Future regulation of securitisation markets

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Author
Paul Smith
Partner

Paul Smith

Partner
T +61 2 9296 2407

Future regulation of securitisation markets - IOSCO report handed down

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Summary

The International Organisation of Securities Commissions (IOSCO) recently released the Final Report of the Task Force on Unregulated Markets and Financial Products (TFUMP), following a Consultation Report in May. The Final Report gives Australia a clear mandate to implement changes in a way which recognises the particular features of market practice in Australia.

Two areas of concern for Australia at the Consultation Report stage - around the "skin-in-the-game” requirement and recommended changes to disclosure rules for securitisation transactions - have been somewhat addressed in the Final Report. However, the challenge for the Australian securitisation industry and our Federal Government will be to provide a framework which balances the protections provided by a mandatory skin-in-the-game requirement with the inherent protections in the Australian market.

With respect to disclosure, given the less rigid approach in the Final Report it appears that there is a task ahead for Australian regulators to determine the right level of regulatory intervention by either encouraging market led initiatives or by mandating formal disclosure to investors in securitisation transactions.

Given that mandated disclosure and the maintenance of an economic interest in a transaction will increase the cost of securitisation, the cost of compliance with any new regulations will need to be carefully compared to any benefits for investors in securitised products.

Background

The Final Report was issued on 4 September and follows the Consultation Report issued in May. Industry participants will be pleased to note that the IOSCO report recognised that securitisation is an important part of the global economy stating that:

The absence of a well-functioning securitisation market will impact consumers, banks, issuers and investors. The price of credit is likely to be higher for the consumer and the availability scarcer. Banks will no longer have a tool to reduce risk and diversify their financing sources. More broadly, the current absence of an efficient and smoothly functioning securitisation market has substantial implications for continued economic growth. The Global Joint Initiative in its report…estimated that banks may fail to meet US$2 trillion of demand for credit origination in the absence of well-functioning securitisation markets.

The Report sets out the key TFUMP recommendations for regulation of the securitisation market as follows:

Consider requiring originators and/or sponsors to retain a long-term economic exposure to the securitisation in order to appropriately align interests in the securitisation value chain.

Require enhanced transparency through disclosure by issuers to investors of all verification and risk assurance practices that have been performed or undertaken by the underwriter, sponsor, and/or originator

Require independence of service providers engaged by, or on behalf of, an issuer, where an opinion or service provided by a service provider may influence an investor's decision to acquire a securitised product

Require service providers to issuers to maintain the currency of reports, where appropriate, over the life of the securitised product

Provide regulatory support for improvements in disclosure by issuers to investors including initial and ongoing information about underlying asset pool performance. Disclosure should also include details of the creditworthiness of the person(s) with direct or indirect liability to the issuer

Review investor suitability requirements as well as the definition of sophisticated investor in the relevant market and strengthen these requirements, as appropriate, in the context of the relevant market

Encourage the development of tools by investors to assist in understanding complex financial products.

Skin in the game

The Consultation Report proposed that originators may be required to retain a long term economic interest in their securitisation transactions (“skin in the game requirement”). In May, Europe (in respect of transactions to be marketed to regulated credit institutions) and the United States of America (in respect of transactions in respect of certain residential mortgage loans) introduced a skin in the game requirement which requires originators to retain a 5% economic exposure to the transaction.

Several Australian industry participants, including Mallesons, made submissions on the Consultation Report noting that there were several differences in the Australian market which means that a one-size mandatory skin-in-the-game requirement is inappropriate. Reasons included that:

this would not differentiate structures based on their risk (for example, transparent and plain vanilla structures backed by prime mortgages would be treated no differently to complex structures backed by sub-prime mortgages)

Australian structures typically have a strong incentive link between the originators and the performance of the pool (transactions are often branded with the originator’s logo, originators typically act as the servicer of the loans and the originators typically receive a substantial amount of income as a subordinated distributions)

the traditionally vibrantly competitive mortgage lending market in Australia would be stunted if new entrants were required to raise and maintain a 5% exposure to their securitisation transactions

Australian housing loans are a comparatively robust asset classes (unlike their American counterparts, mortgage loans are full recourse debt obligations, meaning that borrowers cannot simply walk away from their obligations when they have a negative equity position in their house. Australia also has a long history of regulation of the origination of housing loans), and

authorised-deposit taking institutions may be prevented from conducting traditional securitisation transactions due to restrictive capital treatment in holding exposures to their own transactions.

Pleasingly the Report notes that:

Financial market regulators need to consider the importance of the introduction of a retention requirement and the specifics of that requirement in light of the characteristics of the securitisation market in their jurisdiction…financial market regulators may wish to consider the nature of the economic exposure, the required percentage level…and whether a more risk sensitive approach, such as between asset quality and asset classes, is appropriate.

Disclosure

Australia has a long held regulatory regime of requiring adequate disclosure to certain classes of investors but not mandating:

Disclosure where investors are genuinely capable of determining the risks of products, and

That certain products are, per se, too risky for certain classes of investors.

The Australian securitisation industry has usually structured transactions to avoid mandatory disclosure by issuing instruments to “sophisticated investors” for the purposes of section 708(8) of the Corporations Act 2001 (Cwlth).

The Consultation Report caused concern in the Australian market by suggesting that regulators should “mandate improvements in disclosure” and “strengthen investor suitability requirements”. Importantly in the Final Report, this language has been softened by suggesting that regulators “provide regulatory support for improvements in disclosure” (which TFUMP recognised could be as informal as encouraging behavioural change or recommending compliance with industry codes) and “review investor suitability requirements”.

Moving Forward in Australia

TFUMP has recognised that the regulation of securitisation cannot be a “one size fits all” model. Australia has a clear mandate to implement the recommendations from the Final Report in a way which recognises the market practice in Australia and particular features.

For the skin in the game requirement, the challenge is for the Australian securitisation industry and the Australian government is to provide a framework which balances the protections provided by a mandatory skin in the game requirement with the inherent protections in the Australian market.

With respect to disclosure, it appears that there is a task ahead for Australian regulators to determine the be regulatory response which may be one of the following:

to formally regulate disclosure on all securitisation transactions (which would be contrary the current policy of only protecting unsophisticated investors)

to expand the definition of investors who must be protected by formal disclosure under the Corporations Act for securitisation transactions (and providing guidance as to that disclosure), or

to simply provide its formal support to market initiatives, which are already underway, to standardise and improve disclosure made to investors in Australian transactions.

All of these issues raise delicate questions as to the cost of compliance with any new regulations compared to any benefits for investors in securitised products.