NPL securitisation: will the EU's 'quick fixes' help?

We raised concerns in a previous blog post that the EU Securitisation Regulation (SR) was problematic because in a number of respects it conflicts with the broader EU policy of reducing non-performing loans (NPLs) in Europe. The SR was not designed with NPL securitisations in mind and arguably discourages banks from securitising NPLs.

The good news is that the rules have been improved for NPL securitisations by amendments recently made to the SR. (Note, however, that no equivalent amendments have been made to the UK onshored SR.) Meanwhile, the European Banking Authority (EBA) has just published a consultation on draft regulatory technical standards, which will set out further detail on these new rules for NPL securitisations. 

In this blog post, we consider the effect of and response to the recent changes for NPL securitisations and whether it will encourage the use of securitisation as a technique to sell, acquire or fund NPL risk.

Background to the recent changes

In October 2019, the EBA published an opinion on the regulatory treatment of NPL securitisations ('the EBA opinion'), which noted that, while securitisations can play an instrumental role in reducing NPL stocks in credit institutions’ balance sheets, such a role may be hindered by certain provisions in the EU law securitisation framework. The EBA opinion advised the European Commission (EC) to consider making certain amendments to the SR and the EU Capital Requirements Regulation (CRR) to remove these constraints.

Pressure to remove these constraints grew with the global pandemic and predicted increase in NPLs in Europe. 

In July 2020, as part of its capital markets recovery package, the EC published proposals to amend the SR and CRR. The text of the proposed amending regulations was developed and eventually agreed by the EU Council and the European Parliament. Regulation (EU) 2021/557 amending the SR and Regulation (EU) 2021/558 amending the CRR ('the Quick Fix Regulations') were published in the EU Official Journal on 6 April 2021 and came into force on 9 April 2021. 

The aim of the Quick Fix Regulations in general is to help prevent the future build-up of NPLs on bank balance sheets across the EU, as a result of the coronavirus crisis. To achieve this, the Quick Fix Regulations loosened some of the regulatory restrictions in the SR that made NPL securitisation more difficult and, by doing so, have made NPL securitisations more achievable. 

It is too early to say whether this will increase NPL securitisations. But it has certainly made it easier for market participants using securitisation to sell, buy, finance or otherwise service NPL exposures.

On 30 June 2021, the EBA launched a public consultation on revised draft regulatory technical standards on the risk-retention requirements ('the draft RTS'), which include specific provisions relating to NPL securitisation.   

The Quick Fix Regulations

In order to reduce constraints on NPL securitisation, the EU has made the following 'quick fixes' to the SR.

Risk retention

The SR requires the originator, original lender or sponsor of a securitisation to retain a material net economic interest in the securitisation of not less than 5 per cent.

The original aim of this requirement was to ensure an alignment of interest between the originator/sponsor and investors in the securitisation, often referred to as the originator/sponsor retaining 'skin the game'.

Article 6 of the SR (and the supporting technical standards) provides for this risk-retention requirement to be calculated with reference to 'nominal values'. The Quick Fix Regulations allow for the risk-retention requirement to instead be calculated on the basis of the discounted price paid for the exposures (provided the discount is non-refundable). This means that, if an investor buys an NPL portfolio and raises finance (to enhance returns) by securitising the portfolio, the risk retainer will now retain less. 

The knock-on effect is that NPLs become much more attractive, as you have to invest less equity, which you can use to bid more for the deal or for other investments. This change will in theory make NPLs much more commercially attractive to both sellers and buyers.

The Quick Fix Regulations also amend Article 6 of the SR so that the risk-retention requirements in a NPL securitisation may be fulfilled by the servicer. 

Previously, the legislation did not allow the servicer to be the risk retainer in securitisation transactions. This inflexibility was seen as a material weakness by the NPL market. 

In a NPL transaction, it is the servicer who will manage the loan portfolio with a fee structure containing incentives to maximise recovery on the loans. Commercially, it is the servicer that bears the most risk from an asset performance perspective, and therefore it is more appropriate that the servicer retains this risk. If the servicer retains the risk, the servicer will also have greater incentive to recover the maximum from the loans. 

The Quick Fix Regulations make it possible for the servicer to be the risk retainer, provided that the servicer can show it has: 

• expertise in servicing exposures of a similar nature to those securitised; and 
• has well-documented and adequate policies, procedures and risk-management controls relating to the servicing of exposures. 

The draft RTS would, if adopted in their current form, provide further details on this expertise requirement, including a requirement that certain management and staff have at least five years of relevant experience. Given the increasing expertise, sophistication, size and technology-driven nature of NPL servicers in Europe, we expect this standard can be easily met.

The draft RTS would also provide that where there are multiple servicers, the servicer with the predominant economic interest in the successful workout of the exposures could fulfil the retention requirement (or otherwise each servicer could retain a proportionate share). 

Where the retention requirements are met by a retention of randomly selected exposures, the draft RTS would require that there is no deterioration of the servicer’s standards with respect to the transferred exposures relative to the retained exposures.

Due diligence 

The Quick Fix Regulations also amend the Article 9 requirements relating to criteria for credit-granting in the SR. 

Previously, Article 9(3) of the SR required that NPL purchasers must, in order to securitise those NPLs, verify that the original lender under the loan book fulfilled the requirements of Article 9(1) of the SR. 

This requires that the original lender:

• has 'sound and well-defined criteria for credit-granting' and has effective systems in place to ensure they are applied; and 
• applied the same 'sound and well-defined criteria for credit-granting' to exposures to be securitised as to non-securitised exposures. 

As argued in our previous blog post on NPL transactions, it is difficult to verify compliance with this test, particularly if the original lender under the portfolio no longer exists (say, because it has been acquired, merged or dissolved, or has become insolvent).

Under the Quick Fix Regulations, Article 9(1) has been amended so that it provides instead that 'with regard to underlying exposures that were non-performing exposures at the time the originator purchased them from the relevant third party, sound standards shall apply in the selection and pricing of the exposures'. The level of due diligence by the NPL purchaser needed for an NPL securitisation is, therefore, now less than the level of due diligence needed for a non-NPL securitisation. 

The result of these changes is that buyers of NPLs who intend to use securitisation need to be satisfied they have done enough due diligence (and that they have used this information to apply sound standards in the selection and pricing of the exposures).

The same derogation has been granted in Article 5 of the SR, which sets out due-diligence requirements for institutional investors. Article 5 requires that 'where the originator or original lender… is not a credit institution or an investment firm… the originator or original lender grants all the credits giving rise to the underlying exposures on the basis of sound and well-defined criteria and clearly established processes for approving, amending, renewing and financing those credits and has effective systems in place to apply those criteria and processes…'. 

Historically, the due-diligence requirements of Article 5 of the SR have proved as troublesome as the Article 9 requirements. The same scenarios that provide difficulty for NPL equity investors under Article 9 will have troubled NPL debt investors under Article 5. 

However, the Quick Fix Regulations amend Article 5 of the SR to require that institutional investors must verify that 'in the case of non-performing exposures, sound standards are applied in the selection and pricing of the exposures'. These changes will make NPL securitisations easier by having not only a less difficult due-diligence standard overall but also one that reflects the commercial reality of the NPL product. 

As mentioned, NPL buyers and investors in securitisations remain obliged to ensure sound standards are applied to portfolio selection and pricing. Given the sophistication of NPL buyers and debt investors, and their typical due-diligence requirements and processes related to pricing methods, we expect most participants to be already passing this test.

NPE and NPE securitisation definition

The Quick Fix Regulations have provided a definition of 'NPE securitisation' for the first time: 'a securitisation backed by a pool of non-performing exposures [where ‘non-performing exposure’ means an exposure that meets any of the conditions set out in Article 47a(3) of the CRR] the nominal value of which makes up not less than 90 % of the entire pool’s nominal value at the time of origination and at any later time where assets are added to or removed from the underlying pool due to replenishment, restructuring or any other relevant reason'.

This is significant as you need to meet the definition of an NPE securitisation to qualify for the flexibility provided by the risk-retention and due-diligence derogations discussed above.

What do the changes mean for the NPL securitisation market?

The changes are good news for the European loan portfolio market.

From March to October last year, the European securitisation market slowed down. In 2021, the picture is different. Securitisation performance in general has been surprisingly robust given the anticipated distress forecasted last year. NPL processes have restarted and are pretty much back to pre-COVID-19 levels.

As expected, the amount of European NPLs is forecasted to increase as the effects of the pandemic continue to emerge and the co-ordinated national and supranational financial support eventually tapers off. This will create increasing pressure on banks to transfer NPL risk from their balance sheets, thus creating further opportunities to buyers and funders of NPL risk.

Consequently, the reaction to the Quick Fix Regulations has been positive. Securitisation is an important tool in transferring NPL risk to the private sector, and the changes to the SR will encourage the use of securitisation to transfer NPL risk. 

The changes in risk retention mean that NPL buyers will in theory need their transactions to retain less risk, thus reducing the cost of equity. The revised due-diligence requirements have made NPL securitisation more practical and cost effective (and in some cases, now even possible) to carry out. 

While the reforms are welcome, further steps are needed to remove the challenges of participants using securitisation to sell, acquire and fund NPLs. At the same time the EU has to carefully balance the sometimes competing objectives of encouraging the development of a liquid secondary market for European distressed debt and creating a robust and transparent financial sector. 

The EU has confirmed that it will conduct a further review of the SR by January 2022.

It is currently unknown whether the UK will implement changes equivalent to the Quick Fix Regulations to the UK onshored version of the SR.

Further reading

See the following blog posts:

• Tackling the post-COVID European NPL ‘problem’: a State aid perspective (March 2021)
• EBA guidance on the EU Securitisation Regulation (October 2019)
• NPLs and the new EU Securitisation Regulation (February 2019)