Reform of the EU Securitisation Framework—Part 8: Changes to Certain STS Requirements

Background

The current Regulation (EU) 2017/2402 of the European Parliament and of the Council creating also a specific framework for simple, transparent and standardised securitisations (the "EU STS Regulation") includes a number of requirements that securitisations must meet in order to qualify for the STS label, including, inter alia, the following:

1. Pool homogeneity. All non-ABCP, ABCP and on-balance-sheet securitisations must meet the "pool homogeneity" requirement in order to qualify for the STS label (pursuant to Articles 20(8), 24(15) and 26b(8), respectively, of the EU STS Regulation). Under this requirement, STS securitisations must be backed by a pool of underlying exposures that: (i) are homogeneous in terms of asset type, taking into account the specific characteristics relating to the cash flows of the asset type including their contractual, credit-risk and prepayment characteristics; and (ii) comprise only one asset type. This means that—under the current framework—a securitisation of SME loans (for example) must be backed by an underlying pool consisting solely of SME loans in order to qualify as an STS securitisation. 

2. Active management. In addition to being sufficiently homogeneous, the underlying exposures of an STS securitisation are not permitted to be actively managed on a discretionary basis (Articles 20(7), 24(7) and 26b(7) of the EU STS Regulation). Rather, any changes to their underlying exposures must meet predetermined, clear and documented eligibility criteria, ensuring investors can assess the credit risk of the underlying asset pool prior to investment. With respect to on-balance-sheet securitisations specifically, Article 26b(7) sets out an exhaustive list of permitted actions, which are not considered "active portfolio management on a discretionary basis" for these purposes. Specifically, an originator of an on-balance-sheet securitisation is permitted to remove—without breaching the active portfolio management prohibition—underlying exposures that:

• Have been fully repaid or matured otherwise; 
• Have been disposed of during the ordinary course of business of the originator, provided that such disposal does not constitute "implicit support" to the securitisation; 
• Are subject to an amendment that is not credit driven, such as refinancing or restructuring of debt, and which occurs during the ordinary course of servicing of that underlying exposure; or 
• Did not meet the eligibility criteria at the time they were included in the securitisation.

3. Funded credit protection. Finally, as more fully discussed in the first article in this series, the current STS criteria for on-balance-sheet synthetic securitisations requires credit protection to be funded (Article 26e(8) of the EU STS Regulation).

The Proposals

1. Introduction of a new pool homogeneity threshold for mixed pools with a predominant SME component. In order to support SMEs' access to finance, the Commission has proposed to reduce the threshold for pool homogeneity with respect to pools that consist predominantly of SME loans. Specifically, under the proposals, a pool of underlying exposures would be deemed to be homogenous for STS purposes where at least 70% of the exposures at origination consists of exposures to SMEs (currently the requirement is 100%). The remaining portion of the pool could include other types of exposures—including across different Member States—without affecting the transaction's STS status.

2. Further carve-outs to the "active management" prohibition with respect to on-balance-sheet securitisations. As noted above, active portfolio management on a discretionary basis is not permitted under the STS criteria, but certain permitted actions are explicitly carved out of the prohibition for on-balance-sheet securitisations. The Commission has proposed to expand the list of permitted actions that would not count as "active management." Specifically, originators would now be allowed to remove exposures if:

• The borrower (or related entity) becomes subject to EU sanctions or has engaged in proven fraudulent practices; or
• A change in national law makes the exposure legally unenforceable.

3. Unfunded credit protection eligible for STS on-balance-sheet synthetic securitisations. Finally, as more fully discussed in the first article in this series, the Commission has proposed to amend the STS eligibility criteria so that unfunded credit protection can qualify for the STS label, subject to certain requirements relating to diversification, solvency, risk measurement and minimum size of the protection provider.

Analysis of the Proposed Changes

The introduction of a reduced pool homogeneity threshold for securitisations backed by SME loans is likely to be a welcome development for market participants. The pool homogeneity requirement is intended to promote simplicity—allowing investors to understand the risks of their investment without having to analyse a highly mixed pool. However, the current requirements are widely seen as an obstacle to SME securitisations because banks often originate mixed portfolios that include both SME loans and other asset types. This change could make it easier for banks to bring SME securitisations to market under the STS label because they no longer need a "pure" SME portfolio. Given that SME lending is often blended with other products (such as small commercial real estate loans), the amendment should support more issuance, potentially broadening investor access to this part of the economy and improving SMEs' access to finance.

However, it is important to note that the 30% "non-SME" portion of a pool could still contain quite different types of assets, which might complicate the risk profile for investors. If not handled carefully, investors may find it harder to assess the overall pool. Supervisors and third-party verifiers are therefore likely to expect clear disclosures around the contents of the non-SME portion of the pool and an explanation of why the pool as a whole can still be considered broadly similar. In practice, originators may be expected to set out transparent selection criteria and show how the different exposures behave in line with the SME portion to avoid undermining the intended simplicity of STS securitisations.

The Commission's clarificatory amendments to the "active management" prohibition increase originators' flexibility to deal with certain unexpected events without jeopardising a securitisation's STS status. These changes are also likely to be welcomed by investors, since they enable the removal of exposures that investors would generally not want to remain in a pool: namely, exposures rendered unenforceable due to a change in law, and those for whom the relevant borrower has become subject to EU sanctions or has been discovered to have engaged in fraud. Under the current rules, making such adjustments could risk being treated as "active management" and therefore disqualify the securitisation from STS treatment. 

The revised approach seems to strike a better balance, maintaining the core requirement that STS securitisations not be actively managed in a discretionary manner, while recognising that certain removals are necessary. That said, there will still need to be robust governance and documentation around how these events are identified and acted upon. For example, what counts as "proven fraud" will need clear criteria, and originators will likely be expected to maintain an audit trail demonstrating that removals were triggered only by these specific events, rather than broader portfolio management motives. Overall, this change should give investors greater confidence that their exposures will remain predictable, while also being protected against obvious outliers, such as fraudulent or unenforceable loans.

In short, the Commission's amendments aim to make STS securitisations both more practical (by easing the homogeneity test for SME pools) and more resilient (by clarifying further examples of necessary removals that should not amount to active management). The success of these reforms will depend on how clearly originators document and explain their pool composition and removal decisions, so that transparency—the foundation of STS—is not undermined.

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 nine of this series, we will look at the Commission's proposed changes to the capital requirements.