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Future prudential direction of securitisation

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Pat Brennan

General Manager
Australian Securitisation Forum, Sydney

1 December 2015

Thank you to the ASF for inviting APRA to speak at this forum again. As you know APRA has been reviewing the prudential framework for securitisation and in 2014 we released a discussion paper and received considerable feedback. This feedback has been carefully considered and substantial further progress has been made in 2015. Last week APRA released for consultation a second discussion paper, and a draft prudential standard APS 120 Securitisation. This consultation package includes a response to submissions to the 2014 discussion paper and changes to APRA’s proposals in a number of key areas.  We have also incorporated the updated Basel Committee securitisation framework which was released at the end of 2014 and relates to capital requirements for ADIs with securitisation exposures. 

In developing these new proposals APRA remains committed to the principles communicated at this forum previously, and maintains focus on the intended outcomes of this reform:

  • we want to facilitate a much larger, simple and safe, funding-only market;
  • we want to also facilitate an efficient capital-relief securitisation market; and
  • in both cases, we want a simpler and safer prudential framework.

I note APRA’s intentions here are widely supported by industry, though with understandably varying opinions on the detail of how best to achieve these outcomes. Today I will take the opportunity to outline some key aspects of APRA’s updated proposals, and make some observations on the consultation process.

Funding only securitisation

Let me start with funding-only securitisation. This is where an Authorised Deposit-taking Institution (ADI) is not seeking capital relief, rather the focus is on accessing term funding. APRA’s objective to facilitate a much larger, simple and safe funding-only market is strongly supported by industry. Some key inter-connected considerations here are date-based calls, revolving structures, and when combining these two the ability to have securitisations with ‘bullet’ maturities. 

In 2014 APRA was comfortable with date-based calls and revolving structures in the context of clean-up calls in traditional ‘pass-through’ securitisation, but had some concerns with their use to create bullet maturity structures. Our concern is that a bullet maturity may, even if contractually in the form of an option for the issuer, create an expectation by investors and markets more broadly that repayment will definitely occur on the stated date regardless of circumstances prevailing at the time. There is precedent for this expectation in other forms of structured funding.

Saying that, the benefits of bullet maturity structures have appeal to the industry and, in some particular aspects, to APRA as well. Bullet maturity securitisations, with their more certain cash-flow structures, are likely to attract a much broader range of investors and hence support a much larger funding-only market. There can also be significantly reduced hedging costs for issuers. Whilst these benefits to issuers are likely to be self-evident to the audience today, the prudential advantages may not be as obvious.

Having a much larger funding-only market provides ADIs the opportunity to strengthen their balance sheet resilience by accessing new sources of term funding. On an international comparison the Australian banking industry is notable for its relatively low ratio of deposits to loans, and its relatively high reliance on wholesale funding sourced from offshore. Against this backdrop supporting a new opportunity to strengthen ADI funding profiles is a sound prudential strategy. If some of the new investors in bullet structures are in fact located overseas, then balance sheet resilience can still be improved to the extent that the new term funding raised is used to replace less stable forms of funding, such as short-term wholesale funding sourced from offshore.

Here I would add that for the large ADIs that can access a Committed Liquidity Facility as part of their liquidity management and to satisfy APRA’s requirements under the Liquidity Coverage Ratio, further strengthening of funding profiles is consistent with the ‘all reasonable steps’ APRA expects these ADIs to undertake.

In balancing these various factors, including effects on efficiency and competition, APRA has been convinced by industry submissions that to achieve a much larger funding only market bullet structures are necessary. APRA is therefore now proposing the new prudential framework allow bullet maturity structures in funding only securitisation. Please note that APRA is giving up some prudential ground here – our concerns regarding optional call dates remain – but there are steps that help to reduce APRA’s level of concern.

Firstly the draft APS 120 makes it clear that at no time can an ADI’s senior exposure to a funding only securitisation be subordinated for credit risk to other senior exposures. To be explicit – to facilitate a bullet maturity, cashflows may be directed to other senior investors ahead of the ADI but only if the underlying assets are performing – this is a preference of timing of cashflow, but not a preference in credit risk. This somewhat reduces the prudential risk, but does not totally alleviate APRA’s concerns.

An essential second step is that ADIs do not act or communicate in a way that implies the call date is anything but optional, and that when electing to exercise the call option, and thereby create a bullet maturity, this is only done when the underlying assets are performing to the extent the ADI never assumes losses that are attributable to investors.

A final point on funding only securitisation is to do with master trusts. Our dialogue with industry with regards to bullet maturity structures has generally co-mingled master trusts into the same conversation. In the discussion paper and draft prudential standard released last week we have proposed, as already mentioned, to allow bullet structures with a date-based call option. We made no mention of master trusts on the basis that, in our view, the proposed prudential standard is not an impediment to the use of master trusts so there was no need to say anything further. So this should be read as nothing more than APRA being efficient in its drafting.

Skin in the game

Moving on now to capital relief securitisation and another area where APRA has substantially revised its proposals is to do with risk retention requirements, more commonly called ‘skin in the game’. The experience of the global financial crisis showed all too clearly that in a number of jurisdictions the availability of attractive funding in the form of securitisation lead to some lenders reducing lending standards as, after undertaking a securitisation, they would no longer bear losses from the underlying loans – the ‘originate-to-distribute’ model.

In 2014, with skin in the game requirements still evolving internationally, APRA proposed a simple and intentionally conservative approach. This was for an originating ADI to retain at least 20% of each of the subordinated tranches of its securitisations. APRA’s proposal was based on the broad underlying principle that requirements should be as simple as possible, and more specifically in the case of risk retention if we are to have a requirement then it should be one that makes a difference. That is, an originate-to-distribute business model based on poor lending practices would not be attractive to ADIs.

Since 2014 international requirements have evolved further and it now appears clear that there will be no internationally harmonised approach to risk retention, and that in some cases the requirements are getting quite complex. We also note that the previously proposed level of retaining 20% of each of the subordinated tranches now appears to be even more conservative than it did in 2014.

For a range of reasons the originate-to-distribute model has not been prevalent in Australia, so the underlying risk may not be as significant as in some other jurisdictions. In addition the variety of skin-in-the-game requirements that have emerged internationally means that introducing an additional Australian requirement would add complexity, and this would run contrary to APRA’s objective of creating a simplified framework.

With these factors in mind APRA is no longer proposing an explicit risk retention requirement. This is a reasonably significant step in simplifying our 2014 proposals. APRA will monitor market developments and should the need emerge to review risk retention requirements in the future we will consider that at the time.

Threshold to achieve capital relief

A long-standing principle of securitisation regulation is that where substantially all the credit risk of a pool of assets has been transferred to investors, typically by selling the subordinated tranches of securities, the originating ADI is no longer required to hold regulatory capital. In 2014 APRA proposed that capital relief is allowed on a ‘pro-rata’ basis – that is proportionate to the amount of junior securities sold. Being conceptually straightforward this was intuitively appealing to APRA. Submissions, however, clearly indicated a simple threshold would be preferred. APRA is comfortable with this suggestion and is now proposing a threshold for capital relief where at least 80 per cent of the junior securities have been sold. Similar to the 2014 proposal this will apply to each tranche of junior securities.

Warehouse arrangements

I have to say that in the sphere of capital relief securitisation, warehouse arrangements have been the most difficult of the new proposals for APRA to balance. The current framework includes a deliberate concession for warehouse facilities whereby the originating ADI can treat the underlying loans as ‘sold’ and obtain capital relief, whilst the warehouse provider (often a larger ADI) can apply a relatively low risk-weight. Given this treatment applies when no risk has left the banking system this is a somewhat artificial capital outcome, but one that worked to the extent that warehouses were temporary funding structures to facilitate a term securitisation, including the transfer of credit risk to suitably informed investors. In short APRA has supported a limited concession on the basis it assisted smaller ADIs to access term securitisation markets.

In the aftermath of the global financial crisis, and to this day, many of these arrangements have been proven not to be temporary at all, and so from a prudential perspective the current concession is not sustainable. In 2014 APRA proposed that a concession remain, but be limited in time to a period of one year.  This proposal proved unpopular with industry with submissions noting that for some ADIs a period of substantially more than one year is needed to accumulate a pool of sufficient size to undertake a term securitisation.

This leaves us in a no-mans-land between a prudentially unsustainable capital concession, and industry seeking to maintain a funding mechanism based on such a concession. APRA’s preference is to have a method by which smaller ADIs can have improved access to term securitisation markets, without creating undue prudential risk. APRA is seeking submissions on approaches that address both these considerations. In the absence of any viable option being offered APRA may remove direct references to warehouses in APS 120, and instead let them be considered either capital relief or funding only securitisations depending on how each arrangement meets the relevant requirements. I say again, APRA’s preference is for industry to suggest viable alternative options with regards to warehouse arrangements.

Basel III securitisation

In December 2014 the Basel Committee finalised its updated framework for securitisation. This is mainly directed at banks as investors in, and facility providers to, securitisations rather than the area of APRA’s main focus – ADIs as originators of securitisations. However, given the Australian banking systems’ international interconnectedness, most obviously through the reliance on wholesale funding sourced offshore, maintaining consistency with international standards is an important consideration in maintaining investor confidence. APRA has therefore considered the implementation of the Basel Committee’s framework, but in the Australian context and in light of APRA’s objectives, and is proposing to implement the Basel framework with a number of adjustments. 

The Basel framework has a hierarchy of three approaches for assessing regulatory capital requirements: an approach based on banks’ internal models; an approach based on external ratings; and a standardised approach. There is a modelling approach in the existing framework that has very limited use in Australia. Consistent with APRA’s objective to simplify the prudential framework we are proposing to not adopt a modelling approach, but instead implement the two remaining approaches and apply them equally to all ADIs.

A further adjustment, and simplification, is that under the external ratings-based approach for long-term exposures, APRA is proposing to have eleven, as opposed to eighteen, ratings grades. Given Australian securitisations tend to be of high credit quality, with the majority of securities being rated triple-A, this simplification is possible with little, if any, loss of risk sensitivity in the prudential framework.   

In terms of the implementation timetable APRA is proposing that the updated prudential framework be implemented in January 2018, consistent with the Basel Committee’s timeline. We will include sensible transition arrangements for originating ADIs so that existing issues will not be unduly affected, but with no transition proposed in relation to ADIs’ other securitisation exposures. Industry has often advised APRA to be careful about the speed of implementation timetables when undertaking prudential reform. In this instance we anticipate that some ADIs may in fact wish to avail themselves of the more flexible funding only arrangements before 2018. If this is the case please make it clear in submissions to the current consultation that an accelerated timetable is preferred.

That concludes my remarks on the proposals themselves. I have focused on some of the more material changes APRA has proposed. There is much more in the discussion paper that time does not permit me to cover here today. But before I wrap up I will make some comments on APRA’s approach to consultation on policy proposals.

The consultation process

From time to time APRA gets asked about its process for consultation: how does APRA incorporate feedback from industry and other interested parties? As part of the formal consultation process APRA considers all submissions, individually and collectively. This process is often supplemented and assisted by direct dialogue with regulated entities, industry bodies and other stakeholders. This can be time consuming but a comprehensive consultation process is essential to inform our prudential policy making. Before any policy is released after consultation, APRA’s policy development process includes explicit consideration of how the policy has addressed the feedback received and whether this has been done sufficiently.  The changes to our 2014 proposals, outlined in the consultation package released last week, is an example of this in practice and illustrates that APRA reflects carefully on feedback received through the consultation process and, where appropriate, adjusts policy.

This new consultation is no exception. I have already been asked, given this is a second consultation on securitisation, whether APRA is open to new or different ideas. The answer is yes – that is exactly the purpose of pubic consultation. We invite submissions on all aspects of the proposals.

Through this process APRA will be looking to balance prudential safety with, among other things, efficiency and competition. Submissions can assist in consideration of this important balance.

On a final note, in the period since the 2014 discussion paper was released, APRA has had a high level of engagement from industry, often facilitated by the ASF. We look forward to this continuing as we move through the consultation process and ultimately towards finalising the updated prudential framework for securitisation.

Thank you – I will be happy to take some questions in the remaining time.