02 Feb 2010

APRA flexes muscle in relation to securitisation - the new draft APS 120 and APG 120 reviewed

Reminiscent of the last release of a new draft of APS 120 in November 2007, APRA released a consultation draft of a revised APS 120 and APG 120 in late December last year. The drafts were part of a package of revised prudential standards and practice guides that implement the enhancements to Basel II finalised by the Basel Committee on Banking Supervision in July 2009.

The amendments proposed to APS 120 and APG 120 are, to the extent they implement the "Basel II Enhancements", not controversial. In fact APRA has largely incorporated the enhancements verbatim. The controversy arises from the other amendments which APRA has taken the opportunity to make to APS 120 and its non-binding guidance document APG 120. APRA's justification for the changes is that they are required to address issues that have arisen since the current standards became effective in January 2008 and in response to industry requests for clarification. APRA suggests that these amendments are, in part, consistent with concerns it raised to the industry in letters to ADIs on Securitisation and Funds Management (8 April 2009) and on Covered Bonds (29 April 2008). Although the amendments do reflect some of APRA's thinking in that correspondence with ADIs, with respect to some particular aspects the amendments go a step further.

It is proposed that the amendments will take effect from 1 January 2011 after a process of consultation with the industry.

Basel II Enhancements

As indicated above, APRA is proposing to amend APS 120 to incorporate all the relevant Basel II Enhancements relevant to Australia and it has largely incorporated these verbatim from the final Basel Committee report.

Resecuritisation exposure

APRA has adopted the definition of "resecuritisation exposure" from the Basel II Enhancements and the higher risk weights that apply in connection with these. These changes are reflected in both Attachments C and D that set out the risk-weights for securitisation exposures for ADIs applying the standardised and IRB approaches, respectively.

A resecuritisation exposure is defined as a securitisation exposure:

  • in which the risk associated with an underlying pool of exposures is tranched; and
  • at least one of the underlying exposures is a securitisation exposure (refer to page 7 of draft APS 120).

In addition, an exposure to a resecuritisation exposure is also a resecuritisation exposure.

The definition is intended to apply to CDOs and conduit exposures (for example, commercial paper and liquidity facilities provided to conduits). The changes were proposed by the Basel Committee in order to strengthen the capital requirements under Basel II for these exposures to address the additional risks, including correlation risk which they give rise to and which were highlighted by the financial crisis.

Interestingly, as the definition of resecuritisation relies on the definition of "securitisation" and there are differences between the definition of that term in Basel II and APS 120, this may lead to the inconsistent treatment of certain securitisation and resecuritisation exposures in Australia as compared to other jurisdictions. The Basel II definition focuses on the cashflow from a pool of assets servicing two tranches of "credit risk" (notwithstanding the form of that risk). APRA's definition in APS 120, although similar, refers to those cashflows servicing two tranches of "creditors" (for example, it does not recognise an income unit as a tranche of credit risk). We understand the Australian Securitisation Forum ("ASF") will be making a submission to APRA recommending that the definition of securitisation in APS 120 be more closely aligned to the Basel II definition.

The resecuritisation amendments should not affect the capital required to be held against a typical RMBS or ABS transaction. The only proviso to this is that most transactions contain flexibility which permit the SPV to acquire short-term investments which might consist of appropriately rated asset-backed securities. The acquisition of any such instruments, even if immaterial and short-term, may render the RMBS or ABS a "resecuritisation".

Due diligence requirement

ADIs will be required to ensure they comply with ongoing due diligence requirements in relation to their securitisation exposures or else must treat those exposures as a deduction from capital (refer to new paragraph 13 of Attachment B of APS 120 and new paragraphs 9 to 12 of APG 120). These amendments have been introduced to discourage reliance on ratings and to encourage a greater understanding of the structures ADIs are exposed and concentration risks within their portfolio.

Liquidity facilities

The Basel II Enhancements have removed the favourable treatment afforded to liquidity facilities with a maturity of a year or less for banks applying the standardised approach. APRA has reflected this amendment in both Attachments C and D where APS 120 previously afforded concessions to eligible facilities with a maturity of a year or less by imposing a lower credit conversion factor (20% under the standardised approach and 50% under the IRB approach to both standardised and IRB ADIs). These concessions will be removed and the credit conversion factor for an undrawn eligible facility will no longer vary depending on its term (refer to paragraphs 12 of Attachment C and 38(a) of Attachment D).

This change will also affect redraw facilities that ADIs may have treated as eligible facilities. As the changes in the Basel II enhancements are specifically geared at liquidity facilities we understand that the ASF will make a submission to APRA that the concessionary treatment should be retained for facilities other than liquidity facilities.

Relying on ratings supported by the ADI

ADIs will be precluded from relying on a rating for the purposes of determining the risk weighting applicable to a securitisation exposure where that rating is based (wholly or partly) on unfunded support provided by the ADI to the structure (refer to paragraph 12 of Attachment B). This change was introduced by the Basel Committee to address behaviour witnessed during the financial crisis where conduit sponsors bought securities issued by conduits rather than funding under liquidity lines (and then held capital against the commercial paper based on its rating, which in turn was supported by the liquidity).

As drafted the prohibition may extend to circumstances where a sponsoring ADI in an RMBS acquires securities issued by the SPV where the ADI provides a timely payment liquidity facility and/or derivatives to the SPV (which are required for the rating of the securities but not the sole criteria the rating agencies consider). We understand that the ASF will be making submissions to APRA in relation to this issue.

Other amendments to APS 120

As indicated above, in addition to the Basel II enhancements, APRA took the opportunity of updating APS 120 to address issues that had arisen since its introduction two years ago. In our view the changes made to APS 120 and APG 120 actually go beyond APRA's previous stance in relation to certain issues. They demonstrate that APRA is largely suspicious of the securitisation activities of ADIs.

Non-compliant securitisation transactions - electing to treat a pool on balance-sheet

In previous correspondence with ADIs, APRA took away their ability to rely on the election currently in paragraph 23 of Attachment B of APS 120 which permits an ADI to elect to treat a transaction on-balance sheet for capital purposes. This position is now codified in new paragraph 8 of APS 120. The drafting of the paragraph not only requires that the ADI consult with APRA prior to undertaking the securitisation but also suggests (in paragraph (a)) that the ADI will not be permitted to undertake the transaction to the extent it is not compliant with APS 120. The ADI will also be required to demonstrate that the transaction is not a covered bond and that it will not reduce the protection available to depositors.

If these conditions are satisfied the transaction can be undertaken although APRA has clarified that the amount of capital required to be held against the underlying assets may, where the ADI adopts the standardised approach, be risk-weighted 100% if the ADI can no longer meet the requirements in Attachment C of APS 112 which permit it to apply a lower risk weighting where the assets are residential mortgage loans (refer to paragraphs 26 and 27 of Attachment B of the draft APS 120). Attachment C of APS 112 requires the ADI to have an unconditional right to enforce the relevant mortgages (refer to paragraph 1). If an ADI has securitised those mortgages although it will have the right to enforce them as part of its role as servicer it can be removed as servicer in certain circumstances, so its right will not be unconditional. This capital penalty does not appear in Basel II or the Basel II enhancements and seems to unfairly disadvantage standardised ADIs.

Implicit support

APRA will not tolerate the provision of implicit support (support beyond contractual obligations) by an ADI to a securitisation. It has taken the opportunity to introduce new penalties where it considers implicit support has been provided. Currently it could impose an additional capital charge on the relevant ADI up to the amount of capital required to be held in respect of the relevant securitised pool (or the value of the securities issued by the SPV). The proposal is that APRA will now be able to impose those requirements on any securitisation transaction in which the ADI is involved, not limited to the transaction in respect of which implicit support was provided (refer to the amended paragraph 20 of APS 120). Also, consistent with the amendments described in the preceding paragraph, where additional capital requirements are imposed, the ADI must have regard to whether it can comply with Attachment C of APS 112 in order to risk-weight the assets less than 100% in the case of residential mortgages.

Additionally, APRA is proposing to give itself the power to impose limits on an ADI's securitisation activities to the extent any such additional capital requirements do not adequately address the risk associated with the implicit support (refer to new paragraph 22 of APS 120). APG 120 has been amended to set out examples of the limits that APRA may impose (refer to new paragraph 22 of APG 120). They include, for example, restricting an ADI's securitisation activities until it puts in place relevant policies and procedures, until it demonstrates the capacity to undertake detailed self-assessment or the board and senior management of the ADI demonstrate they understand the ADI's securitisation activities. APRA also proposes to be able to impose limits on an ADI's ability to securitise its loan book where it has relied excessively on securitisation. It is not clear to us how this last restriction necessarily addresses the risk associated with the implicit support provided and would seem to unfairly disadvantage an ADI that has been reliant on securitisation for funding.

Warehouse SPVs

The current draft of APS 120 has never dealt well with warehouse facilities. Firstly, depending on the structure of the warehouse it may not fall within the definition of a securitisation as defined (although APRA corrected this issue in the current APS 120 by specifically including the concept of a warehouse SPV in the definition of securitisation). Secondly, the definition of warehouse SPV seems to assume that all warehouse facilities are ultimately established for the purpose of, or refinanced through, a term securitisation. Finally, the provisions in Attachment D in relation to funding facilities do not recognise that warehouses tend to provide funding to revolving pools of assets.

This confusion has now extended to new paragraphs inserted in APG 120 in relation to warehouse SPVs (refer to paragraphs 43 to 45). Paragraphs 44 and 45, in particular, are problematic. APRA will consider any action taken by the ADI to facilitate the refinancing of a warehouse SPV other than through the "originally anticipated" term securitisation as implicit support. Paragraph 45 lists examples of scenarios that would constitute implicit support. Again, the paragraphs assume that a warehouse SPV is only refinanced by way of a term securitisation and do not seem to facilitate an ADI negotiating an extension to a short-term warehousing facility where the provider imposes additional requirements in connection with the extension which may include, for example, the provision of subordination (which itself complies with APS 120).

On the other hand, the new paragraph 43 is helpful, it seems to confirm that a 364 day warehouse facility can be entered into without breaching the operational independence requirement in paragraph 8(c) of Attachment B of APS 120 (as explained in paragraphs 22 and 23 of the current draft APG 120) provided an ADI recognises that it risks the securitised assets being sold if the warehouse SPV is not refinanced.

Basis swaps

APRA has amended the definition of basis swap in APS 120 (refer to page 5 of the new draft). The change is not controversial. It has also clarified that the positive mark-to-market value of a basis swap must be deducted from capital where the ADI has reported it as an on-balance sheet asset consistent with the current treatment of surplus income arrangements (refer to paragraph 25 of Attachment B of APS 120).


We understand the ASF will be making submissions to APRA about a number of the above amendments made by APRA, in particular outside of the Basel II enhancements. If you would like to be involved in those submissions you should contact the ASF Regulatory Committee. It has established a working group to prepare a response to APRA.

It is clear that APRA is still suspicious of the securitisation activities of ADIs and their relationship with their securitisation structures. We query whether this level of distrust is justified. Based on our experience most ADIs are very careful in their approach to securitisation and APS 120 compliance and have in place robust procedures for understanding their exposures and dealing with their securitisation vehicles. It will be interesting to see if APRA takes note of the industry's response in relation to a number of these issues in the consultation process.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.