3. Comparison of Key Issues
3.1 Output Floor
(a) Substantive implementation
Both the CRR3 and the Discussion Paper implement materially all elements of the output floor set out in the Basel III framework.
The CRR3 proposes to amend Article 92 of the CRR to incorporate the output floor. Institutions will be required to calculate the total risk exposure amount ("TREA") as follows:
TREA=max{TREAU;m x TREAS}
where TREAU is the RWA of an asset under the internal model (if applicable), and TREAS being the RWA of the same asset under the standardized approach. The "m" modifier is the output floor of 72.5%, essentially flooring the minimum RWA at 72.5% of the RWAs under the standardized approach (ie. the RWA of an asset under the internal model cannot be less than 72.5% of the RWA of the same asset under the standardized approach). This is expected to lead to a substantial increase in the minimum capital requirements for banks, as even in scenarios where banks calculated low RWAs under internal models for portfolios with historically low delinquencies and defaults, the impact of m x TREAS would mean that they would be required to hold an artificially higher amount of capital for the same position.
The Discussion Paper similarly expects to implement the 72.5% output floor.
(b) Timing
Both the UK and the EU have accepted a phased implementation of the output floor, with the only expected difference being that UK banks will have a 4.5 year period for the entire transitional phase (given the UK's legislative proposal is expected to come into force 6 months after the EU).
As a result, to avoid the cliff effects, the CRR3 and the Discussion Paper propose the following transitional implementation:
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50%
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EU: 1 January 2025 – 31 December 2025
UK: 1 July 2025 – 31 December 2025
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55%
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1 January 2026 – 31 December 2026
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60%
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1 January 2027 – 31 December 2027
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65%
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1 January 2028 – 31 December 2028
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70%
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1 January 2029 – 31 December 2029
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72.5%
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1 January 2030 onwards (the final position)
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3.2 Securitization capital surcharge (supervisory parameter "p")
(a) General Application
The supervisory parameter "p", a variable input in the capital calculations seen as a premium charge payable for securitization transactions plays a significant impact in the calculation of Securitization RWAs. The parameter is a non-neutrality correction factor intended to reflect the embedded modelling costs (i.e. that the credit and/or the cashflow modelling in a securitization is deficient) and agency costs (i.e. that the information asymmetry and interests of the investors and the originator are not aligned) associated with securitizing assets (which are in excess to the un-securitized equivalent of the Pool RWAs). The supervisory parameter is incorporated in addition to any credit risk mitigants which may be applied at an asset-level (for example, low delinquency rates on a safe asset), and therefore acts as a capital premium against securitizing a particular asset (or being exposed to the securitization position created by such asset).
The capital surcharge is calculated using an exponential decay function and by deriving the area (determined as the interpolation between the tranche attachment and detachment points) under the curve, with the supervisory parameter p being layered into the inputs as a denominator to determine the decay rate (meaning it is inversely proportional to the rates at which the Securitisation RWAs increase). The imposition of the parameter therefore slows down the decay rate (i.e. the rate at which Securitization RWAs decrease as you move up the seniority in a securitization position).
The industry had recommended a slight relaxation of the supervisory parameter, arguing that the modelling and agency risks which the parameter is intended to address is more limited than the impact of the parameter suggests. Industry participants have recommended halving the supervisory parameter for SEC-SA and lowering the floor for SEC-IRBA to 0.1 (for STS) and 0.25 (for non-STS). This may be particularly beneficial for SRT originators: IRB Banks will have the requisite information to calculate the inputs required for the SEC-IRBA and may benefit from a lower capital floor and a lower RWA calculation under SEC-IRBA, and even SA Banks will benefit from preferential treatment for the retained tranches.
(b) EU Approach
Under CRR3, the minimum p for SEC-IRBA is set at 0.3 (regardless of whether the transaction is STS compliant or not). The p for SEC-SA is a fixed 1 for traditional securitizations and 0.5 for STS securitizations – this is notwithstanding the standard capital charge (KSA) of the underlying exposures and/or any credit enhancement through the attachment (i.e. the point at which a tranche starts absorbing losses) and detachment points (the point at which a tranche is completely wiped out), so the equivalent p (1 or 0.5) will now apply to all SA Banks holding positions in a securitization, regardless of the seniority of the notes they hold. This arbitrary addition of the relatively rigid parameter for the SEC-SA approach now has the dual negative effect of not only making it more expensive for SA Banks, but also for IRB Banks which are now caught in the crosshairs through the application of the output floor locking in higher TREAS.
The EU has seemingly acknowledged the market concerns somewhat by the addition of Article 506ca to the CRR3, which requires the EBA (in collaboration with the European Securities and Markets Authority ("ESMA")), by 31 December 2026, to report to the European Commission on the prudential treatment of securitization positions, and in particular differentiating for synthetic securitizations and where significant risk transfer has been achieved. Article 506ca also expressly allows the EBA to consider a downward recalibration of the non-neutrality factor for SRT Transactions depending on evidence. The European Commission would then be required to submit a legislative proposal by 31 December 2027 (although this would have to take into account "internationally agreed standards developed by [the Basel Committee]").
(c) UK Approach
The Discussion Paper has, however, gone further than the CRR3 in outlining potential options for recalibrating the supervisory parameter on a more permanent basis (this is somewhat alluded to in Article 506ca of the CRR3 which requires a report by the EBA on potential prudential treatment of synthetic securitizations, but the implementation timing is expected to be no earlier than 2028). The Discussion Paper outlines three potential options:
(i) Option 1: implementation of the output floor as is (i.e. no changes to supervisory parameter);
(ii) Option 2: implementation of the output floor with targeted and data-based adjustments, including to the supervisory parameter; or
(iii) Option 3: implementation of carve-outs from (or other qualifications to) some or all securitization exposures.
Option 1, whilst aligning with the current proposals, is acknowledged by the PRA to be constraining for firms subject to the output floor and queries whether it adversely affects UK bank SRT originators, is proportionate and advances the PRA’s objectives to achieve competitiveness and growth.
Option 2 would seem to be a more permanent variation of the EU CRR3's transitional output floor relief for supervisory parameters and is seen by the PRA as being a persuasive alternative to Option 1 as benefiting PRA firms and facilitating SRT transactions; however, whilst advancing the PRA’s objectives it does not align entirely with the Basel framework. The PRA analysis suggests that there is scope to reduce the supervisory parameter for SEC-SA, although there was reluctance to significantly reduce it so as to create parity with STS and non-STS positions (which the PRA wants to avoid). The PRA also considers having a risk-based approach to calculating the supervisory parameter, where different factors and structural features of a securitization could result in a different supervisory parameter. This is currently not the case for SEC-SA, and would address one of the biggest issues with the imposition of a one-size-fits-all surcharge on all SEC-SA positions. It would also mean that senior tranches of SRT Transactions could get more favorable treatment under the output floor where they could demonstrate they meet some of the criteria (which could be based on variables such as delinquency rates and pool granularity) as a result of their deep knowledge of the underlying assets in question.
Option 3 seems to go much further than the current CRR3 approach and is most in line with feedback from the industry suggesting the creation of "resilient" securitizations which would grant capital relief to, among other "safe" securitizations, senior retained tranche of SRT Transactions. Although the PRA invited feedback on Option 3, they have made clear that it raises prudential concerns, is not in line with Basel standards and they are currently not minded to adopt this approach. It remains to be seen what the feedback to this will be, although it is possible that market participants will focus their feedback on optimizing the non-neutrality factor under Option 2.
3.3 STS treatment for synthetic securitizations
The EU had already extended STS treatment to synthetic securitizations through Regulation EU 2021/668 and Regulation EU 2021/558 (which amended the EU Securitisation Regulation and CRR, respectively). The PRA has in the past cast doubt on whether the STS label should be extended to synthetic securitizations. This effectively means that such trades would be excluded from the beneficial capital treatment available to STS "true sale" securitizations. It is not entirely clear why this approach has been adopted, as there has been significant positive evidence from the EU of the benefit this has provided to SA banks (in respect of which the STS label remains the key regulatory capital relief they are able to rely on, given their inability to use SEC-IRBA).
Although the EU's adoption of the STS label for SRT Transactions goes beyond the scope of the Basel III framework (which does not extend the so-called "STC" (the Basel equivalent of "STS") designation to synthetic securitizations), the general view has been that this was an acceptable deviation and within the general principles of the framework.
The PRA has stated that it remains unconvinced of the real economy benefits of SRT Transactions and is minded not to extend STS treatment to synthetic securitizations. It has also noted the bespoke nature of SRT transactions and questioned to what extent complex structural features could be streamlined into a "standardized" securitization. An obvious argument against this line of reasoning is that the STS rules never intended to standardize every aspect of a securitization – that would have a dampening effect on innovation. The rules on standardization simply require certain features – those which are deemed by regulators to be most crucial to investors – be aligned, and this is in line with the EU approach (with the STS rules for SRT transactions being more numerous and comprehensive than the true sale securitizations).
In the context of evidence for tangible benefits, it is hoped that industry feedback would be able to evidence the real economy benefits of SRT and that UK securitization is enormously disadvantaged by this limitation. One of two ways in which this can be done include (i) the ability for banks to remain in capital-intensive markets and therefore continue originating financing to the real economy (as a result of the more favorable capital treatment available to them) and (ii) the excess capital which may be unlocked as a result of SRT Transactions which can be used to either originate further reference obligations in respect of an SRT Transaction or be targeted at other product lines of the bank. In a joint response, on 30 October 2023, to the consultations on draft securitization rules published by the PRA and the Financial Conduct Authority, AFME, UK Finance and CREFC Europe supported the extension of the STS framework for synthetic securitizations.[2]
3.4 Impact on significant risk transfer securitizations
Both the EU and the UK have acknowledged the unique position of significant risk transfer securitizations (predominantly in the form of synthetic securitizations) in the capital requirements discussions. SRT Transactions are frequently used by banks as an effective capital management tool to ensure that credit risk is transferred to an investor and/or a guarantor (which itself may not be subject to capital requirements). This has been seen by a number of regulators as a prudentially advantageous position to ensure that banks are able to manage their risk without having to liquidate and/or exit capital-intensive product lines. Unfortunately, one of the common structures of SRT Transactions involves the originating bank retaining a thick senior tranche position which, although in theory could have a relatively low RWA if using the SEC-IRBA approach (given the higher amount of principal losses which need to accrue before the senior tranche starts absorbing losses, being determined by the tranche attachment and detachment points), the imposition of the output floor would mean that the originating bank may be subject to holding a significantly higher amount of capital as a result of the SEC-SA floor. This is even in scenarios where such originating bank may have significant knowledge of the reference portfolio in question, and may have a substantial amount of historic data (including delinquencies) which would allow them to properly assess the actual credit risk under the SEC-IRBA approach. Even though the output floor is applied at a consolidated aggregated level across the entire portfolio, evidence in the Basel and EBA monitoring reports suggests that there will be material increases in RWAs for SRT Transactions. The Discussion Paper has asked for feedback from industry participants in respect of the perceived costs and benefits for SRT Transactions.
The PRA has acknowledged the difficulties with the imposition of the output floor and invites feedback in respect of a (potentially) permanent recalibration of the output floor. The PRA has also gone further than the CRR3 on the recalibration of the supervisory parameter (including in the context of SRT Transactions) by suggesting potential avenues where a more proportionate and potentially risk-adjusted non-neutrality factor could be applied. This goes beyond the CRR3 approach, which has only offered a temporary transitional relief for now.
3.5 Securitization hierarchy of methods
The current hierarchy for calculating RWAs in a securitization position under Basel III are:
(a) SEC-IRBA for a pool which is eligible for internal-rating (an "IRB Pool"); or (if not possible)
(b) SEC-ERBA (provided this meets the jurisdiction and external credit assessment requirements); or (if not possible)
(c) SEC-IAA (for unrated securitization exposures to a pool which is not eligible for internal-rating (an "SA Pool"); or (if not possible)
(d) SEC-SA; or (if not possible)
(e) a risk-weighting of 1,250% (i.e. the maximum RWA under Basel III).
The EU position, as onshored in the UK, broadly elevated limb (d) as a new limb (b) (i.e. the second ranking item), with a number of exceptions set out where the hierarchy would revert to the default Basel III standard. The Discussion Paper proposed reverting to the existing Basel III framework at all times for the hierarchy.
There are a number of embedded parameters in SEC-ERBA which could create issues in these circumstances, particularly where no ratings are obtained or are available for a particular transaction, or where the maturity exceeds the permitted 5-year maturity under the SEC-ERBA model (thereby leading to an increased capital allocation compared to what could have been achieved under SEC-SA).
4. Next steps
Market participants may continue submitting feedback in respect of the Discussion Paper until (subject to any extensions) 31 January 2024. The PRA then intends to publish a consultation paper in H2 2024 on draft rules to replace relevant firm-facing requirements in the securitization chapter of the CRR, once HM Treasury takes steps to effect the repeal of the securitization chapter. We expect that industry participants will be keen to respond both the Discussion Paper and the future consultation to try to secure much needed improvements to the current framework. In the meantime, there are not expected to be substantial changes (if any) to the final legislative text of the CRR3.
5. Final thoughts
Although it remains to be seen what the ultimate feedback and updated PRA position will be, it seems like the PRA has taken on board a number of industry criticisms and feedback which were raised in the context of the CRR3. This may be positively received by UK banks, which may have hoped that the PRA would use the divergence from the EU post-Brexit as a platform to increase the competitiveness of UK banks by removing and/or recalibrating unnecessarily punitive capital parameters.
Allowing for the possibility of a permanent recalibration of the output floor and a more proportionate and potentially risk-adjusted non-neutrality factor gives some room for optimism. Hopefully this should pave the way for SRT market participants to provide further evidence of the important role of such transactions and to argue for a proportionate regime which encourages the re-deployment of capital through SRT Transactions. This also shows a clear departure by the UK from the EU position, which has largely delayed the Pillar 1 re-calibration discussion by interposing a temporary transitional relief on the application of supervisory parameter in the context of the output floor.
Regrettably, the PRA has not moved on its earlier statements on the application of STS treatment for synthetic securitizations. The STS treatment has the advantage of significantly reducing the supervisory parameter under SEC-SA and therefore allowing banks using SA to really participate in the SRT space. Not extending this treatment has the dual negative consequence that SA banks may be discouraged from entering into SRT Transactions, but also that IRB banks may be impacted with an artificially higher output floor (given the SEC-SA calculations will not include the STS relief). This also has the impact of gold-plating capital treatment under Basel III as compared to the EU, which could be very detrimental to UK banks compared to their EU counterparts, where the extension of the STS label to SRT Transactions in 2021 has seen a significant revival of the SRT pipeline (including the entry of more than 10 new banks into the market). Given that the PRA acknowledges the need for improving competitiveness and growth, and that the EU has already demonstrated that the application of STS to synthetics is in alignment with international standards, it would seem a missed opportunity to dismiss the extension of the STS label at this juncture, and industry participants may be hopeful that the position may ultimately be conceded by the PRA.
[1] Part Three, Title II, Chapter 5 of the CRR contains the securitisation chapter.
[2] Response by AFME, UK Finance and CREFC Europe to the consultation on draft securitisation rules published by the PRA and FCA