By Phil Evans, Paul Munday and Jitendra Patil.
This reduction, however, meant missing out on some of the benefits of securitisation. Less opportunity for banks to convert illiquid loan portfolios into funding, or to transfer risk outside the banking sector, means less diversification and makes it harder to allocate capital to the most productive uses. Ultimately, this results in both fewer investment opportunities and less support for banks’ ability to originate new lending and so missing out on securitisation’s potential contribution to economic growth.
It does not now seem controversial to say that securitisation was underregulated pre-GFC, and in some ways has been overregulated since. As Sam Woods has argued, the post-crisis reforms were developed at speed in response to a once-in-a-generation disaster, and, as we learn more about operating those reforms, we discover redundancies, unintended consequences and areas where the risk appetite appears too conservative. We need to have careful regard to the costs of regulation, to ensure these are justified, proportionate and no bigger than they have to be to meet the public interest.
This means the Prudential Regulation Authority’s (PRA’s) task is to find the best middle ground by looking at securitisation in the round – or holistically – and with the benefit of experience to reach the right balance and maximise the contribution of securitisation to medium-term competitiveness and growth.
Finding a holistic balance to policy
When the PRA consulted on prudential requirements for securitisations in 2024, it was described by one market participant as being ‘in the middle of the fairway’. What does this mean? To pursue the metaphor a bit further, there are two caricature approaches that would take us off the fairway, neither of which we want to pursue.
One caricature approach – let’s call it the hook to the heavy rough down the left of the fairway – is to be overly lax on the securitisation framework. We might do this if we viewed increasing the near-term size of the securitisation market as an end in itself. Almost like pursuing industrial policy through the prudential and conduct frameworks. This might take us back to the dangers of complexity not being recognised. The GFC mistakes of poor underwriting would return. International standards would fade in importance. And capital reductions would exceed the risk transferred. On this side of the fairway, we might boost the level of securitisation for a while, but the prudential risks would eventually undermine confidence in the securitisation market, as they did in the GFC, ultimately leading to lower activity down the track.
The other caricature – we’ll call it the shank to the bunker on the right of the fairway – is where securitisation is seen as something uniquely risky, needing to be controlled at all costs. Securitising assets is seen as an opaque approach that magically increases the total level of risk by a vast amount and allowing any risk taking is almost guaranteed to run away in the direction of the GFC as originators continually try to exploit naïve investors. We would unnecessarily forgo the growth benefits of securitisation. There would be lower funding diversification, a reduction in the ability of banks to extend new credit to the real economy, and a narrower pool of assets for non-bank investors. Being off the fairway, to either side, makes it harder to achieve growth in the longer term.
Hitting the fairway right down the middle requires looking at policy in the round, avoiding the dangers in these two stylised scenarios. To guide that, the PRA has a primary safety and soundness objective to steer away from the heavy rough, and a secondary competitiveness and growth objective to remind us of the pitfalls on the other side of the fairway. The caricatures do oversimplify the choices in front of us, for two main reasons. First, a loss of financial stability would itself threaten growth and competitiveness. And second, some measures can both promote safety and soundness and facilitate competition and growth. More risk-sensitive capital requirements can help to promote the efficient allocation of financial resources. And a low friction, stable and predictable regulatory approach can improve the attractiveness of the UK as a location for financial services firms and make compliance easier. The removal of unnecessary barriers to cross-border trade in securities can also support the competitiveness of UK firms overseas and reduce the concentration of risk, without increasing financial stability concerns. So, hitting the fairway can very much come with good distance on the drive.
The rest of this article explains how the securitisation package being developed by the PRA, taken in the round, protects financial stability by preserving an appropriate and risk-sensitive prudential approach, whilst stripping away low value conduct and compliance-based requirements and supporting the secondary competitiveness and growth objective (SCGO).
The PRA approach – prudential requirements
Prudential requirements need to be fair and risk-sensitive. For example, firms told us that the standardised approach (SA) in the Basel agreement was too conservative, affecting SA firms and also internal ratings-based (IRB) firms through the output floor. The PRA sought to establish the strength of the case for this view by publishing a discussion paper (DP3/23) that asked for feedback and, importantly, data. The data did indeed establish that the case was strong, and the responses helped point towards potentially good ways forward. As an aside, this is probably one of the best examples of how we hope to engage with industry to deepen our evidence base earlier in the process of creating rules.
Having considered the evidence provided, we concluded the internationally agreed SA was too conservative and would have a big effect through the output floor. One option would have been to provide a carve-out from the output floor for securitisations. But we thought a better and fairer approach was to arrive at a more balanced calibration of the SA, helping both SA and IRB firms in equal measure. This approach also supports effective competition, which in turn facilitates growth.
We also want the treatment of securitisation to be risk-sensitive and proportionate, in line with the treatment of other instruments. And the treatment of different securitisations needs to be consistent.
Taking these two points together, we concluded the international SA calibration was too conservative when compared to risk weights on the underlying exposures. And under the principle of risk-sensitivity, rather than having a fixed calibration across all securitisations, that riskier positions should have higher capital requirements and less risky positions should have lower capital requirements. To bring that about, we have borrowed from the IRB framework for the SA – thereby limiting the conceptual gap with Basel – and limiting the scale of the deviation to addressing the precise overcalibration. This advances safety and soundness more effectively than uniform capital requirements for all positions.
The PRA does put a lot of weight on consistency with the Basel framework, both conceptually and in terms of the capital outcomes. But we did adjust our implementation of the underlying international approach. When the PRA considers how best to implement international standards, we balance several factors, including the wish to not deviate too far (as the SCGO applies subject to aligning with relevant international standards), the appropriateness in the UK context based on UK data, and how they are implemented in other major jurisdictions. In the case of prudential requirements for securitisation, we see significant adjustments to international standards in similar directions to the UK in both the EU and US. The approach of other jurisdictions to the implementation of standards has potential implications – that we assess and monitor – for the competitiveness of UK firms.
It is noteworthy that major jurisdictions have adopted adjustments to the underlying Basel standard in a similar but not identical direction for securitisations. The future trajectory in other jurisdictions also seems not to be fully settled. From the PRA’s perspective, there are aspects of the standards that appear lacking in risk-sensitivity, such as the fixed risk weight floor. However, a free-for-all on prudential standards for securitisation undermines global standards, and the PRA would support a review leading to the restoration of a more pragmatic de facto international standard for securitisation.
The PRA approach – conduct and compliance requirements
On conduct and compliance, the PRA does not think that the post-GFC requirements cleanly hit the middle of the fairway, at least in a UK context. For that reason, since finalising the prudential changes, the PRA moved on to addressing the conduct and compliance requirements involved in securitisation, taking the second planned step in the package of adapting these to the UK context. We published CP2/26 in February this year, alongside the Financial Conduct Authority’s (FCA’s) consultation paper CP26/6. It included proposals that should make the UK securitisation regime more efficient, more flexible and more accessible, but without materially weakening protection for investors. We might say we are aiming to remove the ‘red tape’.
This is a strong move away from the prescriptive post-GFC environment towards core principles on the alignment of economic interest, due diligence and transparency. It is, though, a carefully calibrated pro-growth, pro-proportionality reform, not a wild deregulatory hack, and it places responsibility on market participants.
To the extent that the reforms improve access to liquidity or facilitate effective risk transfer, the PRA sees them as supportive of safety and soundness.
One goal in the proposals is to remove unnecessary barriers to cross-border investments. We do not think that the purpose of the securitisation regulations is to promote protectionism, or to prevent UK investors from investing in non-UK instruments. The attractiveness of the UK has always been built around responsible openness that provided broad opportunities for investors based here, and competitive conditions for the originators of products. This can be seen particularly in the due diligence and risk retention proposals. The core principles remain, but UK investors would have, under our proposals, much greater flexibility in determining alignment of economic interest. And UK originators would have the additional option of L-shaped risk retention, familiar to some overseas investors.
We also want to remove costly compliance obligations from market participants where those obligations are not meaningfully supporting safety and soundness. This is evident in our proposed changes to transparency and reporting requirements where we have worked with the FCA to simplify as much as possible given our wider safety and soundness objective.
The relationship with international standards is very different for conduct as the status quo was a set of rules that went beyond the global norm and were more prescriptive than those standards. On resecuritisation, where the UK inherited an outright ban that is not in the international standards, we are open minded and have proposed some exceptions where we think those do not bring any prudential risk.
The future
This article has described, at a high level, the sequenced package the PRA has put together to ensure safe, secure but efficient securitisation in the UK. But it is not a one-hole course. So, it is worth finishing by looking ahead to our future plans, with a few key pointers.
First, we are always in listening mode. We can do this because all the rules relevant for PRA and FCA firms have now been transferred into regulators’ rulebooks. That gives us flexibility to adapt more nimbly, within the legitimate accountability constraints we face in our regime, as the landscape evolves. But to stay current we will need to engage on concerns from the industry and assess them using evidence. It doesn’t mean we can keep relitigating the same issues over and over, but it does mean that where the evidence is convincing, we can act in a swifter and more holistic way.
Second, and as a consequence of the rules moving in house, we want our approach to be clear and transparent. We are open to industry asking us where they think things are unclear.
Third, one of the most complex questions is about international positioning and standards. We greatly value international standards. There are definite benefits to the UK from following international standards and the PRA seeks to do so, in line with the text of the SCGO, underpinning confidence in both directions around the level of financial sector openness in the UK. But sometimes the standards don’t fully fit international practices. Where that is so, there can be a case to look again at the UK’s implementation of those standards.
As we continue the work of advancing all of our objectives, the PRA remains clear that robust capital requirements are essential, that appropriate international standards are valuable, protections are needed but must be proportionate and add value, and that securitisation is a tool which can deliver benefits to firms, investors and economic growth. The PRA has shown the importance it assigns to balancing all these holistically to support safety and soundness and growth by reducing the overall regulatory burden and improving risk-sensitivity. That is our definition of hitting it down the middle of the fairway.
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