REGISTRO DE HUELLA DE CARBONO, COMPENSACIÓN Y

In response to the criticism on securitisation and role of regulations, regulators on both sides of the Atlantic developed stringent regulations for securitisation. The reaction to the criticism on securitisation is visible in the new regulations, mainly Dodd-Frank Act in the USA, and Capital Requirement Directive (CRD) IV, Capital Requirement Regulations (CRR), Solvency II and Basel III in Europe. These regulations became a subject of widespread criticism from the market analysts, academicians, and other market stakeholders. The regulations devised after the GFC have been repeatedly revised in response to this criticism. These changes and revisions in the different regulations after the financial crisis show the intensity of the challenge faced by the regulators in regulating this market.The key regulations introduced after the GFC are given below.

• Basel III

– An initial draft of the Basel III was issued by the Basel Committee on Banking Supervision (BCBS) in 2012. This draft was later on revised in 2013, 2014 and finally in 2016 (BCBS, 2016).

• Regulation (EU) No. 575/2013 (Capital Requirement Regulations (CRR)):12 CRR directive provides the provisions for the capital treatment of securitisation and other relevant exposures. Many of the legal provisions provided in CRR are considered very strict by the securitisation industry.

– A proposal for the revision of Regulation (EU) No. 575/2013 has been issued by the European Commission (EC) (European Commission, 2015b).13,14

– Delegated Regulation (EU)2015/61 was issued by the European Union to sup- plement Regulation (EU) No. 575/2013 with regard to the liquidity coverage requirements for credit institutions.15

12REGULATION (EU) No 575/2013 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No. 648/2012,Official Journal of the European Union(June 2013)http://eur-lex.europa.eu/oj/ direct-access.html

13Proposal for a “REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL Amend- ing Regulation (EU) No. 575/2013 on Prudential Requirements for Credit Institutions and Investment Firms”. Brussels: European Commission, No. COM(2015) 473, 30.09.2015.

14This proposal is placed by the EC to supplement the Simple, Transparent and Standardised (STS) proposal. The capital regulations of the original CRR Directive have been relaxed in this proposal for the securitisation meeting the criteria given in the STS proposal.

15COMMISSION DELEGATED REGULATION (EU) 2015/61 of 10 October 2014 to supplement Regulation (EU) No 575/2013 of the European Parliament and the Council with regard to liquidity coverage requirement for

• Directive 2013/36/EU (Capital Requirement Directive (CRD-IV)):16This directive sup- plements the CRR and reflects the capital standards and rules of Basel III.

• Directive 2009/138/EC (Solvency II):17This directive provides the provisions for the treatment of securitisation exposure by the insurance industry,18

– A delegated Act Supporting the Solvency II directive was also issued in 2014 (European Commission, 2014).19

• STS Proposal:20 European Commission (EC) issued a proposal on September 30, 2015 for Simple, Transparent and Standardised (STS) securitisation (hereinafter referred as ‘STS proposal’) to promote STS securitisation (European Commission, 2015c). This proposal is currently under review in the European Parliament (EP) and the Council.21 This proposal is analogous to the BCBS Proposal for Simple, Transparent and Com-

Credit Institutions.Official Journal of the European Union, 11. Retrieved fromhttp://eur-lex.europa.eu/ legal-content/EN/TXT/PDF/?uri=CELEX:32015R0061{&}from=EN

16DIRECTIVE 2013/36/EU OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Dir.Official Journal of the European Union, L(176).

17DIRECTIVE 2009/138/EC OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 25 Novem- ber 2009 on the taking-up and pursuit of the business of insurance and reinsurance (Solvency II).Official Journal

of the European Union, L335/1-129.

18Solvency II deals with insurance companies. However, this act occupies a core importance in the securitisa- tion market as insurance industry has been significantly investing in this market and the current provisions in the Solvency II are likely to reduce the interest of insurance industry in this market, thereby reducing the investor base of the securitisation market.

19COMMISSION DELEGATED REGULATION (EU) 2015/35 of 10 October 2014 supplementing Directive 2009/138/EC of the European Parliament and of the Council on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II),Official Journal of the European Union, 12. Retrieved from

http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32015R0035{&}from=EN

20Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL laying down common rules on securitisation and creating a European framework for simple, transparent and standard- ised securitisation and amending Directives 2009/65/EC, 2009/138/EC, 2011/61/EU and Regulations (EC) No 1060/2009 and (EU) No 648/2012. Brussels: European Commission

21According to the Article 294 of Treaty on the Functioning of European Union (TFEU), EC submits its proposal to the European Parliament and the Council. The Parliament has to approve or amend this proposal and forward the same to the Council. The Council can approve or amend this proposal. The proposal is sent back to the EP if amendments are made by the Council. The proposal is adopted or rejected depending on the approval of the EP. In case of any further amendments by the EP, the EC is asked to give its opinion and the proposal is sent to the Council for the second reading. Decision is made on the basis of majority voting if opinion of the EC is positive or on the basis of unanimity if EC’s opinion is negative. If proposal is rejected by the Council, a Conciliation Committee is formulated and negotiations start. Seehttps://www.eumonitor.eu/9353000/1/j9vvik7m1c3gyxp/vga3bya9max9for details about the ordinary legislative procedure. The STS Proposal is also following the same procedure to take the form of a directive or act.

parable (STC) Securitisation in July 2015,22but the former is proposed as the EU law.

– A draft report has been issued by the Committee on Economic and Monetary Affairs (ECON) of the European Parliament in response to the STS proposal (hereinafter referred as the ‘ECON report’) (Tang, 2016). The ECON report has proposed various amendments in the original STS proposal.23

The post-crisis regulations for securitisation are focused on four key areas: (i) addressing conflicts of interest by aligning incentives; (ii) transparency of securitisation by removing the information asymmetry; (iii) dealing with inappropriate incentives and (iv) reduction in the reliance on rating agencies. In line with these targeted objectives, the post-crisis regulations for the securitisation in Europe can be classified into six categories i.e. risk retention requirements, high disclosure requirements, due diligence requirements, capital requirements and liquidity requirements. These regulations are discussed below.

Risk Retention

The Risk Retention Regulations (RRR) have been introduced because of the alleged moral hazard associated with the so-called Originate-to-Distribute (OTD) model. A general percep- tion about securitisation is that securitising banks do not have a ‘skin in the game’ after the loan transfer from their balance sheet. This results in a misalignment of incentives between investors and originators leading to deterioration in the quality of the originated assets. The RRR is also based on this perception. It is believed that these requirements will help ensure incentive alignment and quality of the underlying assets will improve as originators will have a ‘skin in the game’.

US regulatory authorities introduced the risk retention requirement in Dodd-Frank Act. The European regulations have also focused on the risk retention (so-called ‘skin in the game’). According to RRR, originators are required to retain an unhedged portion of credit risk while securitising their assets. The minimum requirement is 5% of the securitisation transaction.24 The originators are not allowed to use any hedging technique for this retained portion of the risk, as hedging will trounce the (desired) objective of the RRR.

22A complete version was issued in November 2015.

23The amendments proposed by ECON are not binding and the Council will review them in light of the ordinary legislative procedure. A press release has been issued by the European Commission on 30 May 2017. According to this press release, the European Parliament, the Council and the Commission agreed to set out the criteria for the STS securitisation. This agreement is being followed by further discussion for the finalization of the text (European Commision, 2017).

The RRR has been directly placed on originators, sponsors or original lenders. If there are different entities involved in a transaction, then the originator is deemed responsible for the risk retention and the net economic interest in the transaction should not be split among various retaining parties.25 The STS framework — to overcome the loopholes in the definition of an originator — specifies that “an entity shall not be considered to be an originator where the entity has been established or operates for the sole purpose of securitising exposures”. Hence, the Special Purpose Entity (SPE) does not qualify as an originator for the risk retention.

The premise for the RRR is the general perception about securitisation that banks do not maintain a ‘skin in the game’ while securitising. However, this premise is questionable as it may not be the reason behind the astronomical losses emanating during the GFC. The risk retention was mandated by the market before the debacle of securitisation during the GFC. Originators and sponsors of securitisation transactions were already having a strong ‘skin in the game’ as the securitisation might be difficult unless the lower tranches are not retained by the originator.26 According to Chiesa (2008, 2015) and Schwarcz (2009), securitisation should not matter with respect to the risk creation. An investor, being the new owner of the assets, should undertake the risk assessment before making the investment decisions and taking positions in securitisation. However, the assessment for the investors was difficult because of the complexity of the securitisation transactions. Hence, they were excessively relying on the rating agencies (Barth, Ormazabal, & Taylor, 2012; Rösch & Scheule, 2011; White, 2010). Therefore, the complexity of securitisation transactions might support the propagation of STS securitisation but it does not support the risk retention.

Schwarcz (2016) is of the view that risk retention regulation may lead to ‘mutual mis- information’ problem. The originator may exhibit a fake confidence in the issued securities by retaining a portion of the risk in the securitisation transactions. The investors may get misinformed and reliance may also shift on the signal generated by the originator. This may become in conflict with the due diligence requirements. The securitisation carried out by many originators with retention of the lower tranches also contributed to the financial crisis, as it buttressed the false confidence of investors in these securities.

Guo and Wu (2014) argue that RRR may not prove to be effective as one size may not fit all. It may not be sufficient for the banks having a high securitisation intensity and vice versa. The different classes of securitised instruments performed differently before, during and after the GFC.27Therefore, the treatment of securitisation as a homogeneous class in RRR may not

25Article 4 § 1 of STS Framework 26See Gorton and Pennacchi (1995) 27See Moody’s (2015)

be justifiable. Moreover, the risk profile and motives of securitisation also vary from bank to bank. The RRR should be defined by keeping in view the market conditions, the risk profile of Financial Institutions (FIs) and type of assets being securitised. The later aspect occupies a core importance in this context.

Disclosure Requirement

Transparency in the securitisation transactions has been the central concern of regulators after the GFC. The securitisation transactions were considered highly complicated and opaque and several market frictions are attributed to this perceived opacity of the securitisation transactions. Most of the problems related to securitisation are attributed to the information asymmetries. Therefore, regulatory authorities largely focused on promoting transparency of these transactions through higher disclosure requirements. The disclosure is believed to control the information asymmetry and improve transparency. The disclosure requirements are a key element of the new STS framework in Europe.

Chapter 3 of the STS framework provides disclosure requirements. This chapter outlines all the standards that should be followed to qualify as STS.28This chapter defines the transfer mechanism that should be considered as a true sale. The underlying assets must be homo- geneous in their classification. The STS framework discourages re-securitisation as most of the complexity lies in these transactions.29 An originator is required to maintain all the underwriting standards while originating the exposures being securitised like the exposures that have not been securitised. If there are some significant changes in these underwriting standards, the originator must disclose them to the investors.

Article 9 of the said proposal provides standards for standardised securitisation trans- actions. The interest rate and currency risk against these securitisation transactions must be mitigated and the originator must disclose the measures used for the mitigation of these risks.30 The payments against these securitisation transactions must be based on the market interest rate and there should be no involvement of any complicated formulae for calculation of these payments. The relevant documents governing the securitisation transactions should explicitly specify the obligations, duties, rights and responsibilities of the servicer and the

28Article 8 of the STS framework 29Article 8(5) of STS framework

30Interest rate and currency risk are mitigated by FIs through various means e.g. future contracts, SWAPS and options. Securitisation transactions are subject to fluctuations in interest rates and exchange rate if issued in other currencies. The value of the ABS may fluctuate as per movements in interest and exchange rates. Therefore, interest rate and currency exchange risk must be controlled and measures taken for controlling these risks should be disclosed.

trustee. The possible remedies and actions in case of default should be well-defined in the rel- evant documents. Different triggers should be considered while structuring the securitisation transactions and they should be mentioned in the documentation. The documentation should also provide with a mechanism used for conflict resolution.

The STS framework also provides the requirements for transparency. The originator is responsible for providing the historical data related to the default and delinquencies of the underlying exposure. The minimum period covered in this data should be 7 years. A sample of the underlying exposures should be subject to the verification by an external party.31 The investors should be provided with a liability cash flow model by the originator before the investment decision has been taken. The compliance with all these requirements is the joint responsibility of originator, sponsor and Securitisation Special Purpose Entity (SSPE). The securitisation transaction showing compliance with chapter 3 of the STS framework will be regarded as STS Securitisation.

The disclosure requirements may not prove to be effective as the risks associated with complex securitisation and especially subprime mortgage loans were fully disclosed before the GFC, but such disclosure could not prevent the cataclysmic collapse of the securitisation market. Moreover, the information required to be disclosed by an originator is substantial and it is an arduous task to evaluate the long documents with complex legal and technical terminologies. The investor will require a fair amount of financial modelling to understand STS securitisation transactions as well. Therefore, even the most sophisticated institutional investors may continue to rely on the rating agencies while taking the investment decisions. The granular disclosure requirements are likely to place a burden on the securitising institutions without providing a proportionate benefit to the investors (Slaughter and May, 2015). Hence, these requirements may serve as a disincentive to securitisers.

Due Diligence

It is believed that the massive losses faced by investors in the securitisation market can be ascribed to the heavy reliance on the rating agencies. The ratings assigned to the issued ABS were dictating the investment decisions. The investors were not showing the due diligence while taking the investment decisions. The decline in the mechanistic reliance on the rating agencies (BCBS, 2014b) and thereby promoting due diligence has been high on the regulatory agenda after the crisis (The European Commission, 2015).

31This requirement seems akin to the cover pool monitoring in case of CBs. However, the regulations do not clarify that who will appoint this external agency and who will bear the cost. The eligibility criteria for the designated external party is also not given in this proposal.

The due diligence requirements are provided in Article 406 of CRR and Chapter 2 (Article 3) of the STS framework. According to these requirements, an investor must show due dili- gence while making the investment decision. This due diligence entails several requirements. An investor must evaluate before taking positions in the securitisation if the transaction follows the relevant requirements outlined in various recent regulations (e.g. Article 4 of Regulation (EU) No. 575/2013, STS framework etc.). The institutional investors must undertake a risk assessment associated with all the structural features of the target securitisation. The payment priorities and different triggers affecting the payment structure should be evaluated. As part of this due diligence framework, the investors are also required to document the procedures being followed for the risk assessment and regularly perform the stress tests on the cash flows generated from the securitisation exposures. They must be aware of the changes in the risk profile of the underlying exposure of securitisation. Lastly, they must have a mechanism for reporting to concerned authorities about their understanding and management of risk inherent in the securitisation positions.

The due diligence requirements were laid out to avoid feeding-frenzy atmosphere in the financial markets.32 However, these requirements may be unnecessary and considered too paternalistic in nature. They seem to shout at investors: ‘Do a better job!’. Given that investors will suffer the losses in case of poor investment decision, they are already expected to conduct some due diligence before making their investment decisions. Generally, this (expected) due diligence is not confined to the securitisation exposures only, rather investors are expected to show this due diligence in almost all forms of investment decisions, as other market instruments like unsecured bonds, equities and CBs are not inherently less risky than securitised products. It should be investors’ decision to decide about the nature of the due diligence. The empirical investigation performed by Fabozzi and Vink (2012), on the data before 2007, shows that European investors were already looking beyond the credit rating. They were already performing some sort of due diligence while making their investment in the ABS market. Hence, these requirements seem unnecessary.

The reliance on the STS notification by the originator may not be sufficient and investors need to evaluate other accompanying information. These due diligence requirements may prove to be burdensome for the investors. They are required to outlay high level of due diligence before investing in securitisation, and evaluating if a securitisation transaction can be regarded as STS. These regulations require investors to evaluate a number of risks

32Paul Stevenson, Managing Director of Moody’s Investor Service Inc. said, “When everybody wants to securitize, and everyone is willing to buy, and everyone thinks nothing will go wrong, there gets to be a