Securitization Regulation In Focus:

Proposed Liquidity Rules Have

Softened, But May Still Deter
European Bank Investors
Primary Credit Analyst:
Mark S Boyce, London 02071768397; [Link]@[Link]
Secondary Contact:
Andrew H South, London (44) 20-7176-3712; [Link]@[Link]
Table Of Contents
Few Securitizations Would Count As Liquid Assets In The LCR
A Similar Story Holds True For The Net Stable Funding Ratio
The Final Rules Could Soften Amid Rising Support For Securitizations
Among Policymakers
Related Research
STRUCTURED
FINANCE
RESEARCH
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Securitization Regulation In Focus: Proposed
Liquidity Rules Have Softened, But May Still Deter
European Bank Investors
Given the significance of bank investors in the European securitization market, upcoming rules governing banks'
liquidity could hurt demand for the asset class, in Standard & Poor's Ratings Services' opinion. As part of the Basel III
package, the Basel Committee on Banking Supervision (BCBS) initially proposed a set of global liquidity rules in
December 2010. In January 2013, it finalized the liquidity coverage ratio (LCR) standard, which aims to ensure that
banks maintain sufficient high-quality liquid assets (HQLA) to withstand a substantial liquidity stress spanning 30 days.
In January 2014, the BCBS released a consultative document covering its proposed net stable funding ratio (NSFR),
which intends to ensure that banks have sufficient reliable funding over a one-year horizon, and that the degree of
mismatch between their asset and liability maturity profiles is sustainable.
Historically, banks have been one of the largest investor constituencies for European securitizations. However, under
the proposed liquidity rules, few securitization holdings would qualify as liquid assets and contribute to fulfilling a
bank's regulatory requirements, in terms of their LCR and NSFR. The treatment of securitizations in the proposed rules
is also less favorable than that of some other debt securities, such as covered bonds and corporate bonds. This could
significantly reduce banks' incentive to hold securitization tranches and therefore lower overall demand for the asset
class.
Overview
Upcoming liquidity rules could significantly reduce banks' incentives to invest in securitizations.
Most securitization holdings will not contribute to banks' regulatory liquidity requirements under the BCBS'
proposed liquidity coverage ratio and net stable funding ratio rules.
Some RMBS may qualify as high-quality liquid assets, but can account for no more than 15% of a bank's liquid
assets and are subject to a 25% discount of their value.
The BCBS' treatment of securitization compares unfavorably with that for qualifying covered bonds and
corporate bonds, which can account for 40% of liquid assets and are subject to only a 15% discount.
The treatment of some securitizations under the rules has softened since the initial proposals in 2010. For example,
some residential mortgage-backed securities (RMBS) do look set to qualify as HQLA. Furthermore, the European
Commission (EC) recently said that it may consider further revisions to securitizations' treatment in the LCR when it
determines the final standards applicable under European law in June 2014. More generally, an increasing number of
central bankers and policymakers have recently said that a well-functioning and revitalized securitization market is
important for the European economic recovery, and that some pending regulatory proposals may be acting as an
obstacle and should be reassessed.
However, with regulators set to begin phasing in the LCR regulation in 2015, if the European rules remain in line with
the BCBS proposal, we believe some bank investors could soon begin to favor other types of investment over
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securitizations.
Few Securitizations Would Count As Liquid Assets In The LCR
The LCR is the ratio of a bank's stock of unencumbered HQLA to its total net cash outflows over a 30-day period
under certain stressed assumptions. Regulators will require banks to have an LCR of at least 60% when the rules
become effective in 2015, and this will subsequently increase by 10 percentage points each year to 100% on Jan. 1,
2019.
To determine the cash outflow rate in the calculation of the LCR denominator, the regulations will stipulate, for
example, minimum stressed run-off rates for the bank's funding sources (to simulate, for instance, some depositors
withdrawing funds and some wholesale lenders ceasing to roll over debt), drawdown rates for credit and liquidity
facilities that the bank extends to customers, and the extent of cash outflows related to derivative contracts. The cash
inflow rate will depend on stressed assumptions about, for example, the proportion of maturing lending that the bank
rolls over, the amount of scheduled interest and principal payments that the bank will receive on outstanding lending,
the availability to the bank of credit and liquidity facilities extended by other institutions, and the extent of cash inflows
related to derivative contracts.
The LCR numerator depends on the regulatory definition of HQLA. According to a January 2013 update to the Basel
LCR framework, HQLA can fall into either the "Level 1" (extremely HQLA) or "Level 2" (HQLA) categories, with the
Level 2 category subdivided into "Level 2A" and "Level 2B".
The LCR intends Level 1 assetswhich include cash, government bonds, and central bank reservesto be the most
liquid and such assets would not be subject to a discount of their value in the LCR calculation. Furthermore, these
assets can make up 100% of banks' HQLA stock. By contrast, Level 2A assets can account for at most 40% of the stock
and are subject to a 15% discount. Level 2B assets can represent no more than 15% of the HQLA stock, with different
discounts depending on the type of asset.
Under the finalized BCBS LCR standard, the Level 2B category includes some RMBS, subject to a 25% discount (see
table 1). Qualifying RMBS transactions are those that:
The bank or any of its affiliates has not originated;
Carry an external rating of at least 'AA';
Are traded in large, deep, and active repo markets;
During a period of substantial liquidity stress, have not experienced a market price decline exceeding 20%, or a 20
percentage point increase in discount in repo markets over a 30-day interval;
Are collateralized only by full-recourse residential mortgage loans (where the borrower remains liable for any
outstanding loan balance, even after selling the property) with a maximum weighted-average loan-to-value (LTV)
ratio at the time of RMBS issuance of 80%; and
Are subject to "skin in the game" regulations requiring originators to retain an interest in the securitized assets.
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Securitization Regulation In Focus: Proposed Liquidity Rules Have Softened, But May Still Deter European Bank
Investors
Table 1
LCR Treatment For Securitizations, Covered Bonds, Corporate Bonds, And Sovereign Bonds
January 2013 proposal
December 2010
proposal Discount (%)
Maximum proportion of
HQLA buffer (%)
Qualifying sovereign bonds
rated 'AA-' or higher*
Level 1 Level 1 0 100
Qualifying sovereign bonds
rated between 'A-' and 'A+'
Level 2A Level 2 15 40
Qualifying corporate bonds
and covered bonds rated
'AA-' or higher
Level 2A Level 2 15 40
Qualifying sovereign bonds
rated between 'BBB-' and
'BBB+'
Level 2B Not liquid assets 50 15
Qualifying corporate bonds
rated between 'BBB-' and
'A+'
Level 2B Not liquid assets 50 15
Qualifying RMBS rated
'AA' or higher
Level 2B Not liquid assets 25 15
LCR--Liquidity coverage ratio. HQLA--High-quality liquid assets. RMBS--Residential mortgage-backed securities. *Some sovereign bonds rated
below 'AA-' may still qualify for Level 1 treatment, subject to other requirements. Not applicable to the December 2010 proposal. Source:
Standard & Poor's, Bank for International Settlements.
At the European level, the Capital Requirements Regulation (CRR) requires the European Banking Authority (EBA) to
advise the EC on the definition of extremely HQLA (Level 1 assets) and HQLA (Level 2 assets), appropriate discounts
for liquid assets, and the possible impact of the LCR on bank lending, the economy, and financial stability. The EC will
take this analysis into account when it specifies the LCR details under European law by June 30, 2014, and may decide
to make further changes to the rules. For example, we understand that, at the time of writing, the EC may be
considering changing the parameters listed in table 1 for certain types of covered bonds.
In December 2013, the EBA published its findings, based on an analysis of the relative liquidity characteristics of
several different asset classes. The analysis considered various liquidity metricsincluding price impact, trading
volume, zero-trading days, price volatility, and a proxy for bid-ask spreadsusing transactional data from January
2008 to June 2012.
The findings suggested that securitizations were less liquid than all other asset classes for which the EBA could
calculate all liquidity measures (government bonds, non-financial corporate bonds, covered bonds, and equities). The
EBA recommended that senior RMBS tranches rated 'AA-' or higher, with a minimum size of 100 million and a
weighted-average life of less than five years, should count as Level 2 liquid assets, subject to the 25% discount
specified in the Basel text. The EBA also did not foresee any significant detrimental impact from the LCR on the
stability of the financial markets, the economy, or the supply of bank lending.
Some market participants have argued that the analysis of the relative liquidity of securitizations is sensitive to the
chosen subsector, time period, and liquidity metric. For example, a Bank of America Merrill Lynch analysis in October
2013 found that, since 2001, the liquidity of 'AAA' rated European auto asset-backed securities (ABS) transactions was
in line with or higher than that of 'AAA' rated RMBS from the U.K., Netherlands, Spain, and Italyeven during the
financial sector turmoil of 2008 and 2009. This analysis used spread volatility as a proxy to assess liquidity. Also, a
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Securitization Regulation In Focus: Proposed Liquidity Rules Have Softened, But May Still Deter European Bank
Investors
January 2014 analysis, commissioned by the Association for Financial Markets in Europe (AFME), found that the
liquidity of 'AAA' rated European auto ABS was comparable on average to that of similarly-rated European covered
bonds, and higher than that of non-German covered bonds, between May 2009 and September 2013. (The AFME
study was based on bid-ask spreadsthe difference between the quoted selling and offer prices for a security.) The
AFME report also noted that, during much of the sample periodand particularly in early 2012, following the
sovereign debt crisis in 2011bid-ask spreads on U.K. and Spanish RMBS transactions were tighter than on covered
bonds from those countries.
Based on such analyses, some market participants have called into question the notion, implicit in the current LCR
calibration, that covered bonds innately benefit from higher liquidity than similarly-rated securitizations. They have
also suggested that securitization asset classes aside from RMBS may merit more favorable LCR treatment.
We believe that the proposed cap on securitizations in banks' HQLA stock under the LCR, and the higher discount,
could make such instruments less attractive to banks relative to investments in highly-rated covered bond and
corporate bonds. The treatment of non-RMBS transactionswhich have accounted for about half of investor-placed
European securitization issuance since 2008as illiquid may also limit investment choice for banks looking for
LCR-compliant securitization assets.
Moreover, the LTV ratio restriction in the BCBS ruleswhich is not part of the qualifying criteria for covered
bondscould exclude many Dutch RMBS transactions, which often have collateral pools with weighted-average
original LTV ratios that are greater than 80%. Excluding Dutch RMBS, at most one-third of European securitization
issuance placed with investors since 2008 would qualify as HQLA.
That said, in February 2014, Reuters reported that the EC had said it was willing to take into account "possible future
increases in the liquidity of a number of securitization products following further differentiation and standardization"
when it sets the definition of HQLA under European law in June 2014. This suggests there is scope for further revisions
to the final rules.
A Similar Story Holds True For The Net Stable Funding Ratio
The goal of the NSFR is to ensure that banks fund their assets with at least a minimum amount of stable liabilities over
a one-year horizon. Effectively, the standard will ensure that banks match longer-term assets with longer-term
liabilities and offset relatively illiquid assets (which are more difficult to cheaply convert into cash during a one-year
liquidity stress scenario) with less flighty funding (which would see lower funding withdrawal rates in such a scenario).
Banks must maintain an available amount of stable funding at least equal to their required amount of stable funding in
order to remain NSFR-compliant. The rules divide banks' funding sources into various categories, with perpetual (for
example, tier 1 and tier 2 capital instruments), longer-term (that is, those with maturities greater than one year), and
more reliable (for example, retail deposits covered by an effective deposit guarantee scheme) funding sources counting
more toward a bank's available stable funding. Similarly, the rules divide banks' assets into categories, with longer-term
and less liquid assets requiring more stable funding.
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Securitization Regulation In Focus: Proposed Liquidity Rules Have Softened, But May Still Deter European Bank
Investors
As with the LCR, the draft NSFR rules treat securitizations relatively unfavorably relative to some other asset classes,
although the regulatory stance has softened since 2010. Under the original BCBS proposal, banks' securitization assets
with maturities greater than one year required 100% stable funding, but the January 2014 consultation reduced this
figure to 50% for RMBS meeting the Level 2B qualifying criteria. However, this compares with a 15% stable funding
requirement (down from 20% under the original proposal) for corporate bonds and covered bonds rated at least 'AA-',
for example (see table 2). Most non-RMBS securitization assets require 85% stable funding. Therefore, we would
expect the current NSFR calibration to render many securitizations relatively less attractive to bank investors than
similarly-rated covered bonds and corporate bonds. However, the NSFR doesn't become effective until January 2018,
so the ultimate LCR calibration will likely have a more substantial near-term impact on banks' securitization
investment, in our view. The NSFR consultation comment period ended on April 11, 2014, which also leaves scope for
further changes following consultative feedback.
Table 2
NSFR Required Stable Funding Factors For Securitizations, Covered Bonds, Corporate Bonds, And Sovereign
Bonds
January 2014 consultative document December 2010 proposal RSF factor (%)
Sovereign bonds, corporate bonds, covered
bonds, and securitizations with residual
maturities of less than one year
0
Level 1 assets (including qualifying sovereign
bonds rated 'AA-' or higher)
Qualifying sovereign bonds rated 'AA-' or
higher, with residual maturities of one year or
more
5
Level 2A assets (including qualifying corporate
bonds and covered bonds rated 'AA-' or higher,
and qualifying sovereign bonds rated between
'A-' and 'A+')
15
Qualifying corporate bonds and covered bonds
rated 'AA-' or higher with residual maturities of
one year or more
20
Qualifying sovereign bonds rated between 'A-'
and 'A+', with residual maturities of one year
or more
20
Level 2B assets (including qualifying sovereign
bonds rated between 'BBB-' and 'BBB+',
qualifying RMBS rated 'AA' or higher, and
qualifying corporate bonds rated between
'BBB-' and 'A+')
Qualifying corporate bonds and covered bonds
rated between 'A-' and 'A+' with residual
maturities of one year or more
50
Sovereign bonds, corporate bonds, covered
bonds, and securitizations that count as HQLA
under the liquidity coverage ratio, that are
encumbered for six months or more but less
than one year
50
Sovereign bonds, corporate bonds, covered
bonds, and securitizations that don't count as
HQLA under the liquidity coverage ratio, with
residual maturities of less than one year
50
All securitizations, covered bonds, corporate
bonds and sovereign bonds not listed above,
that are not in default
85
All securitizations, covered bonds, corporate
bonds, and sovereign bonds not listed above
100
Note: For unencumbered assets only, except where noted. NSFR--Net stable funding ratio. RSF--Required stable funding. HQLA--High-quality
liquid assets. RMBS--Residential mortgage-backed securities. Source: Standard & Poor's, Bank for International Settlements.
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Securitization Regulation In Focus: Proposed Liquidity Rules Have Softened, But May Still Deter European Bank
Investors
The Final Rules Could Soften Amid Rising Support For Securitizations Among
Policymakers
Recent revisions to draft rules affecting securitization investors suggest that the regulatory stance toward the
securitization market is softening. The revisions to the LCR and NSFR proposals since 2010which relaxed the
liquidity treatment of some RMBSand EC comments about possible further revisions to the current LCR proposal,
point in this direction. The December 2013 and April 2014 recalibrations of the draft rules covering capital charges for
European insurers' securitization investments under Solvency II, and potential changes to the Basel framework
governing securitization banking book capital charges, show a similar trend. Meanwhile, statements from the EC, ECB,
Bank of England, and International Monetary Fund over the past few months suggest rising support for "high quality"
securitizations and the growing belief among some policymakers that harsh regulatory treatment of securitizations may
ultimately hamper lending growth in Europe. However, the extent to which these regulations undergo further changes
remains to be seen.
Related Research
The Basel Funding Ratio: Good Things Come To Those Who Wait, April 14, 2014
Proposed Revisions To The Basel Framework Could Deter Banks From Investing In European Securitizations, April
3, 2014
S&P's Response To The December 2013 Consultation On The Basel Securitization Framework, April 3, 2014
EIOPA's Revised Solvency II Calibration Still Risks Turning European Insurers Away From Securitizations, March
19, 2014
Underwriting The Recovery: European Securitization Could Fund More Lending, If The Regulatory Stance Softens,
Oct. 22, 2013
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Additional Contact:
Structured Finance Europe; StructuredFinanceEurope@[Link]
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Securitization Regulation In Focus: Proposed Liquidity Rules Have Softened, But May Still Deter European Bank
Investors
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