(TPCOM, CC BY-NC-ND)
Securitization is a technique in the financial market that allows converting illiquid assets (usually uncollectible receivables) into transferable securities. The European Commission (EC) believes that regulation prevents much-needed investment in the real economy at a time when the European Union (EU) is facing a serious economic crisis. Banks can use the freed capital to direct the flow of funds to sectors that need loans the most. But if the tool of securitization is in the wrong hands it can have catastrophic impact, which had been seen in the subprime mortgage crisis. The financial system of the US leads in the innovation, growth and use of securitization structures.
Efforts to relaunch the EU securitization market to improve the financing of the EU economy are among the main components of the Capital Markets Union. Till now, two legislative proposals introducing new rules on securitization are included: Regulation on simple, transparent and standardized (STS) securitization, and Decree amending the Decree on Capital Requirements. In May 2020, the Council and the European Parliament reached a political agreement on both proposals. The final version of the regulations will be adopted after the texts are finalized at a technical level.
These two regulations establish common rules for all securitizations and create a framework for safe, simple, transparent, standardized securitization products that are adequately supervised. This will help distinguishing them from more complex and risky financial instruments. The new rules will allow investors to assess the risks associated with securitization, within and between products. This should help create new investment opportunities across the EU and provide an additional source of financing in the economy, especially for SMEs and start-ups. Estimates show that securitization in the EU would produce between EUR100bn and EUR150bn in additional funding. Therefore, securitization, when properly structured, can improve the efficiency and stability of the financial system, provide investment opportunities, and create benefits for businesses and citizens with cheaper and more affordable loans.
According to the EC proposal, securitization covers transactions that allow a lender — usually a credit institution or a company — to refinance expensive loans, exposures or receivables, such as housing loans, car leasing loans, consumer loans, credit cards; or trade receivables by converting them into traded securities. Securitization aims to diversify sources of financing, distribute risks across the financial sector and provide additional sources of financing that are less dependent on the banking sector. From the perspective of the initiators and original lenders, securitization is an effective mechanism for transferring illiquid assets to a separate company (SPV) which, among other things, cleans the balance sheet, improves credit ratings and reduces financing. A cleaner balance sheet very often allows a reduction in the number of capital reserves (which are sometimes required), thus allowing that capital to be used for other purposes. Finally, securitization transfers the risk of possible inability to collect illiquid receivables to investors and currently secures a certain amount of capital raised through the placement of securities. Investors are attracted by securitization due to the separation of a SPV from mother company, which in case of bankruptcy of the initiator or the original lender is not part of its bankruptcy estate.
In order for a transaction to fall under the notion of securitization within the meaning of the Regulation (EU) 2017/2402 (which relates primarily to secure, transparent and standardized (STS) securitization) to meet the prescribed definition requiring it to be a “transaction or scheme in which credit risk is linked to an exposure or set of exposures tranched” — as described in Article 2 of the Regulation, the following conditions are set:
- Dependency — payment must depend on the success of the exposure (more simply, collection of the security will be possible only in case of successful collection of the claim to which the security is linked);
- Subordination — placed tranches must be in a relationship of superiority — subordination (not a pair of strands) and such their relationship must affect the distribution of losses during the transaction;
- Risk element — the transaction must not create an exposure characteristic of that referred to in Article 147 (8) of Regulation 575/2013.
These criteria in practice can sometimes create problems in their interpretation, and especially the first two. First of all, the Regulation nowhere defines the concept of dependence. In the absence of a clear definition, and some stakeholders believe that the term should be interpreted as taking security (tradeable financial asset) issued in a securitization transaction as a risky business — it is questionable whether the investor will be able to collect the security at all and, if so then when. The collection of the security is linked to the life cycle of the securitized receivable and the success of the collection directly depends on whether the collection of that receivable will bring enough money for payment. To further strengthen the dependency, investor claims are not secured. Variants in which the payment on the security, for example, is linked to a fixed date or gives the investor the right to sue the issuer for default, would not be considered dependent and therefore would not be covered by the notion of securitization within the meaning of the Regulation.
When it comes to subordination elements, special attention should be paid to the definition of a tranche under the Regulation (“a verbally determining credit risk segment associated with an exposure or set of exposures (…)” — Article 2 of the Regulation), according to which the tranche must be a contract segment. Thus, even if there was a relationship of superiority — the subordination of certain tranches within the transaction, and if this relationship was not contractually foreseen (i.e. explicitly and in writing agreed) and regulated, then this condition could not be considered fulfilled and the transaction would not be covered by the Regulation.
The Regulation, above all, aims to regulate the legal framework for STS securitizations, for which, in addition to the generally applicable criteria, it prescribes additional conditions that may vary depending on the further specific characteristics of each transaction. The additional conditions are based on the above general ones, which, as a rule, only expand by imposing additional obligations on the participants. Also, ESMA (European Securities and Capital Markets Authority) should be notified of all STS transactions which are then recorded in an appropriate repository established at EU level. The initiator, sponsor or SPV must also determine compliance with the additional requirements related to STS securitizations. In doing so, they may use the services of a third party authorized for such transactions following the Regulation.
Undoubtedly, securitization is an effective mechanism for managing illiquid receivables and allows holders of such receivables to create capital based on them. The amendments made by the end of July are intended to facilitate securitization during Europe’s recovery from the crisis caused by the pandemic by allowing banks to expand their lending and clear their balance sheets of non-performing exposures. Banks should be allowed to transfer part of their SME lending risk to markets, so that they can continue to credit them. The EC also proposes a specific framework for simple, transparent and standardized balance sheet securitization to which prudential treatment that reflects the real riskiness of these instruments is applied. The EC also proposes to remove existing regulatory barriers to the securitization of non-performing exposures. This would allow banks to deal with non-performing exposures that could be expected to grow due to the COVID-19 crisis. Changes are the result of extensive work and analysis by the European Banking Authority since 2019.