. In particular, the imposition of supervisory parameter "p" is of concern in the market; this is widely seen as a premium charge on all securitisations (and, in particular, on investors using the securitisation standardised approach (the "SEC-SA") instead of the more flexible internal models ("SEC-IRBA")). The inclusion of the new output floor, which essentially caps the maximum capital benefit a bank can obtain from using the SEC-IRBA, further exacerbates the difficulties with SEC-SA, resulting in a scenario that even sophisticated banks which can normally rely on SEC-IRBA are constrained by the relative rigidity and embedded premium encapsuled in the SEC-SA calculations. The letter urged the EU legislators to lower the "p" factor by 50% in the SEC-SA model, thereby converging the SEC-SA and SEC-IRBA outputs and minimising the immediate impact of the output floor. This would also bring an alignment with the US simplified supervisory formula, which is seen to be more generous than the EU's SEC-SA equivalent. The concerns with the interplay between the supervisory parameter "p" and the output floor were also flagged by respondents to HM Treasury's review of the Securitisation Regulation published on 13 December 2021.  

The Council's response

On 8 November 2022, following meetings with the Working Party on Financial Services, the Council of the European Union (the "Council") agreed a general approach on the proposed EU Banking Package 2021, including the publication of compromise texts for amendments to both the Capital Requirements Regulation and the Capital Requirements Directive IV. The proposal, if implemented and approved by the European Parliament, is expected to become effective starting 1 January 2025.

Below is a summary of some of the key changes relevant to securitisation transactions:

1. Implementation Delay

The Council agreed with the market and the European Commission to delay the Basel III deadline from 2023 to 2025.

2. Output Floor

The output floor is expected to apply to all levels of consolidation (rather than on an entity by entity basis). To avoid disruptive impacts and a cliff effect on 1 January 2025, the output floor is expected to be implemented on a transitional basis:

1. 50% from 1 January 2025 – 31 December 2025;
2. 55% from 1 January 2026 – 31 December 2026;
3. 60% from 1 January 2027 – 31 December 2027;
4. 65% from 1 January 2028 – 31 December 2028;
5. 70% from 1 January 2029 to 31 December 2029;
6. 72.5% from 1 January 2030 onwards.

This means that banks, when using the Internal Model, will initially face a minimum risk-weighted exposure calculation of 50% of what the SEC-SA calculation would otherwise have been. This floor will eventually be lifted, so even if banks have advanced knowledge in respect of the underlying assets, or are otherwise able to incorporate credit risk mitigation arrangements into their Internal Model, the maximum "discount" of risk-weighted exposures from the SEC-SA calculations would be limited to 27.5%.  

3. Supervisory Parameter "p"

No change was proposed to the supervisory parameter "p", although we await the European Commission's prudential review as required under Article 519(a) of the Capital Requirements Regulation, as to whether a review of the capital requirements specifically linked to securitisations may be beneficial to the market.

4. Internal Models

A number of restrictions were made for the ability of banks to use the internal model: including using a single model for different asset classes and resorting to regulatory loss given default values with low-default portfolios (where the internal loss-given-default calculations were seen as being unreliable).  

5. ESG

Although some mention was made on ESG factors (such as requiring banks and credit institutions to reflect the importance of environmental, social and governance factors in supervisory reporting on a proportionate basis), no specific provisions of capital relief and/or a lower risk-weighting calculation was made in respect of ESG "assets." It is worth noting that although Basel has focused on credit risk, market risk and operational risk, new types of risks relating to climate change and other ESG-related factors have not generally been considered in a way which affects institutions capital requirements. The EBA will assess whether dedicated prudential treatment for ESG is warranted.

6. Alignment of specific asset classes

A number of asset classes and funding arrangements were identified as requiring a more consistent application including, for example, specific retail exposures and more discrete categories for the specialised lending space, allowing the standardised approach to be more nuanced and therefore lowering the impact of the output floor.

7. Lower LTV residential mortgage lending

The calibration of risk-weighting for mortgages with very low loan-to-value ratios, particularly in the residential context, were seen as too conservative and therefore a (transitional) relaxation of risk weighting to 10% for lower-LTV mortgages is permitted until 31 December 2032.   

8. Subordinated debt holdings

The risk weighting of a number of subordinated debt holdings which were expected to obtain a higher risk weighting were dropped.

1. Foreign branches in the EU

The Council agreed to relax the tougher requirements which were previously imposed on non-EU banks' branches in the EU, reducing the pressure for extra capital and supervision required for these entities

10. Disclosure requirements for small and non-complex institutions

Small and non-complex institutions benefit from a proportionate approach in some areas, including that they will not be required to submit the full Title II and Title III information which is required from larger institutions, thereby minimising the supervisory load and the administrative costs of compliance for smaller institutions.

Analysis

The Council of the EU has supported a delay in the implementation of Basel III and have agreed to a number of market requests to water down some of the more onerous capital provisions, including where there was felt to be a disadvantage between EU and non-EU banks. The ECB and the EBA, both of which warned against further deviation and delay for Basel III, may have found that some of the decisions reached by the Council might erode long-term stability. Andrea Enria, chair of the supervisory board of the ECB issued a joint statement with Luis de Guindos (vice president of the ECB) on 4 November 2022 that the Basel rules were articulated to ensure a worldwide minimum safety net against the plethora of risks highlighted by the financial crisis, and that a deviation from these minimum requirements by the EU may impact the reputation, competitiveness and the funding costs of the EU banking sector. The joint statement argued that the original EU Banking Package 2021 prepared by the European Commission already departed from the agreed Basel III standards. This view may be in stark contrast to the approach of the majority of banks, which have largely argued that the current framework already meets a sufficient minimum and further regulation may actually erode the EU's competitiveness and, through higher capital holdings, increase funding costs for originators and other borrowers. This has been raised particularly in the context of securitisation structures, where the regulatory capital burden has sometimes been seen as one of the main reasons for the decreasing volume of issuances.    

Although a transitional arrangement was agreed in respect of the output floor, questions may rightfully be raised as to whether any substantive changes are envisaged to its operation when it ultimately comes into force, or whether this discussion has simply been kicked down the road. The current framework did not make any changes to the supervisory parameter, and no real changes were made to securitisation capital requirements and the SEC-SA more generally, meaning that although the impact of the output floor may have been spared for the immediate future, banks will nevertheless have to be ready for its full effects by 2030. Larger and more sophisticated bank-originators which rely on SEC-IRBA will likely factor in the transition well in advance of its termination in 2030, and views may be formed that for certain portfolios with a high SEC-SA risk-weighting, the capital surcharge of securitisations (in particular on retained exposures) may make them unattractive as a means of managing their balance sheets, and thereby have a depressing effect on securitisation issuances by such larger banks in the European structured finance market, as well as also potentially impacting bank-investors investing in such products. To the extent that banks rely heavily on securitisations and are not able to easily transfer to an alternative efficient way to disseminate risk, this may also have negative impacts on levels of origination.

The securitisation market may now be eagerly awaiting the European Commission's prudential review, as well as possible legislation on the significant risk transfer framework, to see whether a more targeted approach for capital requirements may be needed for the structured finance space. In particular, although the output floor transition is expected to benefit all transactions, due to the layering of conservative parameters embedded in the calculation of SEC-SA (in particular, the supervisory parameter "p"), the output floor would likely have a disproportionate effect on the treatment of securitisations come 2030. This was not addressed in either the EU Banking Package nor the Council's response, perhaps due to the fact that the discussions in respect of the output floor during the Basel III and subsequent EU negotiations were not focussed on the impact of the output floor specifically on securitisation positions, but more widely in the context of risk weighted assets for all exposure types. Although it is unlikely that the European Commission would consider amending the application of the output floor specifically for securitisation transactions, relaxing some of the parameters applicable to the SEC-SA model (such as a recalibration of asset-specific charges and changes to the supervisory parameter) would indirectly relax the impact of the output floor on banks using the SEC-IRBA models. The securitisation industry could also be impacted by further capital requirements depending on the outcome of the proposed consultation on regulatory technical standards for synthetic excess spread and also any future proposals on significant risk transfer.

What's next?

The Council and the Commission are expected to enter into trilogue negotiations with the European Parliament to agree on the final versions of the text. The Basel Committee’s original preferred deadline for implementation was 1 January 2023 (with a transitional period permitted for the output floor). However, it is expected that the European Parliament will review the legislative proposal during the course of next year and, given the length and complexity, may require some time before approving it and/or providing amendments. The expected timetable for entry into force of the EU Banking Package is currently 1 January 2025. In the meantime, the market is also shortly expecting the European Commission's prudential review, which may shed some light on the securitisation-specific capital requirements.

We also wait to see the US's and the UK's approach to the Basel III implementation, although it is likely that they will both strive to meet the 1 January 2025 implementation time proposed by the EU.    

This note is for guidance only and should not be relied on as legal advice in relation to a particular transaction or situation. Please contact your normal contact at Hogan Lovells if you require assistance or advice in connection with any of the above.

Authored by Tauhid Ijaz and George Kiladze.