Regulations & Current Topic
Regulations
Regulation has a profound impact on CRS. As a relatively young asset class, CRS is still in development and regulation continues to shape the market both directly and indirectly. There is a great variety of legal rules that affect the economic efficiency and structuring of CRS, with significant differences across jurisdictions. This is due to the nature of CRS. As such, it has multiple touch points with regulation.
Firstly, the European Securitisation Regulation (“SECR”) governs CRS directly, as a type of securitisation also known as ‘on-balance-sheet (“OBS”) securitisation’. For example, the SECR includes minimum standards and requirements for the main parties involved in a securitisation transaction, such as the originating bank and the investor. It also created a framework for Simple, Transparent and Standardised (“STS”) securitisation which allows banks to avail additional capital relief for transactions that meet additional STS criteria. Since April 2021, CRS transactions are also eligible for the STS designation. We strongly support this development, as we have been advocating for the inclusion of CRS in the STS framework since 2015.
In the UK, following the enactment of the Financial Services and Markets Act and the publication of a Securitisation Regulations policy note and final draft statutory instrument (2024), the UK envisages for most provisions of the UK SECR to be replaced with the PRA and FCA rules. Both PRA and FCA rules seems to be broadly following the EU securitisation rules, with some targeted adjustments. The STS framework for CRS is, unfortunately, not yet included in the UK SECR.
Secondly, CRS is also a way of credit risk mitigation, thereby allowing banks to achieve capital relief. Capital relief is a key rationale for banks to enter into CRS. Banking regulation, such as the Capital Requirements Regulation (“CRR”), determines the extent to which a bank can gain capital relief and under which conditions. Within the European Union, capital relief is only granted if a bank achieves “Significant Risk Transfer” (“SRT”), in other words when a bank can show that the transaction indeed achieves credit risk mitigation to a significant extent.
In addition, banking regulations stipulate the capital requirements for the underlying credit exposures. The Basel Ill framework and its finalisation, also known as 'Basel IV' or 'Basel III Endgame', is the most recent comprehensive regulation affecting capital requirements for banks' credit exposures, as well as overall capital requirements for the bank. Banking regulation and supervision also govern whether banks are allowed to use internal models for determining capital requirements for its credit exposures, and whether these are appropriately calibrated. Sophisticated and well-calibrated internal models are hugely important for investors in CRS, as these typically allow for a more accurate estimation of potential losses that a given portfolio could experience during the life of the CRS transaction. The Basel rules have not been finalised yet. For more details please see below the Current Topic: "Impact of the implementation of the Basel Ill rules on Internal Models"
Finally, the structuring of a CRS transaction and the activities of banks are impacted by many other regulations, such as accounting and tax regulation. These generally have a far broader scope, however, they may have a noticeable impact on CRS transactions, nonetheless.
Firstly, the European Securitisation Regulation (“SECR”) governs CRS directly, as a type of securitisation also known as ‘on-balance-sheet (“OBS”) securitisation’. For example, the SECR includes minimum standards and requirements for the main parties involved in a securitisation transaction, such as the originating bank and the investor. It also created a framework for Simple, Transparent and Standardised (“STS”) securitisation which allows banks to avail additional capital relief for transactions that meet additional STS criteria. Since April 2021, CRS transactions are also eligible for the STS designation. We strongly support this development, as we have been advocating for the inclusion of CRS in the STS framework since 2015.
In the UK, following the enactment of the Financial Services and Markets Act and the publication of a Securitisation Regulations policy note and final draft statutory instrument (2024), the UK envisages for most provisions of the UK SECR to be replaced with the PRA and FCA rules. Both PRA and FCA rules seems to be broadly following the EU securitisation rules, with some targeted adjustments. The STS framework for CRS is, unfortunately, not yet included in the UK SECR.
Advocacy
As a pension fund asset manager, by our nature we have an investment horizon that stretches decades rather than years or months. Therefore, the long-term viability and sustainability of the CRS market is of the utmost importance to us. We strongly believe that this objective is only achievable if a balance is found between the long-term interests of banks, investors and the regulator.
Because of this conviction, we have since many years become a vocal advocate for harmonisation of practices, appropriate standards for healthy transactions and transparency. We do this through active dialogue with regulators, banks and investors, as any rule or standard will need to meet the objectives of all three. We further contribute to roundtables and consultations and publish our opinions where we believe this adds value.
We hope that by helping to shape standards in this young and promising market, we can continue to create sustainable partnerships in which risk is genuinely shared between the bank and investors.
STS Framework for CRS
In April 2021, under the EU’s Capital Markets Recovery Package (“CMRP”) the framework for STS securitisations, became applicable to CRS transactions, to make it easier for capital markets to support economic recovery from the COVID-19 pandemic. As an adamant supporter of healthy transaction structures, we strongly encouraged this development, and we are keen to continue contributing to improvement of the STS criteria for CRS transactions. We believe that key features of any healthy and sustainable investment class are that it is relatively easy to understand and manage, which is closely aligned with the objectives of STS. In our view, the CRS transactions that we have invested in prior to the implementation of the framework already broadly follow the spirit of STS.
To qualify for the STS designation, CRS transactions need to adhere to a variety of criteria, which fall under one of the three main pillars of the label. For ‘Simple’, this includes, among others, a homogeneity requirement for the underlying asset pool: only one type of exposure, for example corporate loans, is allowed. Under ‘Transparent’, the risk sharing bank has to provide data on historical default and loss performance and independent verification of the eligibility for (a sample of) the underlying exposures is required. An example of the requirements under ‘Standardised’ is a minimum risk retention by risk sharing bank (please find more information and our view on risk alignment here). Finally, several specific criteria for CRS transactions are included, such as which credit events should be included at a minimum.
The current STS standards allow for cash proceeds of STS compliant OBS securitisations to be held on deposit by the risk sharing bank, albeit under conditions. We believe strongly that these cash proceeds should always be collateralised in order to mitigate bank counterparty credit risk. More details on collateralisation of investment notional can be found here.
The first year of STS for Credit Risk Sharing has shown that the framework adds positive momentum to the development of this market. The framework has led established issuers to adapt their transactions to meet the STS criteria and has stimulated new issuers to enter the market. Up to Q4 2023, we have invested € 2.1billion in 13 STS-qualifying transactions, with a total underlying loan notional of € 39 billion with banks across the European continent. Indeed, virtually all CRS transactions we see being issued by EU banks since the implementation of the STS framework aim to achieve the STS certification. The first year of the STS framework for CRS has been promising and we expect this trend to continue. Please see our blog “STS for Credit Risk Sharing is proving a success”.
Current topic – impact of the implementation of Basel III rules on Internal Models
Although already published in December 2017, the final package of Basel III reforms has not been fully implemented yet. There are several aspects of these reforms that affect how banks’ capital is calculated hence Basel III also impacts Credit Risk Sharing. One effect of the implementation of Basel reforms on CRS is that it lowers the benefit for banks to develop and maintain sophisticated internal models. The recent proposals for the application of the Basel III standard in the UK and in the US include strict restrictions on the use of internal models. While the UK PRA considers limiting the application of IRBA, the US regulators went a step further and put forward a complete removal of internal models. This is worrying for us as an investor in CRS.
Advanced models, such as the internal models developed under Basel IRBA, are crucial for the proper understanding of the risk of a credit portfolio. These models allow banks to calculate, among others, the probability of default (“PD”), loss given default (”LGD”) and exposure-at-default (“EAD”) levels which are essential for understanding the risk of a credit portfolio. Thus, they enable banks, and therewith investors in the credit risk originated by these banks, to have the best grasp of risks in the portfolio.
The restrictions on using internal models for credit risk capital requirements do not contribute to the goals of the Basel standards. We strongly support the use of internal models, because under this approach banks are incentivised to model, monitor and manage risk factors, constituting the expected loss profile of exposures on their balance sheets in a holistic and comprehensive way. By permitting banks to apply modelled PD, LGD and EAD metrics, as foreseen under the advanced internal ratings based approach, banks are incentivised to develop and maintain robust models for these metrics. Under the new proposals in the US, none of these metrics would be modelled as they’re replaced by fixed risk weights. In the UK, only PD would still be estimated using internal models, while LGD and EAD are prescribed. Consequently, less attention will be paid to modelling the factors which determine expected losses. The loss of time spent on modelling expected losses will reduce the overall quality of risk management and can potentially adversely impact credit underwriting standards and decisions.
As an investor in 'no-name' pools, we highly value precise and granular risk metrics developed by banks and access to the historical data to calibrate the models. In a 'no-name' pool transaction, a bank’s assessment of the risk profile of the borrowers, typically captured by an internal rating and modelled LGD, are key data points for analysing and monitoring the risk profile of the portfolios we are protecting. These metrics are subject to a thorough due diligence process, in which we analyse the historical track record of these metrics through-the-cycle in combination with a qualitative overlay on the bank’s origination and risk management organisation in order to come to a view on expected losses in various economic scenarios. As mentioned above, the restriction on the use of internal models will have a negative impact on the development of these valuable data points and therewith the ability for investors to properly assess the risk profile of underlying portfolios in CRS transactions.
In addition, the disapplication of internal models may impact the underwriting decisions of banks, which may be incentivised to pursue business with a higher risk profile. If a more prudent approach does not lead to a decrease in RWA consumption and therewith does not result in a higher return on capital, banks may be less rigorous in debt sizing and loan structuring. This would be an issue in itself, but it would also impact investors because the degree of uncertainty about the underwriting and risk management practices of banks would increase. Furthermore, it would invoke uncertainty about the representativeness of historical track record data, which were realised under a different capital regime with different incentives.
Finally, developing and maintaining sophisticated internal models requires a significant investment by the banks. By limiting the capital benefit of these models, it becomes harder for banks to justify the cost of continued model development and maintenance to shareholders. This may have an overall negative impact on the risk management practices at a bank, but also on the ability of issuing CRS transactions. Please see as well our blog “Embrace internal models diversity”
Questions?
For questions please contact Mascha Canio.
