Background

The new EU Securitisation Regulation (the SR) became applicable across the EU on 1 January 2019 bringing with it new obligations for originators, sponsors, issuers and investors in securitisation transactions. Some of these obligations are likely to raise concerns for non-performing loan (NPL) securitisation transactions.

Some uncertainty remains in the market about what exactly the SR means for securitisations and how affected parties will comply with their obligations. This is in large part because the majority of the secondary legislation required to flesh out the relatively concise SR has not yet been finalised. This is despite the SR having been applicable for over a month at the time of writing.

Verifying credit-granting standards

A common feature of NPL securitisations is for the NPL purchaser to acquire the loan book from a third party and issue senior notes to investors to fund the acquisition. The SR applies equally to this type of acquisition financing as to more traditional public securitisation transactions. The NPL purchaser may be the ‘originator’ of the securitisation, being the entity which purchases a third party’s exposures on its own account and then securitises them. In such a case, Article 9(3) of the SR requires that the NPL purchaser verifies that the original lender under the loan book fulfils the requirements of Article 9(1) of the SR. This requires that (a) the original lender has "sound and well-defined criteria for credit-granting" and has effective systems in place to ensure they are applied, and that (b) the original lender applied the same "sound and well-defined criteria for credit-granting" to exposures to be securitised as to non-securitised exposures.

These requirements could be challenging for an NPL purchaser and the precise application of the rules is currently unclear. If the original lender has not securitised any comparable exposures, and has sold off the full loan book to a third party purchaser, is the obligation automatically complied with? And what if there is a difference between the credit-granting standards applied to comparable exposures the original lender is looking to sell (the NPLs) and those it wants to keep (which could be performing) – does this mean it will not be able to sell such a selected pool? Is this the case even if the difference in credit-granting standards is fully and accurately disclosed to investors who are willing to finance (and so, assume the risk of) the acquisition of the NPL loan book?

Furthermore, Article 5 of the SR requires institutional investors in a securitisation to diligence credit-granting standards in certain situations and the application of this to securitisations of purchased NPL books is somewhat uncertain.

Compliance challenges and potential effect on NPL transactions

In an NPL securitisation, particularly in the case of legacy NPLs, it may be the case that the original lender is unwilling or simply unable to provide the required information to the NPL purchaser to enable it to satisfy its obligations under Article 9(3). The original lender may not be willing to provide the required information – there is little incentive for them to take on the risk of providing it. Practically, the original lender may have gone insolvent since origination, or otherwise no longer exists (due to a merger / takeover). Loan granting records may have been destroyed or lost, or the original deal or underwriting team may simply have been moved on or disbanded. This is often practical reality for institutions with legacy NPL books.

Whilst these situations are not unique to NPLs, they are particularly prevalent in this area. A lender with a large NPL ratio is more likely to find itself under pressure to sell on its loan book and clean up its balance sheet. A similar issue could arise with a tertiary portfolio acquisition, where a loan book is sold on more than once before it is securitised by an NPL purchaser. In each scenario, it may be practically impossible for the NPL purchaser to verify the existence of “sound and well-defined criteria” on those loans or any difference in credit granting standards between securitised and non-securitised exposures.

The due diligence requirements of Article 5 of the SR are equally troublesome. The same scenarios that provide difficulty for NPL equity investors under Article 9 will trouble NPL debt investors under Article 5.

It is worth noting that there is a carve-out from the application of Article 9(3), which applies to loan books originated prior to 20 March 2014, found in Article 9(4)(b). However, the carve-out only applies if the requirements of Article 21(2) of Regulation (EU) No 625/2014 are satisfied. These requirements may be almost as difficult to satisfy, so this apparent exception is of limited use.

The consequences of breach of the SR for an originator or sponsor may include substantial fines (of at least EUR 5,000,000 and up to 10% of total annual net turnover) and public disclosure (so-called ‘name and shame’) statements for non-compliance. An institutional investor may suffer punitive capital treatment on its investment. Given the severity of these consequences, these compliance challenges have the potential to restrict the well-functioning of the secondary market for NPLs, ultimately to the detriment of those institutions still holding large NPL books.

Market participants are likely to be more hesitant of taking part in these transactions unless they can be certain the SR requirements have been complied with. This could have a negative effect on NPL securitisation supply and demand. Participants may look to other financing methods to assist them in acquiring NPL books or worse still, may find no attractive or even viable alternative, preventing the transaction altogether.

Policy conflict?

At a policy level, the EU, through a series of speeches, papers and draft legislation, have promoted the idea of expanding, reinforcing and reinvigorating the secondary market for NPLs. A European Commission paper from 2017 highlights the importance of removing NPLs from the balance sheets of European financial institutions:

“If banks were better able to off-load legacy assets from their balance sheet via secondary markets for credit, they could use their managerial capacity more on evaluating new lending business.”

The EU Commission stated in a 2018 European Commission paper that:

NPL securitisation has developed into an important NPL disposal strategy used by banks to clean up their balance sheets.

It seems conflicting, then, that as momentum appeared to be gathering for structurally supporting a strong secondary market in NPLs (and rehabilitating the EU’s financial institutions from the crippling effect of holding significant NPL assets) the SR apparently presents new hurdles for financial institutions seeking to manage and dispose of such exposures. Such hurdles would restrict the transfer of risk to participants in the market, contrary to previously stated EU policy.

A 2018 Deloitte report notes that the overall level of non-performing exposures across EU banks fell from €1.1 trillion in 2015 to an estimated €750 billion at Q3 2018. It will be interesting to see the effect that the apparently restrictive nature of the SR has on the NPL reduction program the EU otherwise encourages.

It is currently unclear how regulators will deal with these issues. It is hoped that the guidance from the European Supervisory Authorities (which the market eagerly awaits over the next few months) will allow for NPL securitisations to continue. This should be the case even in situations where the original lending criteria cannot be verified in full. Provided reasonable efforts have been made to identify and assess the applicable standards, and the associated risks have been accurately and fairly disclosed to investors, the SR should not restrict the use of securitisation as a technique to transfer and assume risk to NPLs – and with it, the functioning of the NPL market in Europe.