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Financial Services Post-Brexit: The Age of Equivalence

With Brexit carried out on 31st January, 2020, the clock for the negotiations on the future of the economic relationship between the UK and the EU started ticking aloud. Before bilateral, structured meetings formally kicked off on 2nd March 2020, both sides had already started indirect communication by formulating a Blueprint (PM Johnson) and a negotiation mandate (of the European council for Commissioner Barnier) aiming at setting the scene for later direct talks. Both sides have stated that Financial Services will be on the table, which is not a surprise. If we think of the negotiations as a dinner table, Financial Services would be the Lobster: After use of some tools and techniques (both themselves taking some time to get learned), you get a non-everyday culinary experience (at least for most of us). You will possibly remember a meal for the Lobster served. But If you are hungry and in a hurry, you will probably not choose the lobster, deprioritizing it to the most important target at hand: Not leaving the table hungry.

As of now, Financial Services could well become the Lobster in the Brexit negotiation: The masterpiece of negotiations, but unavailable for time constraints. Instead, it is more likely than not that EU-UK-cross-border financial services from 2021 on will be governed by a concept which is already established in both EU and UK law and will thus not require negotiations: Equivalence.

In this article, we will explain the concept of equivalence, why we consider it the most probable outcome and what this means for the provision of cross-EU-UK-border (cross-border) financial services after the end of the transition period, in the short and medium term.

1. What is equivalence ?

Equivalence, formally called “Third Country Equivalence” (TCE) is an intricate and complex concept. It was established after the financial crisis (beginning in 2009) in order to deal with regulatory differences and similarities between EU customers and Third Country providers of financial services. The goal is to ensure a level playing field between equivalently regulated services (provided by Third Country entities) and restrict regulatory arbitrage by entities moving to less regulated jurisdictions. The core assumption is that EU legislative institutions are unable to influence Third Country legislation (and thus unable to prevent them from lowering regulatory standards). In this case they are enabled to unilaterally prevent suppliers of financial services from those third countries to offer services within the EU at lower prices or otherwise more favourable conditions. If, however, the Third Country implements regulatory standards which are equivalent to applicable EU regulatory standards, the EU Commission may deem this particular service (e.g. derivatives clearing) to be regulated equivalent to EU legislation. As a result, providers of financial services from the Third Country jurisdiction profit from market access under less strict requirements or from market access at all for this specific service. So, since it is a service-centered concept, the same supplier could profit from TCE regarding one service (which is regulated equivalently to EU regulation in his home jurisdiction) and not benefit from it regarding others.

One example for TCE is derivatives trading: Derivatives traded on foreign markets found to be equivalent to EU regulated markets avoid their instruments being designated as ‘OTC derivatives’ (considered higher-risk and more expensive). Another is access to Central Counterparties (CCP): A CCP established in an equivalent Third Country may provide clearing services to clearing members or trading venues established in the Union and can be used to fulfil the EMIR clearing obligation. Was the CCP to offer other regulated services, it would have to check whether those services are covered by a TCE provision and whether the EU has defined the Third Countries regulation concerning these specific services equivalent. If yes, the CCP could also provide those services as it was established in the EU; else it would be treated as a Third-Country-CCP for those specific services. Treatment as a Third Country services provider may result in either hurdles to the provision of services to EU clients (e.g. concerning the trading of securities in on EU trading venues) or such services may not be provided to EU clients at all (e.g. if an EU license is required).

TCE provisions can be found in around 15 EU regulations concerning about 30 specific issues within these regulations. The Commission has taken positive TCE decisions concerning 37 countries since the concept was established and has revoked some of them (the most famous case being that of Swiss). TCE decisions concerning UK regulation are in preparation by the EU.

Since the Brexit referendum, UK as well as EU official and industry representatives have proposed to fundamentally change the EU regulation concerning TCA. The tenor of those ideas is to implement TCE for UK regulation as a general principle in every EU financial sector regulation and TCE for EU regulation in every UK financial sector regulation. By taking a mutual TCE decision both parties would effectively allow each other unlimited provision and demand of cross border financial services. Under this proposal, both parties would closely align on any future changes to financial services regulation in order to avoid revocation of TCE decisions while maintaining full sovereignty on their regulatory decisions (the latter being considered a key reason for Leaver´s Brexit vote). The EU has rejected this proposal from the beginning and the MP Johnson has not established it as the official UK Government position concerning financial services.

It is thus highly probable that the concept of TCE will survive the Brexit negotiations in the present form. Notwithstanding this, new regulations will contain new TCE provisions, specific TCE provisions in existing regulation may be changed, existing EU KOM TCE decisions will be changed and new ones taken. This will influence the type and amount of cross-border financial services provided into and out of the EU but the present concept will prevail. We will explain why in the next paragraph.

2. Why is equivalence the most likely outcome of the FS negotiations ?

As we have explained, TCE is an unilateral concept – each side takes its own independent decision on allowing the provision of financial services by Third Country providers. It decides on the exact services, the country from which this is possible and, in some instances, (e.g. CCP access) also per individual provider. It may revoke any of these decisions at any time by executive (KOM revoking specifically TCE decision) or legislative (EU institutions changing regulation containing TCE provisions) action. As such it is a flexible instrument, adaptable to any decision of a Third Country (e.g. changing its laws and thus making existing TCE decisions obsolete) or any EU internal change of economic or political parameters (e.g. EU changing its legislation with the effect that other legislation is not equivalent any more).

The exact same rationale applies for the UK, which – at least on January 1st 2021 – will have exactly the same TCE provisions in its laws as the EU. For the UK re-gaining autonomy of political decisions (“take back control”) is considered to having been a key driver for the leave vote. Consequently, when setting the red lines of the UK for the Brexit negotiations PM Johnson made very clear that the UK’s autonomy to change its laws is a cornerstone of the economic policy of his government. Accordingly, the EU has always made clear that – in implementation of the EU treaties – after Brexit it will take legislative and executive decisions based solely on the needs of its member states, a group to which the UK will then no longer belong.

Put the other way around: Any other outcome than both sides agreeing on TCE decisions to govern the future cross-border financial services provision is highly unlikely. It would require them to agree on a mechanism which would make one side´s decisions contingent of both sides agreeing to them – which would resemble the UK not having left the EU (at least for financial services regulation purposes). Any unilateral decision of one side would endanger this mechanism, making both sides decide what they value higher: Independence or access – this is no stable solution.

For these reasons and because there is already time shortage to discuss topics with more political visibility such as fishery rights we consider it the most likely outcome that TCE will be the regime governing post-Brexit financial services. We will give our view of the consequences in the next paragraph.

3. What are the consequences of a pure equivalence regime for financial services post-Brexit ?

First, this outcome is the one for which all market participants can prepare best because the assessment of its implications may begin immediately. This does not mean such an analysis is easy. It will require the following key elements inter alia:

  1. Analyze which TCE provisions are relevant to the specific business model
  2. Anticipate both sides’ TCE decisions
  3. Derive and implement necessary measures in the time before and after the end of the Transition Period

Item a) will be required in any other regime than TCE as well. Assuming TCE will be the only outcome of the negotiations concerning financial services, this will give all players the maximum preparation time compared to all others because it is already known. The decision concerning item b) will profit from the fact that, at inception (i.e. January 1st 2021), both legal frameworks will be basically identical which may lead to both sides to take favourable TCE decisions, although – possibly driven by negotiation strategy – this may happen late in 2020. Item c) will be basically possible only in the TCE scenario, because no other outcome may give financial market participants more time (or any time at all) to implement measures before end-2020. Examples for such measures may be to transfer existing business / portfolios / clients or to plan their discontinuation after 2020 under conditions of full market access.

Second, having access to the mutual capital markets under the TCE regime will be clearly inferior to the UK staying in the EU – which is not an option anymore (called the first-best). At the same time, at least at inception, it will arguably be the best of all feasible outcomes (the second-best). Considering that capital markets usually deal better with bad news than with uncertainty, TCE might as well help the markets cope with the insecurity immanent in the Brexit process.

Third, the political process which leads to TCE decisions on the EU side is largely intransparent to the public because there is no openly accessible legislation on the COM’s procedures leading to TCE decisions. Internal standing procedures may exist for the COM, but those are undisclosed to the public. As long as this remains, the process and its output are a black box to all affected market participants as long as the COM does not voluntarily chose to disclose information – something it has done in the past, especially when dealing with prominent cases such as the (negative) TCE decision on Switzerland’s capital markets rules.

Market participants have been urging the COM to disclose its decision-making processes in order to give them the possibility to contribute to and influence the COM´s decision. When deciding to raise transparency of the TCE, the COM will have to weigh up two effects: A positive one from stabilizing industry expectations and avoid underinvestment due to insecurity and a negative one from giving up discretion which could be effective in negotiations with third countries. At the moment we do not how the COM will decide or whether it is discussing the topic at all. With the importance of TCE decisions rising if TCE is the future regime, market participants will probably lobby for more transparency of the rules governing TCE which affect their ability to engage in cross-border financial services.

4. How will financial services relations develop over the medium term ?

As for the way forward, we see two possible options: Either will this be it or both sides will implement an informal mechanism of keeping the equivalence of the two systems. The first option is one of stability and predictability but it will have serious consequences on both sides of the English Channel. Both sides will take their own decisions, with the consequences of TCE and market access in case of legal changes. In this scenario, the EU will have to develop its own capital markets to substitutive the loss of access to the City of London. This can only be done on a medium term and will require a herculean effort by the member states – an effort they were not required to produce when the City was the EU’s capital market.

The UK on the other side will have to find a way to make up for the loss of transactions which do not reach the City anymore. Our guess would be that the UK will adapt more quickly than the EU – reducing the volume of an existing capital market is less complicated than creating capital market structures from scratch. The question will be how the UK economy internalizes the brain drain from the City. One possibility will be its relocation to the EU which may speed up the process of building up a market there. The second option is more dynamical and insecure and we see only a shadowy outline of it: Would both sides decide to informally align the legal framework governing financial services in the respective jurisdictions, a political convergence may result, based on trust in the other sides approach to financial sector legislation. In the medium term, both sides may then initiate negotiations on a tighter cooperation and may agree on a financial services free trade agreement with extended mutual market access, above the TCE level but below the level of a full EU membership of the UK.

The question is this case will be how the dynamic explained before will have shaped both side’s capital markets. All that is certain is that it will not be the capital markets of 2020, when the City was the EU’s capital market. As always in negotiations, both sides’ decisions on convergence and market access will be shaped by the state of their capital markets and the demand for each side to cooperate, since – as we have shown before – it comes at the cost of compromising each sides freedom to take decisions based solely on their own (member states or electorates) needs. Even if the UK decided to re-join the EU in a distant future it would be a totally different financial services relationship than it is today.

Conclusion

It is our argument concerning economic stability / predictability and political / legislative autonomy on both sides which makes us expect that Third Country Equivalence will be the stable regime for financial services Post-Brexit not only in the short but also in the medium term. The negotiation teams will most likely omit the lobster.

You should analyze the consequences of equivalence on your ability to provide cross-border financial services from 2021 on and its effects on your business model as a whole. If you have any questions please contact our experts:

Stephan Lutz
Partner

Tel: +49 69 9585-2697

Mobile: +49 151 14623538

stephan.x.lutz@pwc.com

Dr. Philipp Völk
Senior Manager

Tel: +49 69 9585-3991

Mobile: +49 160 74 35 320

philipp.voelk@pwc.com

 

PwC Live-Webcast: Responding to the impacts of COVID-19

The current CoViD-19 situation is evolving dynamically. While the immediate focus is on making sure that as many people can be treated medically in appropriate and life saving ways, business matters come to the fore due to more and more constraints and interrupted supply chains and subsequent impact on financial institutions’ business models.

How are businesses coping with the situation globally? Which conclusions can be drawn so far? What should businesses look at to react effectively, protect employees and maintain their brand value?

Those and further issues will be discussed in our live webcast “Responding to the impacts of CoViD-19” on March 19, 2020 at 2pm CET to which we would like to invite you.

Please register here.

Details

When: Thursday March 19, 2020 | 2.00 – 2.45pm CET (webcast opens 1:55pm CET)

Please feel free to share and forward the invite with colleagues and employees who are involved in your task forces.

Your questions

You are invited to ask our experts live during the webcast. Alternatively, you can submit questions upfront to tobias.bremser@pwc.com

 

We are looking forward to welcome you and your colleagues to the webcast.

Integration von FinTechs in das Risikomanagement von Banken

Der digitale Wandel trifft den Finanzsektor derzeit stark. Bankkunden verlangen mehr und mehr digitale Dienstleistungen von „ihrer“ Hausbank. Banken müssen somit neue digitale Dienstleistungen für ihre Kunden entwickeln und gleichzeitig ihre veraltete IT und Prozesse modernisieren. In diese „Lücke“ sind nun die FinTechs getreten und rauben den etablierten Banken nach und nach Marktanteile.

Banken sind somit gezwungen, schnellstmöglich digital „nachzurüsten“ – sowohl bei ihrem digitalen Kundenangebot als auch bei den eigenen Prozessen. Zusätzlich bieten sich dadurch im derzeitigen Niedrig-Zinsumfeld wiederum neue Ertragsquellen und Wachstumschancen. Aktuell besteht eine hohe Investitionsbereitschaft im Bereich Digitalisierung, insbesondere im Private Banking, Wealth Management und Transaction Banking.

Banken stehen nun vor der Entscheidung, entweder eigene digitale Lösungen zu entwickeln oder auf bereits bestehendes Know-how diverser FinTechs zu setzen – durch Akquisitionen oder strategische Kooperationen. Dabei stehen sie vor großen Herausforderungen. Sie können die genauen Auswirkungen eines Kaufs bzw. einer Kooperation auf ihr Geschäftsmodell, ihre bestehenden Prozesse, ihr Risikomanagement und die Erfüllung regulatorischer Vorgaben oftmals nicht vollumfänglich abschätzen. Neben dem strategischen Fit ist dabei die konkrete Ausgestaltung der Integration des FinTechs in die bestehenden Bankprozesse, insbesondere im Bereich Risikomanagement, von entscheidender Bedeutung für den Erfolg.

In jedem Fall sind dabei vor der Geschäftsaufnahme die Anforderungen nach AT 8 MaRisk einzuhalten. Größte Herausforderung für Banken stellt dabei die Durchführung einer detaillierten Risikoanalyse vor der Aufnahme der Kooperation bzw. vor dem Kauf dar:

Diese Analysen und Konzepte sind noch vor der Geschäftsaufnahme durchzuführen:

 

Nach dem Zusammenschluss ist eine stringente Einbindung des FinTechs in die innerhalb der Bank bestehenden Prozesse im Risikomanagement von hoher Bedeutung (Post Merger Integration). Die jeweilige Form der Kooperation bzw. Beteiligung determiniert dabei die konkrete Behandlung im Risikomanagement. Dabei sind sowohl die bankinternen Prozesse als auch die bestehenden Methoden und Modelle betroffen:

 

Um mit diesen Herausforderungen gerecht zu werden, unterstützt Sie PwC gerne mit folgenden Services:

  • Identifikation der bestehenden Prozesse auf Betroffenheit durch Integration des FinTech
  • Impact-Analyse des FinTechs auf die bestehenden Prozesse und Erstellung des operatives Zielmodells
  • Analyse auf Synergiepotentiale
  • Darstellung von Optimierungspotentialen an den bestehenden Prozessen im Zuge der Integration (Identifikation von „Quick Wins“)
  • Erstellung von Fachkonzepten bei Prozessanpassungen
  • Unterstützung beim Rollout der neuen Arbeitsabläufe
  • Unterstützung beim Auslagerungsmanagement
  • Impact-Analyse hinsichtlich SREP: Analyse der Auswirkungen auf geändertes Geschäftsmodell
  • Erstellung eines Projektkonzeptes und PMO
  • Ex-Post-Validierung des erwarteten Nutzens
  • Risk Assessment – Analyse des FinTechs auf neue Risiken für die Bank: Reputation, operationelle Risiken, etc.
  • Impact-Analyse neuer Risiken durch FinTech auf bestehendes Risikomanagement: Governance, Prozesse, Methoden, etc.
  • Erarbeitung eines Integrationskonzeptes für das Risikomanagement der Bank: Risikoinventur, Risikostrategie, Risikotragfähigkeitskonzepte auf Gruppenebene (AT 4.5 MaRisk), Waiver, etc.
  • Unterstützung bei der revisionssicheren Durchführung eines Fusions- bzw. Anpassungsprozesses (AT 8 MaRisk) sowie Outsourcings (AT 9 MaRisk)

 

Ihre Ansprechpartner:

Stephan Lutz
Partner

Tel: +49 69 9585-2697

Mobile: +49 151 14623538

stephan.x.lutz@pwc.com

Steffen Bätz
Manager

Tel: +49 69 9585-5359

Mobile: +49 160 90137103

steffen.baetz@pwc.com

 

ESMA Opens Consultation Period on Data Completeness Thresholds and their Calibration

On Friday January 17, ESMA opened a period on assessment of data completeness of Securitization Disclosure. The consultation paper can also be accessed on ESMA’s web site.

Each party reporting data under Article 7 of the Securitization Regulation may use different No Data option for fields it cannot populate (each option disclosing the reason for its use, e.g. ND1 meaning that required information has not been collected because it was not required by the lending or underwriting criteria at the time of origination). In order to keep up the information value of the disclosures, ESMA limits the use of the different No Data options. The core of the new consultation deals with a calibration of acceptance thresholds for the use of No Data[1] options in the disclosure templates. ESMA defines two root causes of No Data usage – Legacy Assets and Legacy IT Systems. The first one represents a situation where the reporting entity lacks most of the data for a limited number of loans granted whereas the later one would be referred to if a limited number of fields is unavailable across many exposures. These thresholds will be applied to all asset classes from templates for underlying exposures, not including Investor reports (Annexes 12 and 13) and Inside Information and Significant Events (Annexes 14 and 15) and are expected to change over time with a trajectory towards increased data completeness.

The consultations paper deals in greater detail with data analysis and requests for a feedback on proposed calibration of initial thresholds for data from both Legacy Assets and Legacy IT Systems. Further to his, ESMA opens a discussion around threshold revision process without making any specific suggestion about the timing.

It also worth noting that ESMA does not expect the Securitization Repositories to check for data completeness for non-STS transactions issued prior to 2019. Only public securitizations issued after Jan 1, 2019 or deals seeking the STS label will be subject to the aforementioned data completeness requirements.

ESMA has announced to close the consultation period on March 16 and evaluate all feedback collected. At PwC, we expect to see ESMA’s follow up on this topic later in Q2, 2020, for which we will publish our detailed opinion via a separate blog entry.

For more information on securitization markets, please feel free to get in touch with your PwC’s subject matter experts.

 

Dr. Philipp Völk – Mail: philipp.voelk@pwc.com

Petr Surala, CFA – Mail: petr.surala@pwc.com

 

[1] ND1-4

The Securitization Market: 2019 recap and 2020 expectations

Dear readers,

The first year of our blogging activities concerning Securitization and Structured Finance Issues is over. We have received quite some feedback from you and would like to thank you accordingly. Knowing that our topics are of interest to the Securitization community is key for us and guides us to compile not only informative but also relevant posts.

Therefore, our first post of 2020 will provide you with a short recap of what happened in 2019 and our expectations of the key market developments for 2020. We welcome your input on this and will provide you with an update on our expectations at the end of this year. As always, we take a regulation-driven look and analyze its effects on market developments.

 

Stephan, Philipp & Petr

 

2019 short recap

2019 was one of the most important years for the Securitization markets since 2009. New regulatory provisions for Securitizations came into effect and – unlike to what had happened in recent years when new regulation was introduced – markets saw an increase in activity.

Their first reaction to the new regulation was surprisingly positive. Even an increase of risk weights for the better-rated senior tranches (moving from a floor of 7% to 10% means an increase by over 40% after all) while more subordinated tranches profit from lower risk weights in many cases, depending on the approach used (interestingly, under SEC-ERBA it is not possible to calculate a risk weight of exactly 1250% for a first loss piece due to the formula’s math but the resulting risk weight will remain some percent below 1250%). The reaction of the markets was positive however. This was probably due to investors valuing the decisive step to higher transparency which the disclosure requirements introduce, independently of whether the transaction is STS or not (although STS transactions fulfill even higher transparency requirements than other transactions). While there was little activity in the first quarter, STS transactions started to appear with a clear trend visible in the second half of the year.

Despite total volume issued in 2019 was lower than in the previous years, we could observe a growing ratio of publicly placed to total issuances which continues to follow the trend from previous years. This is clearly a positive signal demonstrating a healthy securitization environment.

Even though we do not expect final 2019 issuance (as soon as Q4 numbers are available), to reach the heights of the previous years, we still see the market positively. Lower issuance in 2019 was caused by almost ceasing market activity in Q1 as a cautious as well as preparatory reaction to new regulatory rules. During that period during the impression was that markets were literally gaining momentum for the issuance of transactions which had been under preparation for months. Market pick-up can be seen form March on where both “classic” transactions as well as STS deals started being issued. The STS label became quickly recognized and used by many originators. The following figure illustrates its growing popularity throughout 2019.

2020 Expectations

Peak regulation most likely reached Regulation activity has been going on since Securitization Regulation and the CRR Amendment came into effect in January 2019. EBA issued, among others, draft technical standards on Weighted Average Maturity and STS for Synthetics or its Opinion on NPE securitizations while ESMA published their Draft Technical Standards on the templates for disclosure under article 7 of the Securitization Regulation. Although it seems like a lot of additional regulation and thus business as usual, the list for 2020 has become shorter. We expect to see work on the application of Article 7 for third country issuances, a finalization of the STS for Synthetics and – towards the end of the year – a new draft of the DP on Significant Risk Transfer (see (4)). ESMA will start the process of licensing Securitization Repositories (see [Link]). Although this sounds like a lot, we clearly expect the regulation activity to slow down in 2020 compared to the past years. This will give market players the possibility to further develop their business under existing rules and develop market standards for STS and other open issues (e.g. Data Quality under Article 7 or expectations on Cash Flow Models).

1. Loan-level data becomes the topic of the day

Loan-level data or underlying exposures, as commonly being referred to by ESMA, will in 2020 find its way to regulators and investors in two formats – by ECB templates and newly by ESMA templates. Even though the reporting logic is similar, the data reported differ to some extent (depending on asset class). In general, the new ESMA templates cover a wide range of new data fields which we expect to be quickly leveraged by investors and regulators to better understand embedded risks. Further, we expect ECB to incorporate ESMA templates to its eligibility requirements[1] defining what is an acceptable collateral for ECB liquidity. Is effectively means that ECB will gradually move away from its own loan-level data templates over the next years, likely starting in the second half of 2020.

2. STS takes over public transactions

The 2019 trend towards the issuance of STS transactions will gain additional momentum. Big market players have already done their first issuances in 2019, as illustrated by Figure 3. Smaller players will now learn to achieve STS compliance. 2020 will also see a further increase of the use of third-party verification agents who, after their first verification, will help smaller players by spreading Know-how gained in 2019. A specificity of the German market, smaller Cooperative and Savings Banks without an individual capital market access will enter the market via private transactions hosted by their respective core institutions (DZ BANK and the Landesbanken). Relevant asset classes will be car loans and leases at first with MBS assets classes next in line.

Besides cashflow securitizations, the success of STS and thus the principles governing it (a better understanding of each transaction leading to enhanced market resilience from policymaker’s perspective) will also depend on the further development of STS for Synthetics. Although in the end a decision taken by COM (not in 2020), in the course of this year market players will gain insight into the political sphere´s appetite to extend STS to other transaction types. This will have impact on the further development of the market for Synthetics and thus the availability of efficient solutions for SRT (see (4)). We do not expect a final decision on the matter in the course of 2020.

3. SRT is back on the agenda

Basel IV, supervisory capital add-ons as result of the SREP process (in many cases due to IT / Data deficiencies, see (2)) and the macroeconomic environment will see a rise in securitization transactions targeting risk transfer. This will lead to each risk transferring bank developing its own understanding of compliance with the 2017 EBA DP on risk transfer. Under market conditions of increasing demand for SRT, ECB will communicate its own view of the 2017 DP bilaterally. Lawyers and professional services firms will spread the word, moving the system to a more homogeneous implementation of the 2017 DP. EBA is expected to take market developments into account and will likely issue an updated version of the DP towards year end. EBA will most likely position itself concerning tranche thickness, commensurate risk transfer and structural features. Whether EBA offers one or more approaches such as it did in the 2017 DP, towards the end of 2020 market players can be expected to have gained a substantially better understanding of the way SRT takes that at the beginning of the year.

4. Registration of multiple Securitization Repositories

The first and currently only Securitization repository was established as a part of the ECB’s loan-level data initiative[1] in June 2012 and became fully operational in January 2013. Since then, it has been the only place to store and access underlying information on collateral backing publicly issued ABS bonds. The Securitization Regulation, however, brings forth a provision which allows ESMA to register more Securitization repositories, eventually leading to decentralization of the information curtail for all data users. We are likely to see more than one Securitization Repository registered by the end of 2020. It is yet to be seen whether de-monopolization of this business justifies the costs and efforts made by investors, supervisors, rating agencies and researchers to acquire relevant information and data from multiple sources and will as such enhance transparency and resilience of Securitization markets. It is unlikely that ESMA will reveal its interpretation of the related regulation in 2020, so cost structures originating from Repository-stored data use will remain an open issue during 2020. Further, we expect ESMA to finalize its consultation period for data completeness scoring which will consequently be implemented by the Securitization Repositories. Given ESMA’s intention to gradually increase the scoring requirements we expect this to create dynamics for the originators, leading eventually to enhanced data availability for investors. We expect ESMA to release its first data completeness thresholds in second half of 2020 with further revisions to them in the coming years.

 

Stephan Lutz – Mail: stephan.x.lutz@pwc.com

Dr. Philipp Völk – Mail: philipp.voelk@pwc.com

Petr Surala, CFA – Mail: petr.surala@pwc.com


[1] See press release

 

Valuation in Resolution

The global financial crisis 2007-09 revealed the need for developing adequate, effective tools and methods to deal with severe crises in the banking sector and for increasing financial and operational resilience of financial institutions to avoid future reliance on bank bail-outs by taxpayers’ money and to prevent contagion in the case of bank failure.

Answering this need, recovery and resolution planning (RRP) has been introduced into regulation, starting in 2011 with the Financial Stability Board’s (FSB) Key Attributes which set out essential features of RRP and which have been endorsed as international standards by the G-20. Since then, RRP has been incorporated into legislation in various countries globally. In Europe, after multiple cycles of drafting recovery and resolution plans, RRP is reaching a steady state with the focus shifting towards operationalization and finetuning of requirements.

One recent policy initiative focuses on operationalizing valuation in resolution: to inform resolution decisions and ensure the effectiveness of resolution actions, different valuations are to be performed within a short timeframe during a crisis and prepared in resolution planning.

Why is valuation in resolution important?

Valuation is the basis for determining whether an institution is failing or likely to fail. If this is the case[1], a more comprehensive valuation informs the choice of resolution tools and the amount of losses to be absorbed. After resolution, another valuation is required to ensure that shareholders and creditors did not receive worse treatment under resolution than under normal insolvency proceedings.

Regulators expect well-documented valuations by independent valuers to ensure informed decision making, accountability, and transparency.

What are the requirements and implications for banks?

To be robust, a valuation must rely on the timely provision of high-quality data. Banks are expected to have adequate management information systems (MIS), valuation, and data provision capabilities in place to support valuation in resolution and test abovementioned capabilities by means of self-assessments.

What are the key challenges banks need to overcome?

In the following, the above-mentioned requirements and implications of valuation in resolution are examined in more detail.

 

Valuation is an essential aspect in resolution (planning); operationalizing valuation in resolution has become a recent focus of authorities

The general criteria and requirements that valuations for purposes of resolution must comply with are set forth in the Single Resolution Mechanism Regulation (SRMR)[2] Article 20 as well as in the Banking Recovery and Resolution Directive (BRRD)[3] and its national transpositions:

  • Article 36 BRRD – Valuation for the purposes of resolution,
  • Article 74 BRRD – Valuation of difference in treatment, and
  • Article 49 BRRD – Derivative close-out and valuation.

 

The BRRD delegates responsibility to supplement and specify the general law to the European Banking Authority (EBA) to ensure effective and consistent implementation of BRRD across the EU.

With respect to valuation in resolution, EBA has developed several technical standards enacted in the form of Commission delegated regulations (CDR)[4]:

  • CDR 2018/345 – Regulatory technical standards (RTS) specifying the criteria relating to the methodology for assessing the value of assets and liabilities
  • CDR 2018/344 – RTS specifying the criteria relating to the methodologies for valuation of difference in treatment in resolution
  • CDR 2016/1401 – RTS for methodologies and principles on the valuation of liabilities arising from derivatives
  • CDR 2016/1075, Articles 37-41 – RTS specifying the requirements for independent valuers.

 

Furthermore, in order to operationalize the valuation process, both the EBA and the Single Resolution Board (SRB) have published guidance on valuation in resolution:

  • EBA Handbook on valuation for purposes of resolution (incl. data dictionary), and
  • SRB Framework for valuation.

 

This guidance represents the best practice approach and industry standards which should be adhered to.[5]

In 2019, SRB and EBA have further specified their expectations regarding valuation in resolution

The EBA Handbook on valuation is intended to support (national) resolution authorities (NRAs) in the context of valuation and facilitate the valuation process in times of crisis. It provides details on considerations and methodological issues, such as:

  • Measurement bases: hold value vs. disposal value,
  • Best point estimate vs. value ranges,
  • Preliminary vs. final valuation, and
  • Resolution tool-specific considerations.

 

The SRB Framework for valuation is addressed to the general public and future potential valuers. It specifies the expectations of the SRB regarding the principles and methodologies for valuations in resolution and details the main elements to be included in a valuation report. Though still being relatively principle-based in nature, it provides some specific expectations and guidance, e.g. regarding:

  • The length of projection periods to be used in DCF valuations depending on the resolution tool(s), and
  • The appropriate valuation range around the best estimate (± 5-10 %).

 

Banks are expected to have adequate MIS, valuation, and data provision capabilities in place to support valuation in resolution; resolution authorities will monitor progress and may impose measures if progress is deemed insufficient

In its “Expectations for banks 2019” document[6], the SRB emphasizes the need for banks’ MIS to provide accurate and timely information in the context of resolution preparedness for the reliability and robustness of valuations.

The availability of reliable data in an accessible format is a fundamental prerequisite for the performance of valuation work. Banks are expected to demonstrate their capabilities in resolution planning and increase their preparedness with respect to the SRB framework for valuation. As a first step, banks are expected to perform self-assessments regarding their in-house valuation and data provision capabilities, identifying any gaps and including those in their comprehensive resolvability work program.

In this resolvability work program, banks shall propose how to address potential impediments to resolution, outlining concrete deliverables, timelines, and milestones, which they will be held accountable against by SRB and NRAs. Progress will be monitored via a resolvability progress report which banks will have to submit at least semi-annually.

If banks’ valuation and data provision capabilities do not meet the resolution authorities’ expectations, do not represent best practice and progress is insufficient, this may be deemed as a ‘substantive impediment to resolution’.

SRB and NRAs have formal legal power to impose measures to reduce or remove impediments to resolution onto institutions (Art. 17 BRRD). Additionally, identification of shortcomings may be reflected in higher MREL requirements.

Generally, three distinct valuations are required in the resolution process

Valuation 1 is an accounting valuation aimed at determining whether an institution is failing or likely to fail. It informs the determination of whether the conditions for resolution and for write-down or for conversion of capital instruments are met. Valuation 1 is performed irrespective of the resolution strategy.

Valuation 2 is a much more detailed valuation to determine the economic value of the institution in resolution’s assets, liabilities and equity, ensuring that all losses are fully recognized and aimed at informing the choice and design of resolution tool(s). Hence, valuation methodology depends on the respective resolution tool(s) chosen as part of the (preferred) resolution strategy.

Valuation 3 is an ex-post counter-factual valuation, comparing actual resolution actions taken to a liquidation scenario. It aims at ensuring that shareholders and creditors do not receive worse treatment under resolution than what would have been expected in regular national insolvency proceedings (“No creditor worse off” principle) and hence safeguards the rights of shareholders and creditors against decisions adopted on the basis of valuation 2.

Figure 1 provides additional details regarding the three types of valuation required in resolution:

 

While valuation 1 largely follows the institution’s existing valuation methodologies for accounting purposes amended by applying assumptions made by the independent valuer, valuation approaches applied for valuations 2 and 3 may differ depending on the specific circumstances and due to different emphasis of the inherent time-accuracy trade-off. Broadly speaking, valuation 2 focuses more on informing timely decision-making while valuation 3, conducted post-resolution, requires best possible accuracy.

 

EBA and SRB emphasize their preference for the discounted cash-flow (DCF) valuation approach, which relies most heavily on the timely provision of a large set of accurate data.

From both a theoretical perspective and a practical standpoint, the method that best incorporates all factors affecting the value of an institution is the DCF valuation method.

A DCF valuation in the context of resolution requires the determination of three main parameters:

  • Projection period (depending on the resolution strategy / resolution tools applied, contractual / behavioral lifetimes of assets, time to normalization, cyclicality),
  • Cash flows over the projection period plus any terminal value (considering the restructuring / reorganization plan, macroeconomic / financial scenarios), and
  • Discount rate(s).

In practice, however, the adjusted book value method is a pragmatic alternative in case of significant time pressure. Adjustments and haircuts are applied to the balance sheet in order to consider the effects of resolution (e.g. fire sales leading to depressed prices).

A third valuation approach is the comparative market valuation, i.e. the use of multiples derived from market capitalization of similar entities or from comparable transactions. Typically, a DCF should be validated by a second valuation as a sanity check, giving a valuation range of ± 5-10 % around the best point estimate.

 

In valuation 2, one main determinant of the valuation parameters is the resolution strategy, impacting for example the following:

  • Use of hold vs. disposal values,
  • entity level vs. portfolio / asset view (The entity level view is suitable in case of a share deal or if all or the majority of assets are to be transferred. The portfolio / asset view is suitable in case of an asset deal or when assets can be grouped into relatively homogeneous portfolios in terms of risk profile, business line, or similar characteristics (stratification)), and
  • whether to include franchise value or resolution costs (e.g. set-up and running costs of a bridge bank, workout costs and benefits of an asset management vehicle (AMV)).

Furthermore, institutions are expected to leverage their internal capabilities such as systems in place to meet IFRS 9 requirements, stress tests, AQR exercises or portfolio reviews and consider data from historical bank failures.

Figure 2 details the impact of resolution strategies on valuation 2:

 

Institutions are expected to perform self-assessments as to their preparedness for supporting valuation in resolution and propose how to close any identified gaps

One of the main challenges for institutions is the need for providing a large set of accurate data within a very short timeframe (e.g. 12-24 hours)[7] during or leading up to resolution.

A robust valuation is essential to the effectiveness of resolution actions, including the legitimacy and soundness of the decision, and the achievement of the resolution objectives. To be robust, a valuation must rely on the timely provision of high-quality data and information to the independent valuer:

  • Data must be provided within a very short period of time (target: 12-24h),
  • Data provided need to be complete, correct, and consistent, and
  • Data must be up-to-date as per the chosen reference date.

To ensure smooth resolution in actual crises, there is the need to enhance institutions’ preparedness in the course of the resolution planning phase.

As a starting point, EBA has developed its so-called data dictionary as best practice to structure, store and link data for purposes of valuation in resolution, detailing a large number of required data points with a “one-fits-all” approach. As indicated in its “Expectations for banks 2019” paper, SRB is currently working on its own best practice dataset for valuation in close collaboration with EBA.

Institutions are asked to do a self-assessment of how they would approach the valuations and to map their current data infrastructure to the data dictionary, thereby identifying any gaps and providing insights for future resolvability work programs (mentioned above). With regard to their existing internal valuation models which may be used as a starting point for valuation in resolution, banks are asked to document underlying assumptions, methodologies, and parameters.

Figure 3 summarizes information required for valuation in resolution according to the EBA data dictionary:

PwC suggested approach

PwC is at your disposal to further discuss implications of mentioned requirements and possible ways to approach the self-assessments.

Based on our extensive experience in bank valuation, resolution planning, and actual bank resolution we have developed an approach for completing the self-assessments in a strategic and goal-oriented manner.

If you are interested in discussing any implications of the abovementioned requirements and expectations, our project approach and how it may be adjusted to your institution’s individual needs, or would like to address any questions, please do not hesitate to contact us using contact details as provided below.

 

 

Marc-Alexander Schwamborn

Telephone    +49 69 9585 5824

Mobile       +49 175 432 3885

marc-alexander.schwamborn@pwc.com

 

Stephan Lutz

Telephone   +49 69 9585 2697

Mobile       +49 151 146 23538

stephan.x.lutz@pwc.com

 

Stefan Linder

Telephone   +49 69 9585 2915

Mobile       +49 160 539 5454

stefan.linder@pwc.com

 

Dr. Philipp Völk

Telephone   +49 69 9585 3991

Mobile       +49 160 743 5320

philipp.voelk@pwc.com

 

Sarah Kirmse

Telephone    +49 40 6378 2762

Mobile       +49 170 569 1678

sarah.kirmse@pwc.com

 

 

 

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[1] And if there is no private sector alternative and a resolution is in public interest (see conditions to resolution, Art. 32 BRRD).

[2] Regulation (EU) No. 806/2014, article 20

[3] The BRRD has incorporated RRP into EU law, transposed into national law by each country (in Germany via the Sanierungs- und Abwicklungsgesetz, SAG) – so-called “level 1 regulation”. Additionally, various specifications of the general law, so-called “level 2 regulation”, as developed by the EBA, apply.

[4] Regulatory and implementing technical standards drafted by EBA become directly applicable law in all EU member states by publication as CDR in the official journal of the EU Commission.

[5] Though legally subordinate to the Level 1 and Level 2 regulation

[6] Consultation paper specifying the capabilities the SRB expects banks to demonstrate, reflecting best practice and setting benchmarks for assessing resolvability.

[7] See e.g. Ma Bail-in (BaFin Circular 05/2019).

PwC’s Guidance for Disclosure Requirements of Private STS Securitizations

The objective of this article is to explain how private[1] securitization can obtain the STS label by complying with the legal disclosure requirements. Following paragraphs aim to outline areas of concern to any reporting or in other way designated entity that wishes to issue and maintain STS label for its securitization. According to Article 7 (2), it is the originator, sponsor or special purpose entity that shall make the data available to third parties. As the interpretation logic between ABCPs and non-ABCPs does not differ significantly, for the purposes of this paper, we further continue with analysis of STS criteria for short-term[2] securitizations only.

In order to fully understand these requirements, this document refers to Regulation (EU) 2017/2402 (Securitization Regulation) and Regulatory Technical Standards (RTS), published by ESMA. The RTS concerning the use of Securitization Repositories (SR) is not legally binding yet[3], therefore some changes altering its interpretation may take place upon finalization.

Any ABCP securitization, irrelevant of its private of public nature, can obtain STS label if Articles 23-26 are met. Further, compliance with Article 7 (Disclosure) is required as this Article is being referred to within the STS criteria. Nevertheless, compliance with Article 7 and Articles 23-26 only will not automatically grant the STS label to a given securitization unless the full regulatory text is considered. An analysis of full Securitization Regulation is beyond the scope of this paper, therefore only dependencies between Article 7 and the STS Criteria will be further discussed.

 

STS Criteria

STS can be considered an additional layer on top of regulatory requirements for non-STS securitizations. It shall signal fulfillment of more strict rules, demonstrating higher quality of the underlying collateral and sponsor’s commitment to given issuance. STS criteria outline requirements for any European securitization that seeks the STS label. These requirements are defined directly in the Securitization Regulation in chapter 4, section 1 for non-ABCP securitizations and section 2 for ABCP securitizations. Each of these sections breaks down into four articles listing conditions for simple, transparent and standardized issuances.

A short-term transaction that complies with Article 24 and a short-term programme that complies with Articles 25-26 shall be considered STS[4]. None of the aforementioned requirements forbid private securitization to obtain the STS label. It is therefore correct to state that compliance of securitization in question with Articles 24 – 26 shall grant the STS label to both public and private ABCP securitization.

It worth noticing that the STS criteria (Articles 24 – 26) contain a set of specific requirements (e.g. weighted average life) but also cross references to other Articles. Specifically, Article 25 (5), (6) require compliance with provisions stated in Article 6 and Article 7, respectively. Non-compliance with interlinked provisions elsewhere in the Regulation would mean automatic non-compliance with the STS criteria.

 

Disclosure Requirements – Article 7

Since STS criteria did not state any limitation for securitization being either private or public, we further examine disclosure requirements. Compliance with Article 7 is a prerequisite for the STS label but also a base requirement for any transaction falling under the Securitization Regulation. Unlike the STS criteria, the disclosure requirements do differentiate between private and public securitizations. All securitizations are required to disclose:

  • regularly information about underlying exposures [see (1)(a) of Article 7]
  • information through supportive documentation (e.g. OC) [see (1)(b) of Article 7]
  • STS notification referred to in Article 27 in case of STS securitization [see (1)(d) of Article 7]
  • regularly investor reports [see (1)(e) of Article 7]
  • significant events and inside information [see (1)(f-g) of Article 7]

 

It shall be noted, that 1) and 4) are an ongoing disclosure activity, performed on monthly basis for ABCPs. Points 3) and 4) are one-time notifications and 5) only when applicable. Listed reporting requirements shall be done through a Securitization Repository (SR) as stated in the second subparagraph of paragraph (2) under Article 7. Private securitizations, however, need to additionally provide a transaction summary as per (1)(c) and are exempt from data disclosure through a SR[5]  This is stated in recital 13 of the Securitization Regulation where the bespoke nature of private transactions and its value for the transaction parties is explained.

Article 7 further delegates the development of relevant RTS to ESMA, EBA and EIOPA in paragraphs (3) and (4). Since the disclosure requirements do not further discuss how the data disclosure will physically be carried out, we need to refer to the relevant RTS in order to understand how the disclosure must be technically conducted.

 

Reporting of Private ABCPs

Given the fact that STS criteria do not distinguish between private and public securitizations, the reporting rule will be driven solely by the RTS related to Article 7. We therefore refer to ESMA’s Q&A document[6] that provides additional guidance and explanation to RTS. Under Q5.13.5 ESMA states that disclosure templates[7] for significant events and inside information (Annex 15 to the RTS) are not required for the private transactions[8]. ESMA further lists templates to be used for reporting of both private and public ABCPs where it states that both public and private ABCPs shall disclose data as per Annexes 11 and 13 (underlying exposures and investor report)[9].

This essentially means, that private ABCPs, compliant with RTS under Article 7, are required to disclose underlying exposures via the data templates in Annex 11 and 13 on monthly basis. The disclosure does not have to happen through a SR, yet the data templates shall be made available directly to holders of securitization positions, to competent authorities[10] referred to in Article 29 of the Securitization Regulation and, upon request, to potential investors.

 

Guidance for Reporting

Our analysis confirms that private securitizations are required to disclose information about underlying exposures. This shall be done on timely basis for both STS and non-STS issuances. Since private transactions were not provided with any type of disclosure template prior to the Securitization Regulation[11], the new  standards will require a similar data-handling infrastructure as for public securitizations – IT setup for data aggregation, validation and dissemination.

In case instructions or guidance provided by national competent authorities on reporting of private securitization are not available, reporting entities are free to make use of any arrangements that meet the conditions of the Securitization. Therefore, we recommend using a private area of SR, if available, that offers appropriate infrastructure that satisfies ongoing requirements for data disclosure. We further propose to setup, maintain and regularly update data quality management system to reflect ESMA’s up-to-date minimum quality standards (discussed below). Also, such a system can later be easily used for a verification of underlying exposures as per Article 26(1) of the STS criteria.

Further, we notice that Article 7 (2)(a) requires specifically a disclosure of relevant data through a platform offering a data quality control system until the first SR is registered by ESMA. Specific requirements for functionalities of SR can be also found in relevant SR RTS[12]. Here we can see that ESMA plans to impose data quality rules comprising No Data values, interfiled inconsistencies but also STS-compliance checks for securitizations reported to SR. Even though this seemingly does not concern private transactions; as they do not have to channel their data through SR, it is likely to see similar efforts from Competent Authorities to ensure comparable quality between public and private STS transactions in the future.

 

Conclusion

Private ABCP securitization may obtain the STS label upon fulfillment of all relevant disclosure requirements. In order to do so, private STS ABCP securitization must follow a data disclosure schedule for investor reports and underlying exposures by using specified templates. The use of a SR for this ongoing disclosures is not mandatory and can be expected to rather depend on guidance provided by National Competent Authorities which may eventually create a heterogeneous disclosure universe across the member states.

 

Please contact PwC where our subject matter experts are available in case of any questions.

 

Dr. Philipp Völk – Mail: philipp.voelk@pwc.com

Petr Surala, CFA – Mail: petr.surala@pwc.com

 

[1] defined as those where no prospectus has been drawn up in compliance with Directive 2003/71/EC

[2] short-term securitizations refer to ABCP securitizations (Asset-Backed Commercial Paper)

[3] Final Report, published by ESMA on December 12, 2018. Endorsement from European Commission is still pending

[4] see Article 23 of the Securitization Regulation

[5] see third subparagraph of paragraph (2)

[6] Questions and Answers on Securitization Regulation, version 3 from July 17, 2019

[7] Disclosure Templates developed by ESMA for data reporting

[8] Q&A document states under Q5.13.5 that Annex 15 shall not be used, however, the information itself must be disclosed in some way

[9] See Q5.1.2.1 in Questions and Answers on Securitization Regulation

[10] National Competent Authority in Germany is BaFin. Please refer to ESMA’s full list.

[11] Disclosure of data through ABS Repository was a condition for eligibility assessment determining whether collateral can serve in Eurosystem’s credit operations. For non-eligible transactions, there was no disclosure of loan-level data required.

[12] Final Draft on SR RTS

[13] Additional Credit Claims are non-marketable asset type, comprising exposure to residential real estates or small-medium enterprises. See ECB’s Occasional Paper

Capital Markets Blog Series – Part II: The mechanisms and key objectives of the Capital Markets Union key building blocks

 

Banking Union and Capital Markets Union: Objectives and state of play

One of the conclusions of the financial crisis from a political and supervisory perspective was that the European banking system requires a uniform supervision across the EU. As part of the Banking Union roadmap, EU institutions agreed to establish a single supervisory mechanism (SSM), a single rulebook for banking regulation (CRD/CRR) and a single resolution mechanism (SRM) for banks. While the SSM and SRM have become an integral part of the prudential banking supervision and are fully operational, the implementation of a single European deposit insurance (EDIS) is still missing in order to complete the Banking Union roadmap. However, the implemented regulatory actions and the enforcement of supervisory expectations have subsequently led to a substantially more resilient banking system evidenced by an improvement of all material regulatory ratios for capital and liquidity as well as for resolvability.[1]

While the Banking Union mainly focuses on regulating banks’ activities (including those on capital markets by the FRTB-framework[2]) and strengthening the resilience of the financial sector by strengthening banks, the Capital Markets Union’s (CMU) overall aim is to complement bank financing by facilitating EU businesses’ direct access to harmonized EU Capital Markets, attracting more investors and fostering capital market growth and enhance its ability to provide capital and liquidity to the real economy. The biggest difference between these two initiatives is that – with regard to the Banking Union – a large part of the implementing regulation is directly applicable by banks based on European law – a prerequisite for the uniform supervision by the European Central Bank (ECB). By contrast, most of the implementing regulation of the CMU legislative framework will remain dependent on national transposition of European regulation, thus creating room for national discretion. The uniform implementation of the CMU will thus depend upon the participating European countries agreeing to implement it in a coordinated and rather similar way by the word. While uniform implementation is valuable in terms of creating a level playing field between the countries, the CMU is less regulatory and supervisory in nature and foresees no uniform supervision like the banking union.

Recognizing the growth potential of EU Capital Markets and the associated positive impact on the real economy, the European Commission adopted the Capital Markets Union action plan in 2015. As part of its mid-term review in 2017, further measures were identified and added to the CMU action plan. The legislative framework implementing the CMU currently comprises 13 key CMU building blocks and 3 sustainable finance initiatives. Furthermore, the Commission is planning to issue another action plan (‘CMU 2.0’), once political uncertainty on Brexit will be reduced. While the Banking Union was mainly geared towards increasing the regulation of bank´s activities and strengthening the resilience of the financial sector by strengthening banks, the Capital Markets Union’s overall aim is to foster growth of EU Capital Markets and provide a broader range of funding and investment alternatives to the real economy and consumers.

The following diagram shows a holistic overview of the key objectives of the key CMU building blocks mapped to the Capital Market participants (as defined in part I of this blog series):

 

 

The Capital Markets Union key building blocks: Overview and intended effects

Overall, the CMU was designed to mobilize and channel capital to EU companies and infrastructure projects, offer additional investment opportunities for savers and investors and make the financial system more resilient.[3] At present, the most important capital market in Europe is the UK capital market which currently offers financial intermediation to all European capital market players. After Brexit, the terms of access to this market will be uncertain. The remaining capital market landscape can be characterized as being fragmented nationally or regionally. Although cross-border investment and financing is legally possible and promoted as part of the Single European Market for goods and services, cross-border financial activity for many market players constitutes more an option than a widely used instrument. There are numerous reasons for this fragmentation, the most important ones being the remaining differences regarding legal frameworks governing national markets, national market supervision (as opposed to the SSM´s European supervisory scope), resulting in a wide range of regulatory/supervisory practices, product types and market specificities.

Under such market conditions transaction costs are high as is information asymmetry between market players. These market inefficiencies make markets thin (characterized by a small number of participants and transactions), slow and therefore inefficient. The individual CMU building blocks address these inefficiencies by (1) standardizing existing or creating new standardized products (such as STS securitizations) and thus reducing information asymmetries, (2) creating harmonized legal frameworks in fields that are not product-specific (such as insolvency procedures) and (3) stabilizing the financial system by ensuring consistent implementation of regulatory measures and achieving a level playing field. The last point also includes the regulation of banks as the predominant players on the European capital markets where this regulation is not yet integrated.

The following table provides an overview over the 13 key CMU measures structured by the underlying mechanism.

Mechanism Policy Description Objective (Factsheet)
(1) Reduce information asymmetry / standardise Covered bonds To provide a source of long-term financing for banks in support to the real economy
Pan-European personal pension product (PEPP) To give citizens more and better options for retirement savings.
Prospectus Regulation To facilitate access to financial markets for companies, particularly small and medium-sized enterprises.
Simple, transparent and standardized securitization To broaden investment opportunities and boost lending to Europe’s households and businesses.
Sustainable finance: Taxonomy To help to reorient private capital flows towards more sustainable investments, such as clean transport, and help finance the transition to a low-carbon, more resource-efficient and circular economy
Sustainable finance: Disclosure
Sustainable finance: Low carbon Benchmarks
(2) Reduce transaction cost / integrate Cross-border distribution of collective investment funds To remove burdensome requirements and harmonize diverging national rules
Crowdfunding To improve access to this innovative form of finance for start-ups, while maintaining investor protection.
European Venture Capital Fund Regulation (EuVECA) and European Social Entrepreneurship Funds Regulation (EuSEF) To stimulate venture capital and social investments in the EU.
Preventive restructuring, second chance and efficiency of procedures To provide honest entrepreneurs with a second chance and facilitate the efficient restructuring of viable companies in financial difficulties.
Promotion of SME Growth Markets To cut red-tape for small and medium-sized enterprises trying to access capital markets.
Third-party effects on assignment of claims To enhance legal certainty about the applicable national law to the effects on third parties where a claim is assigned cross-border.
(3) Stabilize financial system European Supervisory Authorities review including anti-money laundering rules To enhance supervisory convergence and strengthen enforcement, including against money laundering and terrorist financing.
Investment firms review To ensure a level playing field between the large and systemic financial institutions while introducing simpler rules for smaller firms.
European market infrastructure regulation (Supervision) To ensure that the EU supervisory framework effectively anticipates and mitigates risk from EU and non-EU central counterparties servicing EU clients.

 

(1) The following four building blocks are and will be implemented based on measures aiming at reducing information asymmetry and increasing standardization with regard to investments and funding opportunities:

  • Covered bonds: Acknowledging that covered bond markets are very fragmented across the EU, the new rules aim at enhancing market volumes in those Member States with less developed covered bond markets in order to raise overall market efficiency. By providing a common definition of covered bonds, defining the structural features of the instrument and identifying those high-quality assets that can be considered eligible in the pool backing the debt obligations, the EU Commissions aims at introducing standardization to the market and increasing the transparency for investors. The rules also establish a supervision mechanism for covered bonds and sets out rules allowing the use of the ‘European Covered Bonds’ label.
  • Pan-European personal pension product (PEPP)[4]: Based on the low interest rate environment, investment in shares and bonds increases slowly. However, EU households still hold their savings mainly in cash, bank deposits and insurance and pension products although higher returns could be generated by alternative investments. By introducing an EU wide cross-border standardized voluntary scheme for saving for retirements, PEPP aims at complementing existing public and national private pension schemes and therefore offer consumers more investment choices.
  • Prospectus Regulation: The CMU measures aim at increasing the transparency regarding the risks of the investments by introducing new rules that require firms to include multiple thresholds of risks in the prospectus and allowing cross-references to certain existing documents. Lighter disclosure rules which will be applicable by certain SMEs and mid-sized companies, aim at facilitating their access to Capital Markets to companies which currently mainly rely on bank financing.
  • Simple, transparent and standardized securitization (STS)[5]: Assuming the EU securitization market was built up again to the pre-crisis average, it would generate up to EUR 150bn in additional funding for the economy.[6] In order to achieve the aim of fostering the EU securitization market and restoring an important funding channel for the EU economy, the EU Commission has implemented new rules which differentiate between high-quality securitization products and other products which do not satisfy such criteria.
  • Sustainable finance initiatives: By introducing new sustainable finance initiatives the Commission aims at increasing transparency e.g. by creating a common classification system and taxonomy, establishing labels for green financial products and strengthening the transparency of companies on their environmental, social and governance policies (ESG) with the objective of supporting economic growth while reducing pressures on the environment and taking into account social and governance aspects.

(2) Furthermore, six of the CMU key building blocks are based on the idea to foster growth of EU Capital Markets by reducing transaction costs and with that allowing new participants into the market, which so far mainly rely on bank financing and fostering new cross-border investment opportunities:

  • Rules introduced in relation to Cross-border distribution of collective investment funds aim at aligning national marketing requirements and regulatory fees, harmonizing the process and requirements for the verification of marketing material by national competent authorities (NCAs) as well as enabling the European Securities and Markets Authority (ESMA) to better monitor investment funds.
  • Crowdfunding: Acknowledging that the EU market for crowdfunding is underdeveloped as compared to other major world economies[7], the new rules aim at improving access to crowdfunding for small investors and businesses in need of funding, particularly start-ups. Investors will potentially benefit from the new rules relating to a protection regime, information disclosures for project owners and crowdfunding platforms, governance and risk management and supervision.
  • European Venture Capital Fund Regulation (EuVECA) and European Social Entrepreneurship Funds Regulation (EuSEF): By introducing these two types of collective investment funds, the Commission is aiming at making it easier and more attractive for investors (e.g. insurance companies) to invest in unlisted SMEs.
  • Preventive restructuring, second chance and efficiency of procedures: By providing a second chance through debt discharge to businesses and entrepreneurs the Commission’s proposal aims to facilitate the restructuring of companies in financial difficulties with the aim to avoid insolvency and the destruction of going concern value.
  • Promotion of SME Growth Markets: By introducing a new category of trading venue dedicated to small issuers the Commission aims, among other things, at reducing the administrative burden and costs faced by SME growth market issuers while increasing market integrity and investor protection.
  • Third-party effects on assignment of claims: In order to foster cross-border growth of EU Capital Markets, the Commission acknowledges that a common legal framework across the EU is a key success factor. By determining which national law is applicable to the effects on third parties where a claim is assigned cross-border, transaction costs will potentially be reduced.

(3) One of the key CMU objectives is furthermore to stabilize the EU financial system, e.g. by enhancing the supervisory convergence, ensuring a level playing field and strengthening enforcement measures:

  • European Supervisory Authorities review including anti-money laundering rules: While the EU has strong AML rules in place, recent cases involving money laundering in some EU banks have raised concerns that those rules are not always supervised and enforced effectively across the EU. Planned changes regarding the AML directive therefore aims at further improving the level playing field among all firms operating across the Single Market (domestic, EU27-based or operating from third countries). A new specific provision requiring the European Supervisory Authorities (ESAs) to have in place dedicated reporting channels for receiving and handling information provided by a natural or legal person reporting on actual or potential breaches, abuses of or non-application of Union law are expected to increase transparency and contribute to improved rules and their consistent enforcement across the EU27.
  • Investment firms review: The investment firms review divides investment firms into three categories, with the aim to ensure a level playing field between the large and systemic financial institutions while introducing simpler prudential rules for non-systemic investment firms.
  • European market infrastructure regulation (Supervision): A proposal to strengthen the supervision of central counterparties: to ensure that the supervisory framework of the Union is sufficiently robust to anticipate and mitigate risk from Union central counterparties and from systemic third-country central counterparties servicing Union clients.

 

The CMU: First conclusion

In order to achieve the overall objective of fostering growth of EU capital markets, the Commission formulated the key objectives of the CMU action plan. In order to reach these CMU objectives in due course, it is essential that necessary measures are implemented homogeneously across the EU, considering that – in contrast to the Banking Union´s measures – most of the CMU building blocks will require national implementation of European directives. The uniform implementation of the CMU will thus depend on the agreement of participating Member States to implement it in a coordinated way in order to balance the administrative cost originating from it and the benefits of larger, efficient and resilient capital markets for the real economy. Furthermore, taking into account the latest political developments regarding Brexit, it is necessary that additional measures identified as part of the ‘CMU 2.0’ initiative focus more on the development of the EU27 capital markets and how to best minimize disruption regarding financial intermediation currently offered by the UK capital market participants post-Brexit.

 

 

 

Please contact our PwC experts in case of any questions.

Stephan Lutz – Mail: stephan.x.lutz@pwc.com

Ina Alexandra Steiner – Mail: ina-alexandra.steiner@pwc.com

Dr. Philipp Völk – Mail: philipp.voelk@pwc.com

 

 

 

 

 

 

[1] https://www.consilium.europa.eu/media/39698/joint-risk-reduction-monitoring-report-may2019.pdf

[2] https://blogs.pwc.de/regulatory/tag/frtb/

[3] https://ec.europa.eu/info/business-economy-euro/growth-and-investment/capital-markets-union/what-capital-markets-union_en

[4] For more information regarding the PEPP rules, please read our already published blog: https://blogs.pwc.de/insurance/risk-finance/aufsichtsrechtlicher-dialog-genehmigungsverfahren/europaeisches-parlament-hat-dem-vorschlag-ueber-eine-verordnung-fuer-ein-europaweites-privates-altersvorsorgeprodukt-pepp-zugestimmt/2923/

[5] For more information regarding the new STS rules, please read our already published blogs: https://blogs.pwc.de/capital-markets/category/securitization-structured-finance/

[6] https://europa.eu/rapid/press-release_IP-17-1480_en.htm?locale=en

[7] https://ec.europa.eu/info/business-economy-euro/growth-and-investment/financing-investment/crowdfunding_en

European Commission Endorses ESMA Templates for Loan-Level Data Reporting for Securitizations

Why new templates?

The European Securitization Regulation that came into force in January 2019 requires data disclosures for most securitizations originated in Europe. Compliance with the disclosure requirements will mean submission of an official set of templates of loan-level data to a securitization repository, a process that has some similarities with the disclosure of derivatives transactions under EMIR. The Regulation bestows ESMA with the power to develop the templates which then have to be endorsed by the EU Commission (EC), adopted by European Parliament and finally be published in the Official Journal as a European regulation. Only after this, the templates will become mandatory for all securitizations issued after January 1, 2019.

Just a few days ago, on October 16, 2019, EC released the official disclosure templates that were so impatiently awaited by the securitization market. It took the Commission exactly 288 days to endorse the templates since the time ESMA published their final draft on its web site. Besides the field-by-field addendum, EC further provides details by releasing an endorsed RTS where it states among others:

Private transactions are fully exempt from data disclosure though a securitization repository. Despite interim proposal from ESMA to include private transactions into disclosure requirements through repository, this effort finally did not find its way into the endorsed RTS.

Standardized identifiers will be used across all asset classes, including fields for “back-up” IDs in case the original ones can no longer be maintained. From a data user perspective, this is a very welcome feature as it allows easy data reconciliation and time series analysis.

No Data options are allowed for most of the fields in either option of ND1-4 or ND5. The meaning of individual inputs remains the same when compared to ECB’s taxonomy:

 

Very limited use of ND values was the main reason of rejection of the final RTS draft published by ESMA in August 2018 (“the Commission requests ESMA to examine whether, at the present juncture, the ‘No Data’ option could be available for additional fields of the draft templates”). EC seems to have viewed the templates as being too strict and inflexible to accommodate a unified standard across multiple jurisdictions in Europe. As a result, the number of fields allowing ND5 or ND1-4 increased. From our perspective, ND5 does not influence data analysis, performed by investors or regulators as it only signals non-relevance. ND1-4, however, give a room to data providers to omit some data that is currently not available for disclosure.

Template Comparison

Having the templates’ history in mind, we looked closer at the final layouts released by EC in Annexes 1-15 and compared them to the final draft ESMA submitted for endorsement in [January 2019]. Apparently, EC took the proposed templates over as drafted by ESMA with very few changes:

ND1-4 became newly available for:

  • Interest Revision Date 1 (field RREL51)
  • Interest Revision Date 2 (field RREL53)
  • Interest Revision Date 3 (field RREL 55)

ND5 became newly available for Primary Income Currency (AUTL18).

Other fields from all remaining 9 ESMA templates remained unchanged. In our opinion, allowing RREL51, 53, 55 to potentially report no data does not hamper data analysis and risk assessment significantly. Allowance for ND5 for AUTL18 has no impact on data reported at all since primary income (AUTL16) has to be disclosed in a format of {CURRENCYCODE_3} which already includes currency denomination.

What is coming next?

We expect the European Parliament to adopt the templates in the following months. Formally, the maximum time allotted to this process is 6 months. After that, the legislation foresees additional 20 days after release in the Official Journal for the RTS to apply. Market participants that are affected by this regulation need to switch to the new templates without any delay as soon as this RTS becomes a European regulation.

At PwC, we have analyzed the templates over the past 10 months. As they differ significantly from the ECB templates for collateral purposes (being used by the market from 2013 onwards*) we do expect data inconsistencies caused by lack of clarity on field-by-field interpretation, but also technical challenges for IT departments. Additionally, ongoing monitoring and data quality issues, especially for STS-seeking deals, may become burdensome. This and other data issues may also be caused by a split legislative governance – templates and their field-by-field setup were developed by ESMA which is also mandated with data quality enforcement, whereas national competent authorities (full list here) are appointed with supervisory power concerning the compliance of data owners with the template provisions.

ESMA is entitled to impose and enforce data quality rules on the level of the securitization repository. Those rules will be primarily linked to ND1-4 values which to certain extend resemble ECB’s efforts in data completeness, indicated by ECB score. ESMA will further develop and propose rules for other fields, including ND5, interfiled inconsistencies and STS non-compliant values. This means that even though more flexibility is given by the final template layout, ESMA still retains tools to enforce more strict disclosures in the future if deemed necessary. One of them is development of a data quality threshold that will indicate a “minimum passing score” which will be calculated by the securitization repository for each incoming data tape. Falling below the threshold would mean automatic rejection of the data and thus non-compliance with the regulation. ESMA further indicates that those thresholds will evolve over time; converging to as little ND values as possible.

2020 will likely bring new ECB eligibility criteria

In March of 2019, ECB announced that eligibility requirements for loan-level data reporting in the ECB collateral framework for the ABSPP is going to be adjusted to reflect EU Securitization Regulation’s disclosure requirements. The convergence depends upon two conditions – (1) ESMA templates entering into force and (2) the first securitization repository getting registered with ESMA. The first condition will most likely be met in the following months, whereas registration of the first repository with ESMA will happen only after finalization of legal framework governing Securitization Repository. Timing for the latter is uncertain yet since this is the last open issue concerning Securitization data reporting, we believe this could happen soon.

It is likely that reporting through ESMA templates will have to take place before the first securitization repository gets registered with ESMA. During this time, the data tapes need to be published and made available to the data users through a website that meets certain criteria (secure hosting, data quality management etc.). Currently, this is being fulfilled by the largest ABS data platform and ECB’s designated repository, the European DataWarehouse.

PwC’s focus

Adoption of the new reporting standards may be challenging for some originators, namely those issuing ABCPs, CLOs or NPL as there has never before been a mandatory disclosure of these data sets. Besides this, data management, monitoring and remediation system will have to become an essential part of overall IT infrastructure on data provider’s side, irrelevant of the specific asset class. Non-compliance with templates or falling below data quality threshold could lead to a loss of ECB’s collateral eligibility, STS label and/or reputation damage.

 

Please contact our PwC experts in case of any questions.

 

Dr. Philipp Völk – Mail: philipp.voelk@pwc.com

Petr Surala, CFA – Mail: petr.surala@pwc.com

 

* The ECB loan-level reporting templates apply from January 3, 2013 for RMBS and SME ABS,  March 1, 2013 for CMBS, January 1, 2014 for Consumer Finance ABS, Leasing ABS and Auto ABS, and from April 1, 2014 for Credit Card ABS.

Capital Markets Blog Series – Part I: Capital Market Structure and Market Participants

 

Capital Markets Blog Series – Part I: Capital Market Structure and Market Participants

Brexit will almost inevitably initiate a transition towards a new EU27 Capital Market, needed to finance European economic growth and development in times of political uncertainty and technological disruption. Based on the publication of our Thought Paper “The Development of European Capital Markets Post-Brexit”, this blog will focus on EU27 Capital Markets structures and participants.  Further posts will focus on the main areas and the progress of the Capital Markets Union (CMU), which we consider the most important regulatory condition for the future development of EU27 Capital Markets.[1]

Capital Markets – Overview

Capital markets fulfill an intermediation function by transforming size, maturity and risk. The intermediation function of Capital Markets leads to risks being transferred directly between market participants while intermediation by banks involves the temporary use of bank’s balance sheet, resulting in a high reliance on banks’ continued capabilities to carry, manage and hedge these risks while owned by them. In times of increasing regulatory capital requirements and low interest rates, both resulting in a reduced risk appetite of banks, this intermediation function is constrained.

On Capital Markets, securities such as shares and bonds are issued to raise medium to long-term financing on what is called the primary market, and securities, commodities, currencies as well corresponding derivatives are traded on what is called the secondary market – disregarding newly developing asset classes and tokenization of real assets. Short-term transactions within a currency take place on the money market.

On primary markets, an issuer usually engages investment banks to place its securities (e.g. bonds and shares) with investors. In secondary markets, an issuer’s bonds and shares as well as other asset classes such as e.g. derivatives and commodities are traded between market participants.

The following diagram shows a holistic overview over the Capital Market structure as well as market participants which will be referred back to throughout the following blogs:

 

Capital Market Participants – Roles and Responsibilities    

In primary markets, issuers (e.g. public sector entities, corporates and banks) use investment banks (so called sell-side banks) in order to support them in structuring IPOs or debt issuances. Investment banks may thus act as intermediaries in the primary market either by connecting the issuer with potential investors (matching function) or by acquiring the issuance and re-selling it to other participants (underwriting function). Furthermore, banks depend on Capital Markets to issue their own debt and equity instruments, needed to fulfill their intermediation function, especially if they cannot attract (sufficient) deposits. The ability of Capital Markets to provide financing is a critical prerequisite of financial intermediation needed to finance economic growth and innovation. Capital issuances in the primary market are usually acquired by large institutional investors including but not limited to asset managers, hedge funds, pension funds and insurance companies. These market participants hold either issued capital instruments directly or structure investment vehicles to pool capital instruments from different investors.

Generally, shares and bonds issued in primary markets are subsequently traded in secondary markets as well as other asset classes such as e.g. derivatives and commodities. In secondary markets, additional investors such as e.g., commodity houses, commodity producers and consumers come into play. As a result of this larger group of investors as well as the increase with regard to the number and complexity of products (e.g. based on restructuring and derivative products), the legal and regulatory requirements for intermediaries are higher in the secondary market than in the primary market. Intermediaries in the secondary market include investment banks’ Sales & Trading divisions, which focus on creating investment and hedging opportunities for investors who are looking at transferring risks. In order to increase market demand for primary market products, these specialized traders use techniques such as financial engineering or structuring, creating new products that allow investors to buy portions of risks and cashflows of the original assets. In addition to investment banks, the group of intermediaries generally includes e.g. trading venues, such as e.g. stock exchanges, Multilateral Trading Facility (MTF) focusing on equity transactions (no operator discretion) as well as Organised Trading Facilities (OTF) focusing on non-equity transactions. Furthermore, FMIs such as e.g. clearing houses (CCPs such as LCH, Eurex Clearing, CME or Iceclear) and Central Securities Depositories (CSDs such as Clearstream, Euroclear or DTCC in the US) play a key role on the secondary market. Besides the intermediaries mentioned above, which usually share part of the risk of the underlying transactions or support the execution of the transaction process, other relevant market players such as rating agencies have emerged in order to enhance transparency and therefore reduce the information asymmetry between issuers and investors. Statutory auditors foster reliance in financial statements and thus reduce disincentives. Law firms and advisors help transfer best market practices between market participants.  Furthermore, regulators issue legal requirements and supervisors enforce them contributing to a functioning, stable and integrated, fair and transparent financial system and prevent its misuse for fraud, money laundering and terrorist financing purposes. Shortcomings with regard to the above-mentioned functions may result in severe market disruption with respective effects on the real economy.

 

Need for action in order to realize the growth potential of EU27 Capital Markets

The different size and structure of Capital Markets often relates back to the underlying economy and market structure, including its market participants. As an example, the majority of EU27 entities are bank-financed in contrast to the US, where Capital Market funding plays a major role for market participants. On average, bank lending represents 78% of corporate debt for EU27 companies and bond markets account for 22% in 2016 (compared to 13% in 2006). This is the inverse of the US with its market-based financial system, where bank lending accounts for 26% of corporate debt in 2016 (compared to 27% in 2006). In the UK, bank lending represents just over half of corporate debt with 54% in 2016 (compared to 63% in 2006) which shows the path the UK has taken to convert from a bank-based to a market-based financial system.[2]

Currently, the EU is facing enormous challenges: Trying to tackle demographic and technological change, border protection and climate change will require significant investments which cannot be provided purely by banks as financial intermediaries. Furthermore, Brexit preparations revealed the extent to which the EU27 member states are dependent or (over-)reliant on the UK Capital Market, which effectively absorbs a large part of Capital Market transactions entered into by European market participants. In order to ensure growth and become more independent in an international context, the European Union needs a genuine, integrated and innovation-friendly Capital Market. Since Capital Markets are fragile constructs with legal, political and social determinants being the main drivers to ensure a stable development, the Capital Markets Union (CMU) introduced by the EU Commission is an important first step towards the creation of an integrated European Capital Market. The subsequent blogs will thus focus on the CMU action plan, analyzing the issues it tries to tackle as well as identifying potential gaps and remediating actions.

 

 

Please contact our PwC experts in case of any questions.

Stephan Lutz – Mail: stephan.x.lutz@pwc.com

Ina Alexandra Steiner – Mail: ina-alexandra.steiner@pwc.com

Dr. Philipp Völk – Mail: philipp.voelk@pwc.com

 

 

 

 

[1] The authors thank Fabian Faas and Philipp Böhme, both PwC, for their valuable contribution to this blog series.

[2] Wright, W./Asimakopoulos, P. (2018): A decade of change in European Capital Markets, p. 10.

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