Reform of the EU Securitisation Framework—Part 7: Changes to the SRT Framework

Background

Under Regulation (EU) 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions ("CRR"), Articles 244 and 245 establish the framework for recognising SRT in securitisation transactions. These provisions set out the conditions under which originator institutions may obtain capital relief, subject to assessment by the relevant competent authority, by demonstrating that a material portion of credit risk associated with the securitised exposures has been transferred to third parties. Specifically, Article 244 addresses the requirements for traditional securitisations, while Article 245 provides those for synthetic securitisations. 

Under these provisions, an originating institution may apply reduced capital requirements to the transferred exposures where it meets one of the following quantitative tests:

• The "mezzanine test": The originator retains no more than 50% of the risk-weighted exposure amounts of all mezzanine tranches; or
• The "first loss test": If no mezzanine tranche exists, the originator retains no more than 20% of the exposure value of the first loss tranche and the originator can demonstrate that such exposure value exceeds a reasoned estimate of the expected loss "by a substantial margin", in addition to also satisfying certain structural requirements to ensure effective transfer and complying with the other requirements for securitisations generally (e.g., with respect to risk retention).

However, despite its quantitative approach, the current framework provides competent authorities with significant discretion. An originator's competent authority is entitled to block capital relief where it decides, on a case-by-case basis, that the resulting capital relief is not commensurate with the risk transfer (notwithstanding that one of the above tests is satisfied). Conversely, even if neither of the mechanical tests is satisfied, a competent authority is entitled in certain circumstances to permit capital relief where it determines relief is commensurate with the risk transfer (the "permission-based approach"). 

Market participants have highlighted that this approach presents several obstacles to the smooth and effective functioning of the securitisation market and have advocated for the framework to be applied in a more transparent, consistent and efficient manner. In its report of 23 November 2020, the European Banking Authority ("EBA") made several recommendations to the European Commission on harmonising SRT assessment practices and processes, and also suggested simplifying and improving the SRT tests set out in Articles 244 and 245 of the CRR. The Commission subsequently gathered industry feedback on selected aspects of the EBA SRT report through a consultation, and these concerns were reiterated in the Commission's Report. In light of the EBA recommendations and industry feedback, the Commission is currently considering changes to Articles 244 and 245 of the CRR, with the aim of further harmonising the SRT framework while improving transparency and efficiency for market participants.

The Proposals

1. Replacement of the mechanical SRT tests by a principle-based approach. The Commission proposes to replace the existing mechanical tests under Articles 244 and 245 of the CRR with a single, principles-based approach ("PBA"). This new approach requires originators to demonstrate—through a self-assessment supported by cash-flow modelling—that at least 50% of the unexpected losses of the securitised portfolio are irrevocably transferred to third parties. 

2. Introduction of a self-assessment and cash-flow modelling obligation for originators. One of the key innovations of the Commission's proposals is the mandatory self-assessment that originators must submit to their competent authority at the time of origination. The self-assessment must:

• Evidence that SRT is achieved under both baseline and severe stress conditions over the entire life of the transaction;
• Include a cash-flow model that allocates lifetime expected losses and unexpected losses to the individual tranches and demonstrates the sustainability of the risk transfer; and 
• Quantify the capital relief generated, so supervisors can gauge whether complex or innovative structures produce disproportionate reductions in own-funds requirements.

3. Deletion of the mezzanine definition and amendment of the senior definition. The Commission also proposes to delete the definition of mezzanine securitisation positions—which is now redundant following the removal of the mechanical tests—and to amend the definition of senior securitisation positions to clarify that a senior tranche must attach above K_IRB/K_A (i.e., the ratio used to assess the extent to which a party is transferring credit risk when it engages in securitization transactions). 

4. Removal of the permission-based approach. The Commission further proposes to abolish the seldom-used permission-based approach, under which competent authorities may grant SRT recognition on a case-by-case basis to transfers that do not otherwise meet the quantitative thresholds.

5. Establishment of a fast-track supervisory assessment process. To balance the more granular demands imposed on complex securitisations, the Commission has proposed a simplified, fast-track review process for straightforward transactions that clearly satisfy the PBA. 

6. Forthcoming regulatory technical standards. Going forward, supervisory assessments will instead be harmonised and standardised through forthcoming regulatory technical standards ("RTSs"). These RTSs will also provide further detail on the technical requirements for the self-assessment, the standards for cash-flow modelling and the conditions for a fast-track process to be applied to straightforward transactions.

Analysis of the Proposed Changes

The Commission's proposal to replace the two mechanical SRT tests with a single PBA aligns with the EBA's March 2022 recommendations. By focusing on the economic substance of risk transfer, rather than prescriptive quantitative thresholds, the PBA is expected to remedy long-standing concerns of both supervisors and market participants that the existing rules are overly rigid and not always reflective of the true distribution of risk. 

Further, the proposed changes align with the Commission's broader goal of increasing regulatory convergence and predictability. The existing approach—despite employing quantitative tests—affords domestic authorities with substantial discretion to grant or withhold SRT recognition, which can result in a fragmented approach across the market.

The new self-assessment required of originators should provide for a more standardised analysis, enhancing supervisory consistency while giving originators greater transparency and predictability ex ante. Likewise, deletion of the seldom-used permissions-based approach means that domestic supervisory clearance would no longer substitute for meeting objective SRT standards. Together, these changes seem likely to reduce divergence and provide SRT outcomes that are more model-driven and portable across jurisdictions, without removing necessary prudential guardrails.

At the same time, despite introducing greater harmonization at EU level, the proposals explicitly preserves the discretion of competent authorities to conduct a comprehensive review where transactions involve complex or innovative features (and either block SRT recognition entirely, or condition it on satisfaction of increased unexpected loss thresholds). The forthcoming RTSs are expected to: (i) set out detailed conditions under which authorities may invoke that broader review; (ii) specify technical standards for the self-assessment and cash-flow modelling (including methodologies for allocating expected losses and unexpected losses); and (iii) address structural features that could undermine genuine risk transfer. 

Taken together, these measures aim to deliver a more risk-sensitive, transparent and efficient SRT framework, providing legal certainty for originators while safeguarding prudential soundness.

Looking Ahead

The Commission's proposed amendments have been submitted to the European Parliament and the Council of the EU for review and approval. Changes to the current draft amendments should be expected as part of the legislative negotiation process, though it is unclear at the present stage how extensive such changes may be. There is no defined timeline for the process, though it is expected to be at least 18-24 months before the proposals would become law. The proposed amendments also give rise to certain practical issues, which might challenge the success of the legislative proposals. 

Further, it is unclear whether the United Kingdom will seek to minimise regulatory divergence by adopting similar changes to its "on-shored" version of the EU regime. Market participants are advised to conduct a thorough legal analysis of the evolving regulatory landscape, including the interplay between EU and UK regimes, to ensure compliance and to capitalise on new investment opportunities that may arise from a harmonised or divergent approach.

Sneak preview: In part eight of this series, we will look at the Commission's proposed changes to certain STS requirements.