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Securitisation and capital requirements – a match (not) made in Basel?
29 September 2022
The updated Basel III framework is the principal response of the Basel Committee to the global financial crisis. The updated framework makes wide-ranging changes to the perceived shortcomings of the previous regime. Although the framework has retained the optionality for banks to select an internal model and assess the credit risk of particular positions based on supervisor-approved and operationally sound internal models, the imposition of a new "output floor" has reversed some of the advantages of this flexibility, and may result in banks no longer having the incentive to commit to further due diligence where their capital benefits are capped. This article will assess the Basel Committee's changes to the credit risk regime in the structured finance space, and consider whether some of the changes will need to be further calibrated or adjusted to ensure that the right balance is struck between a prudential and resilient banking system, and one which levies arduous requirements that stifles access to capital.
How did we get here?
Between December 2017 to 2019, the Basel Committee on Banking Supervision ("Basel Committee"), through a series of amendments, finalised the third instalment of the Basel Accords creating a regulatory framework for bank capital adequacy, stress testing and market liquidity risk ("Basel III").[1] One of the objectives of the final Basel III reforms was the reduction of excessive variability in the calculation of risk-weighted assets ("RWAs") and an improvement in transparency and comparability of different banks' capital calculations and ratios. The Basel Committee's oversight body, the Group of Central Bank Governors and Heads of Supervision (the "GHOS"), on 27 March 2020, agreed to delay the implementation date of the finalised Basel III reforms until 1 January 2023 (with accompanying transitional arrangements for the output floor, as described below).
Although Basel III is not directly applicable or legally binding on banks, its member states (which include, among others, the United States, the United Kingdom, the European Union, Hong Kong SAR, Russia, Singapore and a number of other countries) agree to implement and apply the Basel rules in their jurisdictions within the time frame established by the Basel Committee. The EU does this on behalf of its member states, although national regulators do retain certain discretions.
The EU incorporated the Original Basel III Amendments (as defined below) through EU Directive 2013/36/EU (the "CRD IV") and EU Regulation 575/2013 (as amended, the "Capital Requirements Regulation"). The CRD IV and the Capital Requirements Regulation applied from 1 January 2014 (with certain transitional features being phased in by 2019). The EU also incorporated the net stable funding ratio (published as part of Basel III in October 2014) through EU Regulation 2019/876 ("CRR2", amending the Capital Requirements Regulation). The EU rules ("EU CRR") were on-shored by the UK through the European Union (Withdrawal) Act 2018 ("EUWA"), which simultaneously gave the UK government the power to amend the legislation so that it would operate effectively after Brexit (such on-shored legislation being the "UK CRR"). A number of additional regulations were effected to track, in part, subsequent amendments to the EU CRR through the Capital Requirements (Amendment) (EU Exit) Regulation 2018 (SI 2018/1401) and Capital Requirements (Amendment) (EU Exit) Regulations 2019 (SI 2019/1232). The UK CRR and the EU CRR differ slightly on a number of different issues, and it is anticipated that future divergence may take place depending on the approach of the European Commission and the UK Government on further implementation of the Basel III standards. The current differences include:
- rules relating to group consolidation (including consolidated capital requirements);
- certain exemptions for EU exposures will no longer be applicable in the UK (which mirrors the EU's position that UK exposures are no longer treated preferentially by the EU). Exposures to EU sovereign debt would therefore no longer carry a 0% risk weight;
- certain changes to reflect supervisory structure and reporting requirements to the relevant entities; and
- the role of regulators (i.e. the European Supervisory Authorities for the EU, which were transferred to HM Treasury, the Financial Conduct Authority and the Prudential Regulation Authority (as applicable)).
The UK CRR and the EU CRR refer to RWAs as "risk-weighted exposure amounts" (instead of risk-weighted assets), although this article will refer to RWAs and RWEAs interchangeably.
Consistent with the previous incorporation and legislation of the Basel Accords, on 27 October 2021 the European Commission adopted a review of the EU banking rules (as proposed amendments CRD IV and the Capital Requirements Regulation) to, among other things, incorporate the finalised Basel III reforms into EU legislation (the "EU Banking Package 2021"). The EU Banking Package 2021 makes Europe the first major jurisdiction to set out a vision and timetable for implementing the most recent Basel III changes. The draft EU Banking Package 2021 is yet to go through the European Parliament and the European Council, and it is expected that there may be substantial amendments and/or discussions in respect of the text, given a number of new changes which are seen as disproportionately affecting larger EU institutions. In the UK, the Financial Services Act 2021 grants HM Treasury the power to make consequential provisions or other regulations to incorporate Basel III into the UK's prudential framework. The UK has not, as at the date of this article, published any draft proposals in respect of the Basel III amendments, as it is not yet clear whether they will follow the EU approach or diverge where necessary. However, the Bank of England confirmed its intention to publish a consultation paper on the implementation of the Basel III amendments during the fourth quarter of 2022.
Securitisation exposures
To be eligible for the securitisation framework under Basel III, the exposures must be part of structures that have at least two stratified risk positions (or tranches) with different levels of seniority and the performance and/or the risk of the securitisation exposures must depend upon the performance of the underlying exposures. Broadly, securitisation exposures can arise either from traditional (or asset-based) securitisations where the assets are sold to a special purpose vehicle, or synthetic securitisations where only the risks are transferred through credit derivatives or guarantees.
Regulation (EU) 2017/2402 (the "EU Securitisation Regulation"), which came into force on 1 January 2019 (and was onshored into the UK on 31 December 2020 by virtue of the European Union (Withdrawal) Act 2018) (such on-shored legislation being the "UK Securitisation Regulation"), also created a framework for simple, transparent and standardised securitisations ("STS Securitisations"). STS Securitisations are subject to a number of additional criteria (including verification by a third party as to STS status) designed to make it easier for investors to understand and assess the risks of a securitisation position, and as a result benefit from preferential capital treatment.
The impact of Basel III on securitisation positions[2]
We note that this article is limited to credit institutions (i.e. deposit-taking institutions such as banks) and investment firms.
As a result of the 2007-2008 financial crisis, and the catalytic role which the mortgage backed securities market was widely perceived to play in the unfolding of the credit crunch, the Basel Committee aimed to address what it saw as shortcomings in the previous Basel frameworks. An emphasis was therefore made on strengthening the capital standards applicable to banks when investing in securitisations. Some of the most significant changes between 2010 and 2013 included:
- the creation of a hierarchy of approaches to calculate RWA;
- the calibration of risk sensitivities, drivers and bank inputs for each of the calculations;
- removing the mechanistic reliance on external credit ratings (which were sometimes seen as disproportionately undermining the credit risk of an associated position); and
- increasing the regulatory capital banks must hold for exposures to securitisation positions
(the above being the "Original Basel III Amendments").
The Original Basel III Amendments have now been further supplemented with the final amendments introduced between 2017 and 2019, which also took into account developments in the securitisation regulatory market such as the Securitisation Regulation and the development of STS Securitisations. This Article assesses the newly amended Basel III framework for risk-weighted assets.
It is worth noting that although this article is limited in scope to changes to the calculation of risk-weighted assets, the Basel III Amendments have effected a number of other changes aimed at making banks more resilient to shocks, including:
- increasing the minimum capital requirements for common equity;
- increasing the buffer capital requirement to 7%;
- more defined regulatory boundary between banks' trading and banking books;
- introduction of new leverage ratio buffer for global systemically important banks; and
- refinement of the leverage ratio exposure measure.
The proposed regime on securitisation positions
Risk-Weighted Assets (RWAs)
The updated Basel III standards set out a hierarchy of approaches for banks to calculate RWA. RWA is used in respect of all of the bank's assets to determine the amount of capital a bank has to hold for the purposes of its capital adequacy ratio under Basel III (the "Capital Adequacy Ratio"). Broadly, the riskier an asset (including, in this case, an investment into a securitisation position), the higher the risk weighting that would be applied to such asset, and therefore the more capital which the bank must deploy in order to maintain its Capital Adequacy Ratio. The Capital Adequacy Ratio is defined as follows:
The minimum Capital Adequacy Ratio which banks must maintain under Basel III is 8%. So, if a bank held £100m worth of notes in a securitisation which was ascribed a risk weighting of 200%, it's RWA for the position would be £200m (i.e. £100m x 200%). Since the Capital Adequacy Ratio which must be maintained is 8%, the bank would therefore have to hold eligible capital[3] of £16m (i.e. 8% of £200m) in respect of this transaction. The maximum risk weighting under Basel III is 1,250% - this is the equivalent of holding eligible capital which is 100% of the asset itself. So, in the above instance, the bank would have to hold £100m worth of eligible capital (8% of (£100m x 1,250%) = £100m). This risk weighting is usually reserved for the riskiest assets (such as unsecured loans to an individual or a very junior position in a securitisation) or positions for which the bank has insufficient information to apply one of the other models.
Calculating RWA for securitisation positions
In order to use the securitisation framework, banks are required to have a comprehensive understanding of the risk characteristics of their individual securitisation exposures as well as the risk characteristics of the pools underlying those exposures, be able to access performance information on the underlying pools on an ongoing basis and in a timely manner and to have a thorough understanding of all structural features of a securitisation that would materially impact their exposures.
Banks must calculate their RWA in respect of securitisations in respect of one of the below approaches (listed below in order of priority). In general, the higher up on the list, the more sophisticated the model, the more information which the bank must have in respect of the asset, and the more flexibility in terms of bank inputs and variables which can be considered. As a result, the prevailing expectation is that a bank is likelier to obtain a more favourable RWA (as it will be able to incorporate certain credit enhancement features which may be omitted from other more standardised models). Conversely, the methodologies lower on the list will require less "non-standardised" inputs and, in the case of limb (v) below, will flip to the residual default 1,250% risk weighting. Broadly, the level of knowledge of the underlying assets will determine which rating methodology can be used by a bank, and provide the greatest discretion in the total RWA. This incentivises banks to undergo comprehensive due diligence in respect of their assets, in order to benefit from a more favourable capital position.
i. Securitisation Internal Ratings-Based Approach (SEC-IRBA)
Where the bank has specific supervisory approval to apply the SEC-IRBA methodology in respect of that asset (such approval usually given in respect of specific underlying exposures of the securitisation)[4] and has sufficient information in respect of the position to calculate the exposure-weighted average regulatory capital charge which would have applied to the underlying exposures (or at least 95% of the underlying exposures by nominal value) had they not been securitised (the "KIRB"), then it may use this approach. The SEC-IRBA formula will then also consider tranche maturity and tranche thickness by reference to the (i) tranche attachment point "A" (which represents the threshold at which losses of principal within the underlying pool would first be allocated to the securitisation exposure held by that bank) and (ii) tranche detachment point "D" (which represents the threshold at which losses of principal within the underlying pool would result in a total loss of principal for the tranche in which the bank holds its securitisation position), as well as a supervisory parameter "p" (which is calculated, among other things, on the granularity of the underlying pool, the exposure-weighted average loss-given default and the maturity of the tranche). Any overcollateralisation or funded reserve accounts which are included in the securitisation will also be considered for the purposes of calculating the tranche attachment point A and the tranche detachment point D, thereby giving the bank the benefit of any such credit enhancements in the calculation of its RWA.
However, the cost and the degree of information required to establish with certainty the balance sheet capital exposure for the assets to calculate the KIRB has meant that there is some doubt as to whether banks are able to more liberally deploy the SEC-IRBA model for securitisation deals, unless they have themselves been involved at the origination stage of the underlying assets. In additional, the operational infrastructure required to be able to rely on the SEC-IRBA model tends to favour the larger banks.
The SEC-IRBA model is subject to the following risk weight floors:
- 15% for standard securitisations; and
- 10% for STS Securitisations.
ii. Securitisation External Ratings-Based Approach (SEC-ERBA)
If a bank has (i) specific supervisory approval to apply the SEC-ERBA method, (ii) cannot apply SEC-IRBA (for example, if it does not have sufficient information in respect of the underlying exposures to obtain the KIRB) and (iii) the exposure has an external credit assessment or an inferred rating (i.e. a rating based on an equivalent reference securitisation exposure which is rated) which complies with the Basel III framework, then the bank may use the SEC-ERBA approach.
Provided the operational criteria for the external (or inferred) ratings are complied with, the SEC-ERBA would calculate the RWA based on (i) the relevant risk weight ascribed to that rating for short-term and long-term ratings respectively (as set out in tabular form in CRE42.4), (ii) a linear interpolation of the tranche maturity "MT" between a 1 year floor and a 5 year cap (as set out in tabular form in CRE42.4) and (iii) the tranche thickness (for non-senior tranches). This figure would then be multiplied by the bank's exposure to get the RWA. Generally, tranches with longer MT and/or a lower credit rating will have a higher RWA. For example, a AAA-rated senior STS note with a 1 year maturity may have a risk weight of 10%, whereas that same note, if rated B- would have a risk weight of 340% or, if below CCC- a risk weight of 1,250%. The difference in the eligible capital which must be held in respect of the above example would be, for a £100m securitisation position: £800k (if AAA); £27.2m (if B-); and £100m (if CCC-). Granularity is not considered explicitly as this is already included in the external ratings.
Risk weights of a non-senior tranche can never be lower than the risk weight corresponding to a senior tranche in the same securitisation.
The SEC-ERBA model is subject to the following risk weight floors:
- 15% for standard securitisations; and
- 10% for STS Securitisations.
iii. Securitisation Internal Assessment Approach (SEC-IAA)
If a bank has supervisory approval and has at least one approved SEC-IRBA model, it may use its internal assessments of the credit quality of its (unrated) securitisation exposures and apply them to securitisation exposures to asset-backed commercial paper programmes such as liquidity facilities and credit enhancement. The bank would be able to utilise its internal assessments to obtain the equivalent rating agency ratings (for the purposes of the table set out in the SEC-ERBA model), and then apply the appropriate risk weight based on the SEC-ERBA calculations.
The SEC-IAA is sometimes seen as a subset of the SEC-ERBA calculation.
vi. Securitisation Standardised Approach (SEC-SA)
Where a bank is unable to use any of the SEC-IRBA, SEC-ERBA and/or SEC-IAA in respect of its exposures, it will be required to use the SEC-SA model. There is no requirement to obtain supervisory approval in using the SEC-SA model (provided the bank is able to calculate the relevant inputs required).
The bank would have to incorporate (i) the standard capital charge for the underlying exposures ("KSA"), (ii) the ratio of delinquent underlying exposures to the total underlying exposures in the pool ("W"), (iii) the tranche attachment point A, and (iv) the tranche detachment point D. The supervisory parameter "p" in the context of SEC-SA is set at 1 for securitisation exposures, 1.5 for resecuritisation positions and 0.5 for STS Securitisations. Although Basel III does include capital weights for resecuritisation positions, it must be noted that resecuritisations are not permitted under the EU Securitisation Regulation or the UK Securitisation Regulation.
The KSA will be based on the weighted average capital charge of the entire portfolio of underlying exposures multiplied by 8% (as the minimum Capital Adequacy Ratio requirement under Basel IIII). The Basel Framework, in CRE20, sets out in tabular form the various methodologies of calculating the KSA depending on the type of exposure. For example, in a residential mortgage securitisation, a risk weight of 35% may be applied (subject to the national supervisors being comfortable with the prudential lending criteria and the applicable loan to value ratios of the mortgages being securitised). This can be contrasted with the average EU risk weighting for the same class when using one of the internal models above (which was around 13%) or the even lower average UK risk weighting (of just under 10%)[5]. Meanwhile, where the underlying pool is made up of claims against corporates with a credit rating of below BB- or loans which are past due for more than 90 days, a risk weight of 150% or higher may be applied. National supervisors retain the right to increase such risk weight (but not lower it).
All of a securitisation SPV's exposures will be treated as an exposure to the "underlying pool" – even when the exposure is to contractual counterparties such as swap counterparties or liquidity facility providers. Banks are able to exclude these exposures from the calculation of KSA if they are able to demonstrate to their national supervisors that these risks have been mitigated (for example, by requiring cash collateral to be posted by a swap counterparty).
The SEC-SA is subject to the following risk weight floors:
- 10% for senior tranches of securitisation positions; and
- 15% for non-senior tranches of securitisation positions.
v. Default position (1,250% risk weighting)
For any scenario where the bank does not have sufficient due diligence to perform the calculations under any of the above models, it must apply a risk weighting of 1,250% (that is, hold eligible capital in a value equivalent to 100% of the securitisation position).
What are some issues with the Basel III proposed framework?
Impact of the Output Floor on SEC-IRBA, SEC-ERBA and SEC-IAA
One of the amendments to the Basel III framework was the addition of an "output floor", which was created to address modelling risk for the internal calculations (SEC-IRBA, SEC-ERBA and SEC-IAA, the "Internal Models"), where it has been argued that banks have sometimes mismodelled or undervalued their assessment of the risk, and that this created a larger than expected divergence between the Internal Models and SEC-SA. Because of the role and discretion granted to national regulators, there was also the additional risk of discrepancies in approved internal models between different countries. The output floor essentially creates a minimum RWA for any of the Internal Models based on the RWA which would have been applicable had the bank used the standardised approach. This essentially pegs the potentially varied Internal Models to a standardised output.
Where banks use one of the Internal Models for their securitisation positions, they must:
- Input 1: calculate the RWA under the Internal Model;
- Input 2: calculate the RWA under the SEC-SA method;
- Input 3: multiply the result in Input 2 by 72.5% (i.e. apply a haircut of 27.5% to the SEC-SA result);
The RWA which the bank will be entitled to use under the Basel III framework will then be the higher of Input 1 and Input 3. This essentially means that the maximum benefit which a bank may gain from the Internal Models (compared to the SEC-SA calculation) is limited to 27.5%. This may be particularly problematic where (i) a bank has a particularly good knowledge of the underlying exposures (for example, because it originated them) and is therefore able to obtain a more realistic and lower RWA than under the strict SEC-SA method; or (ii) there are credit enhancement features in the securitisation which are omitted from calculations for the purposes of the SEC-SA. In these instances, banks may find that even though their Internal Model calculates an accurate depiction of their RWAs, the existence of the output floor may nullify a portion of the benefit. Ironically (in light of the Basel Committee's objectives of encouraging investors to diligence the underlying positions ), this may mean that, at specific thresholds, banks may determine that there is no capital regulatory incentive to undertake further due diligence in respect of an underlying exposure as they would be unable to derive any further benefit from such diligence.
For illustration, in the below table a bank calculated its RWA under the SEC-SA approach to be 100%. It then subsequently ran the Internal Model (for example, the SEC-IRBA), and calculated a more accurate RWA of 60% (due to a number of variables in the transaction which the SEC-SA did not take into account). However, as a result of the operation of the output floor, the bank would have to use an RWA minimum of 72.5%, thereby losing the benefit of the additional 12.5% (i.e. 72.5% - 60%) it was able to obtain under SEC-IRBA.
The European Banking Authority (the "EBA"), on 2 August 2019 in its policy advice in respect of the Basel III reforms suggests that the imposition of the output floor will lead to an increase in banks' capital requirements by an average of 9%. This suggests that, on average, banks are able to use the Internal Models over the SEC-SA approach to get (an average) of a 36.5% lower minimum capital requirement using the Internal Models. The impact of the output floor will also be concentrated on the subset of banks which have the supervisory approval and the internal operational infrastructure to be using the Internal Models, so the increase in RWA for the banks which use the Internal Models may be higher than the 9% which is predicted across the entire EU average. The current EU Banking Package 2021 therefore includes a transitional implementation which starts with a 50% output floor (from 1 January 2023) and, over a period of five years, progressively increases to the 72.5% (from 1 January 2028) minimum required under Basel III.
In the HM Treasury's review of the Securitisation Regulation (Report and call for evidence), published on 13 December 2021, multiple respondents flagged the potentially high impact of the output floor for certain securitisations. HM Treasury noted that the output floor would be examined in the PRA's Basel III consultation which was expected to take place in the second half of 2022, but is now expected in the fourth quarter of 2022. UK Finance, the banks' trade body, has highlighted the level of application of the output floor as one of the key concerns with the new Basel III amendments.
In its targeted consultation on, among other things, the functioning of the EU Securitisation Regulation, the Association for Financial Markets in Europe ("AFME") on 30 September 2021 argued that due to the layering of conservative parameters embedded in the calculation under SEC-SA, the output floor would likely have a disproportionate effect on the treatment of securitisations by bank originators. This was likely due to the fact that the discussions in respect of the output floor during the Basel III 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.
The imposition of the output floor is also expected to affect different asset classes within securitisations differently. This is largely based on the difference between the KSA under the SEC-SA model which a bank may rely on (which is subject to a floor) and the KIRB under the SEC-IRBA model. Where the bank has sufficient information in respect of the underlying exposures, it may be able to apply a risk weight which is significantly below the SEC-SA floor for that particular asset class and, where the magnitude of such difference is higher than 27.5%, may find itself subject to an RWA floor. Banks investing in asset classes which have a higher SEC-SA floor (for example, claims on sovereigns, unsecured loans, claims secured by commercial real estate, or retail loans) may be more incentivised to use the SEC-IRBA model given the potential discount can be much higher. However, the Internal Models' effectiveness in these cases may be limited by the output floor.
In the Basel Committee on Banking Supervision's Basel III Monitoring Report dated December 2021, a sample of 84 banks were asked to submit their risk weights under both Internal Model and the SEC-SA. The average weighting showed that the difference between non-STS SEC-IRBA and SEC-SA was 99.5%, meaning the risk weights under the SEC-SA model were, on average, double the amount under the SEC-IRBA method. This would mean that the output floor would operate to significantly increase the risk-weighting used under the SEC-IRBA model. The position for STS Securitisations was much less, at 67.9%. Although there are risk weight floors, it is important to note that under SEC-IRBA, the internally calculated supervisory parameter "p" is subject to a floor of 0.3 (regardless of whether the securitisation is STS or not). Meanwhile, the STS designation does provide benefits from an SEC-SA perspective (where the supervisory parameter for an STS securitisation is half of that of a traditional securitisation). This means that STS transactions may benefit from a lower SEC-SA and, even though a bank may elect to use the SEC-IRBA method for that particular STS transaction, the fact that the corresponding SEC-SA RWA is lower would result in the output floor being higher.
Impact of the supervisory parameter "p"
Both the Internal Models and the SEC-SA include the application of the supervisory parameter "p" (or the "p-factor"), which is intended to reflect the overall level of capital required for the portion of tranches that reside above the securitisation position which absorb losses up to the amount of capital that would be required if the underlying exposures were held directly by the bank (and not securitised). Under SEC-SA, there is a fixed p-factor of 1.50 (for resecuritisations), 1 (for traditional securitisations) and 0.5 (for STS Securitisations). Under the SEC-IRBA, banks may calculate their own supervisory parameter based on the underlying exposures (as mentioned above, this would require knowledge of the KIRB, or the capital charge for the underlying exposures had they not been securitised as well as information in respect of the number of loans, granularity of the loans and the exposure-weighted average loss-given-default of the pool) subject to a floor of 0.30.
The p-factor imposes a premium capital charge on all securitisations (regardless of seniority, maturity, or any other credit enhancing features of the transaction), and such a surcharge has been questioned by a number of market participants. In particular, it is noted that under the Internal Models, the p-factor floor is the same for traditional and STS Securitisations.
Putting aside the RWA floors in respect of the underlying assets (which are applicable equally to holders of securitisation positions exposed to those assets and banks holding those assets directly), one could argue that there are already alternative correction factors which impose an implicit premium on securitisations (including capital floors set out in the hierarchy of models above, to both senior and non-senior tranches). Whether or not an additional floored adjustment is required in the form of the p-factor to address what the Basel Committee perceived as inherent modelling and agency costs associated with a securitisation, and whether or not such p-factor is appropriately calibrated, remains to be seen. Currently, the p-factor has the effect of locking up additional capital just by virtue of the transaction being a securitisation. Although certain banks have questioned the efficacy and appropriateness of the p-factor, regulators and central banks on the whole did not generally see any reason to diverge from the Basel III framework in this respect. On 7 September 2021, the central banks of the Member States of the EU drafted a joint letter to the European Commission affirming that the EU should incorporate the Basel III framework in a "full, timely and consistent" manner.
What next?
Although the flexibility of the hierarchy of approaches (including the ability to use the Internal Models) is generally welcomed, the introduction of the output floor has brought renewed focus on the SEC-SA approach, which will now become much more prominent given its role in determining the minimum RWA for any securitisation exposure. And certain criticisms of the SEC-SA approach which formerly would have been dispatched by the ability of banks to elect the SEC-IRBA model may now be tabled again, particularly in respect of the tabular approach to different asset classes which does not always take into account certain qualitative features of the assets which decrease the credit risk associated with such positions. The EBA, in its impact study in 2020, concluded that the imposition of the output floor would result in a weighted average 6.7% increase in the minimum capital which banks must hold. This figure will clearly be much higher for the larger institutions which rely more heavily on SEC-IRBA, and may be closer to 0% for medium-sized or smaller banks which regularly use the SEC-SA.
At the time of writing this article, it is not clear how the EU Banking Package 2021 will progress through the EU legislative process, nor the approach of the UK in implementing the Basel III framework (which is expected to be consulted on during the latter half of 2022). However, given the substantive nature of the legislation and a number of impact studies highlighting the potential capital burden on European banks, it is unlikely that implementation will occur before the current Basel III timeline of 1 January 2023, with some further developments and another potential extension possible.
In October 2021, AFME responded to the EU Banking Package 2021, agreeing that banks have significantly strengthened their resilience and ability to stress test their balance sheets since the financial crisis as a result of the capital requirements, but that a number of impact studies have suggested that further increases may have negative repercussions on the larger banks' ability to free up capital to deploy in the economy. It also called for further adjustments to the output floor, which it saw as having material effect on certain asset classes and business lines. This will inevitably focus the attention of the European Parliament when reviewing the EU Banking Package 21.
It is also worth noting that the above introduction of the output floor and the recalibrated risk-weighted assets for securitisation positions are in addition to a number of other capital and liquidity requirements under Basel III, as well as other regulatory considerations such as large exposures, counterparty and market risk to which banks are already subject to. These changes should not be assessed in isolation, but rather holistically in light of banks' other regulatory obligations which are aimed at improving prudential oversight and minimising systemic risk and which have generally been seen to be successful in ensuring banks' resilience is considerably improved from the pre-financial crisis levels.
Conclusion
The securitisation market plays a key role in the financing of the real economy, as well as a number of issues which are becoming more prominent in global regulators' views – such as the environmental, social and governance ("ESG") factors and the transition to the sustainable economy as envisaged under the European Green Deal and the green securitisation framework being developed in the UK.[6]And, unlike the last financial crisis, the general consensus was that banks were in much more robust financial positions following the COVID-19 pandemic and the unprecedented economic shock that arose as a result. This has allowed them to play an important role in re-energising the economy and deploying capital to provide finance in the capital markets. The securitisation market has generally been seen as innovative and capable of being able to accelerate and drive market developments. The introduction of the output floor should be observed contextually with the other capital and prudential obligations of banks, and should be weighed against the creation of a capital charge which may increase the cost of capital for banks to invest in securitisations (therefore have a dampening effect on originators wishing to use securitisation as a means of funding their businesses) and, paradoxically, removing the incentive for banks to commit to additional due diligence of the underlying assets in a securitisation where they feel the output floor caps their preferential capital treatment. Encouraging investors to participate in securitisations and unlocking excess capital may play a pivotal role in achieving some of the more ambitious capital-intensive objectives of regulators.
The finalised Basel III framework, how it is ultimately incorporated across various jurisdictions and the impact this may have on banks' capital requirements may therefore coincide with an important global crossroad on which governments and regulators are seeking to drive the green initiative to help achieve a net zero goal.[7]
We look forward to seeing how things develop with respect to Basel III. In the meantime, if you have any questions, please feel free to get in touch with your usual Hogan Lovells contacts, or one of the contacts listed for this article.
Authored by Tauhid Ijaz and George Kiladze.
References
[1] This is sometimes referred to as "Basel 3.1", as they are amendments to the (original) Basel III agreed in 2010. Because of the magnitude of some of the changes, they have also been referred to as "Basel IV".
[2] There are a number of different institutions which are the subject of various capital and prudential requirements, including (but not limited to) banks, insurance and reinsurance undertakings (predominantly dealt with under the Solvency II framework in Europe) and collective investment undertakings.
[3] There are multiple tiers of eligible capital under Basel (Tier 1, Tier 2 and Tier 3), which broadly govern the quality and liquidity of assets which the bank must hold in respect of its position. Tier 3 capital is being removed under Basel III. In summary, Tier 1 capital refers to the bank's "core capital" such as equity capital which is able to absorb losses on an ongoing basis without the bank having to cease trading. Tier 2 capital refers to the bank's capital which will only absorb losses in the winding up of the bank (such as certain categories of subordinated debt).
[4] The changes under Basel III has seen the removal of a number of different asset classes which can now no longer be subject to the SEC-IRBA, SEC-ERBA or SEC-IAA models, and will need to be calculated based on the SEC-SA or the default (1,250%) approaches.
[5] https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/consultation-paper/2020/cp1420.pdf.
[6] We note that on this point, the EBA has, on 2 May 2022, launched a discussion on the role of environmental risks in the prudential framework.
[7] Although there have been discussions about potential EU green securitisations which (not unlike STS Securitisations) may benefit from a more favourable capital regime, these discussions are currently at their infancy and therefore outside the scope of this article, although we will be actively monitoring this space.
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