CLOs in Europe - a round-up of the pipeline regulatory initiatives

Now that some of the dust has settled from the first phase of increased regulatory measures imposed on securitisation following the financial crisis, the European regulators are in the early stages of several projects aimed at creating a re-incarnation of the securitisation market. These include the introduction of "Qualifying Securitisations" which will receive beneficial regulatory treatment, the standardisation of disclosure requirements across the suite of European legislation affecting securitisation, and a possible revision of the definition of "originator" and even "securitisation". Detailed proposals are contained in several consultation and discussion papers. Below is a highlevel round-up of possible implications for the CLO market.

1)"Qualifying Securitisation" Initiatives

Various regulatory initiatives propose that securitisations regarded as "qualifying" according to various criteria should be given preferential capital and other treatment. The following are summaries of the main regulatory workstreams which have either introduced or propose the categorisation of securitisation investments according to whether they meet some form of "qualifying" threshold.

a) EU Commission Green Paper and EBA formal opinion on "Qualifying Securitisation

A consultation entitled "An EU Framework for simple, transparent and standardised securitisation" (the "Commission SSTS Paper"), was published on 18th February 2015 as part of the Commission's proposals for a Capital Markets Union. It references the December 2014 Consultative Document "Criteria for identifying simple, transparent and comparable securitisation", published jointly by the Basel Committee on Banking Supervision ("BCBS"), and the International Organization of Securities Commissions ("IOSCO"). The consultation closed on 18th May 2015.

In parallel, the EBA published a discussion paper in October 2014 (the "EBA SSTS Paper") as a first draft response to the Commission's call for advice of December 2013 on the merits and methods of promoting a safe and stable securitisation market. The advice in the EBA SSTS Paper was finalised in the EBA's formal advice to the Commission on a European Framework for Qualifying Securitisation (the "EBA Opinion") published on 7th July 2015.

In force:

There is no fixed timetable for a Commission Regulation as the EBA' opinion is in response to an ad hoc call for advice under Article 34(1) of the Omnibus Directive, rather than under a specific mandate set out in existing EU legislation on securitisation. However, the Commission has identified this workstream as a priority for early action following publication of its action plan for a Capital Markets Union expected in September 2015.

Scope:

Any category of "qualifying securitisation" established by the Commission as part of this workstream could eventually impact the treatment of CLOs and other securitisations in several areas of regulation, such as capital treatments, qualification as assets to be used as liquidity cover, treatment of assets under proposals for banking structural reform in the EU, etc.

Effect:

The Commission SSTS Paper proposes a distinction between "qualifying securitisations" and other securitisations based on a modular approach under which the transaction will have to meet requirements for i) simplicity, such as limitations on the use of derivatives, exclusion of resecuritisations, and homogeneity of the assets; ii) transparency, such as disclosure of loan-level data; iii) standardisation, such as the requirement for a true sale, no synthetic transfer, and standardisation of waterfalls; and iv) additional risk factors such as credit quality of the underlying exposures.

The Commission SSTS Paper sought input from the market with regard to matters including the simplicity, standardisation and transparency criteria, whether risk retention requirements should be revised for qualifying securitisations so as to impose a direct obligation on the originator or sponsor, whether prudential capital requirements should be adjusted for qualifying securitisations, and adjustment of swap collateral requirements for qualifying securitisation vehicles (there is currently no specific exemption for securitisation vehicles from the clearing and collateral exchange requirements under EMIR, and consequently CLOs and other securitisations have to rely on remaining below certain thresholds based on the notional amount of derivative contracts entered by the vehicle and its group).

The aims behind the simplicity and transparency requirements are discussed more fully in the EBA Opinion which constitutes its formal response to the Commission's call for advice.

The EBA Opinion makes five recommendations, the first of which is for a systematic review of the entire regulatory framework for securitisation across all regulations and regulators - that recommendation mirrors the work of the Joint Committees of the ESAs in their 12th May report (see "The ESAs' report on Securitisation" below). The remaining recommendations centre on creating a framework for simple, standard and transparent securitisation ("SSTS"), the criteria on which the status of "Qualifying Securitisation" should be based, and the recalibration of the BCBS Securitisation Framework published in December 2014 (the "BCBS Framework") in so far as it applies to such qualifying securitisations.

Perhaps most importantly for the CLO market, in the context of establishing the criteria for Qualifying Securitisations, the EBA states that "it is considered essential that the effectiveness of EU retention rules, particularly with respect to issues related to the definition of "originator" be re-considered in line with the EBA advice on EU retention rules included in the EBA report published in December 2014". The December 2014 report stated that "The EBA believes that the entity claiming to be the ‘originator’ should always be of real substance and should always hold some actual economic capital on its assets for a minimum period of time." It is not clear whether any restriction on the retention being held by originators who purchase assets in the market would apply only to qualifying securitisations or more widely.

"Qualifying" securitisation status would indicate that the structure mitigates all risks in the transaction except for the credit risk of the underlying assets. The BCBS Framework however treats securitisation as "non-neutral" and imposes a capital surcharge across the credit structure post-securitisation versus the capital charge on the portfolio prior to securitisation to reflect the additional riskiness the BCBS perceives to be inherent in the structure. The EBA Opinion proposes that although the capital charges should remain above the BCBS framework minimum, Qualifying Securitisations will benefit from a reduction in the capital surcharge on securitisation positions.

The criteria currently proposed by the EBA for Qualifying Securitisations would not include managed CLOs, as they specifically exclude any transaction where the underlying pool is actively managed on a discretionary basis. The EBA is of the view that active management adds a layer of complexity and increases agency risk in the transaction. Indeed, this seems to ignore the structural features of CLOs which add credit enhancement to the underlying pool by requiring that coverage and collateral quality tests are met - the additional layer is to that extent actually an additional layer of risk-mitigation.

We await the Commission's proposals and publication of the Capital Markets Union action plan in September.

b) Solvency II level II

In force:

Insurance investors applying capital charges to their securitisation positions when Solvency II begins to come into force in January 2016 under the standardised model will be required to calculate the applicable spread risk capital charge for those positions by reference to the categorisation as "Type 1" or "Type 2" securitisation under the Delegated Acts made under the Solvency II Directive (the "SII Delegated Acts")

Scope

The standard securitisation capital charges apply to insurance companies holding securitisation positions, who are required to calculate the Solvency Capital Requirement ("SCR") under Solvency II and use standardised models to do so.

Effect

In the SII Delegated Acts, the criteria for qualification as "Type 1" securitisation only apply to certain asset classes, including prime residential mortgages, consumer loans and loans to SMEs. Syndicated-loan CLOs (other than CLOs of SME loans) are automatically within Type 2.

The treatment of Type 2 securitisation positions is significantly more onerous from a capital perspective than is the treatment of Type 1 securitisation positions. For example, the "stress factor" which must be applied to the modified duration of a AAA-rated Type 1 securitisation position to calculate the reduction in value of that position (and therefore the capital requirement which must be input into the spread-risk capital component) in the event of a spread shock is 2.1%. The equivalent factor applied to a AAA-rated Type 2 securitisation position would be 12.5%. Insurers may be able to avoid the high capital charges applicable to Type 2 securitisation by using internal models to calculate their SCR, but these require supervisory approval and generally will only be available to larger insurance companies.

In our view, the categorisation of CLOs as Type 2 by EIOPA i) fails to give any credit for the riskmitigating structural features of managed CLO transactions, (such as deleveraging for failure of coverage tests) and ii) focuses on rating downgrades imposed on CLO tranches during the financial crisis - these downgrades were not reflected in CLO default rates, and have since largely been reversed. However, some comfort can be taken from the fact that the categories of securitisation position which meet the Type 1 criteria will be limited - for example in the residential mortgage asset class, only senior tranches of prime RMBS securitisation will be considered to be Type 1.

Furthermore, the effect of the higher capital requirement for spread risk on Type 2 securitisation positions is diluted by its input into the calculation for the capital requirement for market risk, which recognises levels of correlation in the insurer's portfolio. Thus while the higher capital requirements for Type 2 securitisations such as CLOs are certainly not welcome, the true impact of being a Type 2 securitisation will depend on the constitution of the insurer's whole portfolio.

c) Liquidity Coverage Ratio

In October 2014, the Commission adopted a delegated regulation (the "LCR Regulation"), under Article 460 of CRR, detailing the application of the Liquidity Coverage Requirement ("LCR") outlined in Article 412(1) of CRR. The LCR requires credit institutions (and in future may require investment firms) to hold sufficient high-quality liquid assets ("HQLA") to cover the net liquidity outflows (i.e. the excess of liquidity outflows over liquidity inflows) that would be expected over a 30 day period of market stress. The LCR begins to apply in stages - from 60% of the full LCR expected to apply later in 2015 to 100% of the LCR in 2018.

HQLA are split into two tiers - Level One assets are considered to be extremely high quality and include cash, highly-rated sovereign debt and certain bank debt and covered bonds (the latter subject to a 7% haircut and other requirements governing issue size and over-collateralisation). Level Two assets are split into level 2A and Level 2B. Level 2A includes certain regional government debt, certain covered bonds and highly-rated corporate debt, and are subject to a 15% haircut to market value. Level 2B includes certain high-quality asset-backed securities, which are subject to haircuts to market value of between 25% and 35%. Level 2B assets are permitted to make up a maximum of 15% of the LCR.

The asset-backed securities eligible for inclusion in the Level 2B assets must meet criteria similar to those used in the Solvency II Delegated Acts to identify Type 1 securitisations, although the requirements are more restrictive (for example, Type 1 securitisations must be at least equivalent to a rating of A+, whereas Level 2B securitisations must be rated at AAA). In particular, the assetclasses eligible for inclusion in Level 2B securitisations in the LCR are the same as those eligible as Type 1 in the SII Delegated Acts, which excludes CLOs.

The criteria for qualification as HQLA in the LCR, and for Type 1 securitisation in the SII Delegated Acts, were part of the background and impetus for the Commission SSTS paper referred to above. It is possible that these criteria will be amended to be brought into line with any "Qualifying Securitisation" criteria which emerge as a result of the conclusion of the Commission workstream on Capital Markets Union.

2) ESAs Joint Committee Report on Securitisation (the "Report")- 12 May 2015

In Force :

Some way off - the Report constitutes the ESAs' response to the Commission SSTS Paper, and there is no clear indication as to the timing of a likely legislative proposal.

Scope

The Report is a review of the due diligence and disclosure requirements applying to structured finance instruments ("SFIs") across the full range of EU legislation, as well as the central banks' collateral frameworks (which do not currently apply to CLOs), and certain rules applying to structured finance instruments marketed to retail investors. Thus the products and entities to which the Report is relevant are wide-ranging. CLOs will undoubtedly be affected by any legislative proposals resulting from the Report, although not all of the recommendations will be relevant. We highlight below the main points for CLO market participants.

Effect

The stated objective of the Report is to assess whether the existing framework has been set up in a consistent manner and to put forward recommendations that can be undertaken at EU level. The recommendations likely to affect CLOs fall into the following categories:

Disclosure obligations to be driven by Investor's Due Diligence obligations

The Report recommends that at all times there should be a match between the information the investor requires to perform its due diligence and the disclosure requirements on the originator and sponsor. This should include disclosure requirements for loan-level information, transaction documents, stress test information and investor reports. Currently, some of the disclosure provisions, for example those in Article 406 of CRR, are not prescriptive as to these matters and the Report recommends that they should be made more so. Furthermore the Solvency II Delegated Acts require insurer investors to establish the sponsor's process for approving, amending, renewing and refinancing loans to be securitised - for which currently there is no clear matching disclosure requirement either under CRR or under Solvency II. There are also clear differences in frequency of due diligence required under CRR, which requires due diligence on a continuing basis, and under CRA3, which requires a one-off disclosure requirement following closing of a transaction issuing SFIs.

Loan by loan level disclosure

CLOs do not currently have to disclose loan-by-loan level data under Article 8b of CRA3, although they are within its scope and will be required to comply once further regulatory technical standards are published. The recommendations in the Report would suggest that the information required to be disclosed in future (either under any future regulatory technical standards made under Article 8b of CRA3 or as a consequence of future implementation of the Report), is likely to be more prescriptive than what is currently required by Article 406 of CRR, and CLO managers may need to move toward fuller disclosure of underlying loan information.

The Report proposes that the loan data templates should allow investors to see the incidence of loans more than 30, 60, or 90 days past due, default rates and prepayment rates and loan to value ratios, and should have mandatory fields covering borrower credit-worthiness, such as Probability of Default and Loss Given Default, as well as credit scores.

The Report also recommends that all investors should be put in a position to conduct their own stress tests on SFIs in which they invest. At a minimum these should identify the default rate at which, given a set of assumptions on the pool, the relevant tranche of notes begins to suffer principal losses. It is not clear from the Report (which does not mention CLOs specifically at all), whether these requirements will be adapted for a CLO which must meet collateral quality and coverage tests and is required to deleverage if these are not met.

The Report does however suggest that these enhanced disclosure requirements could apply only to SFIs admitted to trading on an EU regulated market or offered to the public in the EU (i.e. those for which a Prospectus would be required under the Prospectus Directive) as extending the disclosure requirements to SFIs admitted to trading on a non- EU regulated market or traded OTC would present supervisory challenges within the EU. This leaves open the possibility that CLOs admitted to trading on markets such as GEM in Ireland will be given a reprieve from any enhanced disclosure requirements, in contrast to the requirements currently in place in CRA3 which apply to SFIs whether traded on an EU regulated market or not, and are expressly applicable to private and bilateral transactions.

Standardised investor reports to be made public and interactive

One of the specific recommendations made by the Report is that data in the investor reports should match the data appearing on the Issuer's website on the underlying loans. Such investor reports, along with transaction documents, should be stored on the Issuer's website and made public. The Report goes on to recommend that further work be done to assess whether investor reports should be standardised and integrated with the loan-by-loan database on the Issuer's website, with loan data presented in a dynamic interface so the investor can adapt the format to suit the performance its due diligence requirements.

Definitions - securitisation/originator

The Report also reviews the various definitions used in identifying structured finance instruments, and recommends that further work is done in this area to avoid discrepancies in scope of various regulations or to justify the different definitions used. Potentially, this could lead to a glossary of structured finance definitions at a European level, to maximise the certainty and uniformity of application for the regulation of SFIs.

Currently, SFIs are defined for the purposes of i) disclosure of loan-level information under Article 8b of CRA3, ii) the dual rating requirement in CRA3 (each outlined above) and iii) risk retention provisions in CRR, AIFMD and Solvency II, and iv) for identifying securitisation positions for capital treatment under both CRR and Solvency II, by reference to the definition of "securitisation" in CRR. This definition requires tranching of credit risk of a pool of exposures (or a single exposure) but does not require the transfer of credit risk through true sale or synthetic securitisation.

However, the definition used of "securitisation special purpose entity" ("SSPE") in AIFMD, which is used to exempt an entity from requiring authorisation as an AIF, is based on the definition of securitisation used in the ECB's regulation requiring statistical information on financial vehicle corporations engaged in securitisation transactions. This definition depends on the transfer of assets from an originator to an entity which is separate from the originator and/or the transfer of the credit risk of the assets to holders of securities or derivatives. No tranching is required for a transaction to be a securitisation for this definition, and some uncertainty has always surrounded whether the requirement for a transfer from an originator would preclude a CLO falling within the exemption for SSPEs.

It may be optimistic to think that CLOs could be excluded from any new definition of securitisation used in imposing retention requirements, although some support has been given in the past to a possible relaxation of the retention rules for CLOs – notably by IOSCO in its 2012 paper "Global Developments in Securitisation Regulation". The definition has also caused considerable difficulty for other non-bank securitisation structures (e.g. Commercial Mortgage-backed Securities, multiseller conduit vehicles) attempting to comply with retention rules since their implementation. The ESAs do not cite these difficulties as reasons for reviewing the definition, and instead focus on the justification for the use of differing definitions in different regulatory rules, but nonetheless their recommendation is that the definition is reviewed. In any event, the practical effect of such a review would still be some way off.

The Report also highlights other areas in which relevant definitions lack clarity, and in particular quotes the definition of "originator" used in CRR, saying "there may be confusion on whether "SPV" may be included in the definition of originator within the meaning of the CRR..". This could be a reference to the use of originator SPVs by some mortgage-backed securitisation programmes rather than a reference to the originator permanent capital vehicles established by CLO managers, but a review of the level of economic substance required in order to meet the definition of "originator" seems clearly to be on the radar of the regulators.