DP3/23 – Securitisation: capital requirements

In view of the upcoming replacement of all retained EU legislation (REUL), including the retained Capital Requirements Regulation (UK CRR), and the upcoming authority of the Prudential Regulation Authority (PRA) to put in place all firm facing rules and regulations for those rule replacements affecting prudential regulation of PRA authorized entities, the PRA has launched a discussion paper (DP3/23) on various issues under the UK CRR pertaining to the capital requirements for securitization exposures. This discussion paper is aimed to pave the way for a subsequent official consultation on new rules in this context to replace those in the UK CRR.
Specifically, the discussion paper addresses the following four issues.
1. the output floors and subsequent capital requirements for securitization exposures;
2. the hierarchy of methods for determining capital requirements for securitization positions;
3. the scope of the framework for STS securitizations; and
4. the use of credit risk mitigation in synthetic SRT securitizations.
Each issue is briefly described below, along with some remarks and / or questions provided by the regulator.
#### (1) The output floors and subsequent capital requirements for securitization exposures
In the context of output floors and subsequent capital requirements for securitization exposures as stipulated in the Basel 3.1 framework whereafter firms must apply – at a minimum – capital requirements to ALL securitization positions derived from the use of the standardized approach (SA) to assess credit risk regardless of whether or not the use of an internal ratings based approach (IRBA) reveals lower capital requirements, the PRA presents three options for the application towards securitizations, namely:
– to adopt the Basel 3.1 framework without any changes, that is the requirements would apply to all securitizations, including significant risk transfer (SRT) securitizations;
– to make targeted changes to the framework, for instance, to more closely align the IRBA and SA;
– to adopt changes to the framework to allow exemptions from the output floor requirements.
It may be noted in this context that the PRA does not seriously consider option 3 as securitization exposures always carry inherent risks and should be subject to capital requirements. However, any views on the three options would be welcome.
#### (2) The hierarchy of methods for determining capital requirements for securitization positions
The PRA seeks feedback on this hierarchy which is currently different from the one outlined in the Basel standards. Specifically, the UK CRR places the SA for assessing credit risk on securitization exposures above the external ratings based approach (ERBA). The IRBA is on top in both policies as it presents a highly reliable measure for determining credit risk and subsequent capital requirements within an acceptable amount of effort. The differences in the hierarchy are outlined in the graphic below:
Hierarchy of methods for determining capital requirements in the Basel Standards and the UK CRR

It may be worth noting in this context, that the PRA very well acknowledges the risks associated with the prioritized use of an ERBA over the standardized approach in determining capital requirements, but finds that it would be worth considering an alignment with the Basel standards. Any comments and evidence on this issue are highly welcome.
#### (3) The scope of the framework for STS (simple, transparent, and standardized) securitizations
In the context of the scope of the framework for securitizations, the PRA seeks feedback on whether or not synthetic securitizations should be included in the STS framework which provides for capital relief for securitization positions that qualify as STS positions in accordance with the requirements set out in the retained Securitization Regulation. It is the view of the PRA that synthetic securitizations should not be included as it doubts the meaningfulness of additional disclosures for institutional investors and the adherence to the STS requirements altogether as synthetic securitizations are mostly highly unique tailored to the needs of private investors. However, the PRA would welcome any feedback on this issue.
#### (4) The use of credit risk mitigation in synthetic SRT securitizations
Typically, significant risk transfer (SRT) in securitization is an ongoing requirement and firms should ensure that any reduction in capital requirements through securitization is consistently accompanied by a corresponding transfer of risk throughout a transaction’s lifespan. The PRA thereby encourages a substance-over-form approach in assessing SRT, requiring firms to demonstrate that post-transaction capital relief accurately represents the economic substance of the entire transaction and aligns with the retained risks of a financial institution.
In the context of SRT, the PRA now seeks information on credit risk mitigation (CRM) in synthetic SRT securitizations. Specifically, the PRA aims to identify and understand potential prudential risks in synthetic SRT securitizations, so as to properly assess potential CRM requirements via unfunded and funded credit protection (use of collateral) measures. The PRA thereby acknowledges the prevalent use of funded credit protection in UK SRT securitizations, but particularly seeks market input on the use of unfunded CRM. Any feedback on current practices in this context and the potential risks associated with the use of either of the two methods, and comments on other mitigation strategies for sustained SRT achievement would be highly welcome.