PRUDENTIAL REFORM IN SECURITISATION

Charles Littrell
Executive General Manager, Policy, Research and Statistics
Australian Prudential Regulation Authority

Australian Securitisation Forum, Sydney

22 October 2012

PRUDENTIAL REFORM IN SECURITISATION

Today I propose to briefly review APRAs take on the Australian securitisation
market, in the context of our statutory mission. Then I will outline APRAs current
thinking on how to secure the benefits of securitisation for Australia, while
reducing the potential for problems that we have seen emerge over the past five
years.
Section 8 of the APRA Act states:
APRA is to balance the objectives of financial safety and efficiency, competition,
contestability and competitive neutrality and, in balancing these objectives, is to
promote financial system stability in Australia.
APRA interprets the first part of this statutory instruction as an optimisation
problem. To wit: we seek to maximise safety, constrained by the need to avoid
undue damage to the Australian financial systems efficiency, competitiveness,
contestability, and competitive neutrality.
The second part of the statutory instruction adds the need to promote financial
stability. So we end up with two objectives and four constraints.
How does securitisation fit into APRAs objectives and constraints? From the 1990s
to the mid 2000s, rather well; from 2008 through say 2011 less well; and now we
want to discuss reforms that will make Australian securitisation more satisfactory
in prudential terms than it has been in recent years.
In theory, and from the mid 1990s to the mid 2000s in practice, securitisation was
largely a winner in APRA statutory terms. Any glance at the spreads on home
loans, for example, supported the idea that securitisation helped increase
competition. A look at the names of the lenders and brokers for home loans
suggested that securitisation was also promoting contestability and competitive
neutrality, as smaller regulated lenders and unregulated lenders were much better
placed than previously to enter the market, and compete profitably with the
largest banks. There were however some issues with systemic stability, as
increased access to cheaper home loan financing helped create, if not a bubble,
then a quite frothy home lending market from around 1998 to 2003. In the event,
APRA and RBA action in arenas other than securitisation, and generally sensible
self-control by Australian lenders, averted, at least so far, any substantial problems
in home lending.

Globally and in some instances locally, this benign view of the good fit between
securitisation and APRAs statutory objectives changed rapidly from 2007 and
particularly 2008. The apparently inevitable rise of securitisation in Australia
reversed sharply, a trend which now shows some sign of moderating.
In traversing the last five years, we have learned at least four lessons about
securitisation.
First, lending models based upon laying off all the funding and all the capital to
other parties, the so-called originate to distribute model, create unacceptable
agency risks. Allowing lenders to lend without the constraints associated with
putting their own money, or at least their shareholder money at risk, too easily
leads to an unrestrained focus upon lending volume at the cost of lending quality.
This insight has led to more global focus upon skin in the game for the original
lender, and any new Australian securitisation regime will need to respect this
outcome.
Second, a number of international firms, using the complexities of securitisation
and structured credit more generally, created investments that were more likely to
fail than was advertised. Australian regulated entities were the victims rather
than the instigators of these schemes, which I suppose is some comfort.

Third, as illustrated in this chart, the securitisation markets can suddenly close
even to the highest quality underlying assets in the simplest structures. Had the
public sector not supported Australian securitisation via the AOFM then this chart
would have been even flatter since 2008, with near zero issuance for
approximately 18 months. The securitisation markets vulnerability to near-total
closure means that liquidity risk is at least as high in securitisation as it is in normal
banking, and the usual cautions associated with lending long and borrowing short
apply.

Funding Composition of Banks

in Australia

Share of total funding

Major Banks

Other AustralianOwned Banks

Finally, the fact that securitisation markets can close even to good credits, for
extended periods, means that securitisation-reliant business models are at risk of
being placed in de facto run-off. This strongly suggests that no prudentially
regulated lender should rely too heavily upon securitisation for funding. As shown
in this chart, closing securitisation markets were an inconvenience for the largest
Australian banks, but were a strategic constraint for some of our mid-sized ADIs.
Happily for the ADIs and the Australian economy, depositors have more than
covered the gap, but we cannot always rely upon this outcome.
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In addition to these core lessons, you will recall that APRA last made major
changes to the securitisation requirements in APS 120 in January 2008. Our intent
was as a supervisory matter to check the ADI industrys implementation of the new
approach, which among other things no longer required APRA pre-approval for each
issue. What we discovered in subsequent supervisory reviews was not always
pleasing. Too many ADIs had engaged in securitisation without completing some of
the basic governance requirements, including board oversight. Some ADIs had
interpreted the rules, particularly on risk retention, in a way which ranged
between convenient and wrong. Less troublingly but not well catered for in the
current APS 120, a number of ADIs had commenced securitisation for funding
purposes only.
From 2010 until now, APRA has issued a number of ad hoc industry letters. These
letters are intended to allow the securitisation market to continue, until APRA has
the ability to undertake more fundamental reforms to the relevant prudential
infrastructure. For the past two years Basel III has taken centre stage for
prudential reform purposes, and neither APRA nor industry has had the capacity to
address securitisation in any fundamental way. It is also the case that the Basel
Committee and IOSCO, among others, continue to develop international
frameworks for securitisation, and APRA intends to comply with those frameworks
as they reach completion.
Happily, APRAs policy development capacity is now freeing up beyond Basel III.
After conducting initial and informal discussions with some participants in the
securitisation markets, we are currently drafting a discussion paper to commence
the process of prudential reform for securitisation.
In our proposed reforms, APRA intends to push three themes:
explicitly catering for funding-only securitisation, subject to some prudential
limits;
greatly simplifying the overall prudential regime; and
addressing the lessons learned about securitisation which I previously referred
to: agency risk, liquidity risk, and business model risk.
I remind listeners that todays talk is not the discussion paper. APRA has
considerable work and consultation in front of it to turn todays themes into
specific prudential proposals.
Funding-only securitisation
We propose first to define the approach to funding-only securitisation. Such an
arrangement is characterised by three features:
the originating ADI retains substantially all the credit risk, and all the capital
requirements associated with the underlying asset portfolio;
APRAs prudential requirements will ensure that such arrangements are sensibly
managed in liquidity terms; and
the issue is not a covered bond in disguise.
Our current thinking is that we can achieve a sensible prudential outcome in the
following way.

1) The securitisation structure is, speaking somewhat loosely, restricted to two

tranches.
2) The A tranche is senior, and is likely to comprise approximately 90 per cent
of a typical home loan securitisation. The expectation is that the A tranche
will be AAA rated.
3) All A tranche notes must be pari passu in credit seniority terms, but the A
tranche may consist of issues with varying maturity, meaning that the
shorter maturities are in a repayment order sense, but not a liquidation
sense, ahead of the longer maturities.
4) ADIs will be free to trade in their own A notes; the current 20 per cent rule
would be abolished. ADIs may also trade in other issuer A notes, using risk
weightings that already exist under Basel III.
5) This leaves the B note, which in a funding-only securitisation is simply held
in its entirety by the originator. APRAs expectation is that the B note will
comprise the current mezzanine and equity tranches of a securitisation.
Liquidity in a funding-only securitisation
APRA is still considering how best to ensure that liquidity is properly managed in a
funding-only securitisation. We expect that any new arrangement will include the
following features:
the structure is consolidated with the originating ADI for Basel III liquidity
purposes;
there is a supervisory expectation that originators will seek to match the
expected underlying asset tenor with appropriate liability tenors; and
there would be some limit on the proportion of an ADIs balance sheet that may
be pledged for securitisation purposes. This means that the originate to
distribute model will not be available for the entirety or even the majority of
any ADIs balance sheet.
APRA will consider whether or not we continue with our current prudential
preference for pass-through structures, or whether we allow more freedom for
date-based calls. This is doubtless a matter for consultation.
Securitisation for capital relief
APRA observes that the largest ADIs are primarily interested in securitisation as a
funding vehicle, but some middle-sized ADIs are interested in both funding and
capital benefits. This brings us to securitisation for capital relief, which boils down
to: find a third party investor for the B note.
APRAs thinking is that ADIs would be allowed a pari passu capital reduction to the
extent that B notes are sold, but with a minimum retention on the order of 20 per
cent of B notes to reduce agency risks associated with unconstrained and
nonrecourse lending. This is the skin in the game requirement.
The B notes would look quite different from the current mezzanine and equity
tranche arrangements. They are unlikely to be rated, for example, and this is good
from APRAs perspective. The A notes are intended for investors who want safety
and the comfort of a strong rating. B notes are meant for investors who have
themselves built serious credit analytics capacity, and in particular for investors
who rely upon their own analysis, not a credit rating.
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APRAs expectation is that ADIs would place B notes with investors outside the ADI
sphere.
To this end, APRA intends to propose that ADIs holding another
originators B notes will attract a 100 per cent equity deduction for any such
holding. ADIs swapping B notes create no net credit transfer, but do shift risk from
the original fully informed lender to less informed secondary lenders. In a systemic
stability sense, APRA would much prefer to see B notes shifted to less levered
investors, such as insurance companies and superannuation funds.
I note that APRAs B note thinking and resultant prudential capital arrangements
have yet to be optimised with international skin in the game requirements, and
with issues such as the sellers share, LMI cover, and profits left in or expected by
the securitisation vehicle. These issues will doubtless feature in our upcoming
consultation.
Other issues
APRAs prudential arrangements currently allow for synthetic securitisation, under
which an ADI can enter a credit derivative, and claim capital benefits for loans
remaining on the ADI balance sheet. For various reasons ADIs have been slow to
take up this opportunity. Thinking more in a systemic stability sense, APRA is
increasingly unconvinced that allowing synthetic securitisation is a good strategy
for Australia. Accordingly, we are likely to commence consultation on the basis
that synthetic securitisations will no longer produce capital benefits.
Similarly, current arrangements allow for remarkably complicated and opaque resecuritisation instruments to be originated, traded, and held by ADIs, often at low
risk weights. It is not evident that these instruments have any practical use, and
painfully evident that these instruments have been acquired by investors, including
Australian investors, who were unable to understand the risks inherent in them.
Accordingly, APRAs likely position for consultation is that ADIs are expected not to
hold subordinated securitisation instruments, or any resecuritisation instruments,
and any such holdings will attract an equity deduction. It will be up to industry to
argue the case for any more liberal treatment.
Finally, APRA observes that there has been much discussion of master trusts over
the years. We will be interested to hear any views on how our proposed reforms
might facilitate or retard the development of master trusts.
APRAs prudential objectives
I will close by summarising APRAs prudential objectives.
First, we want to ensure that Australian securitisation arrangements do not
encourage lax lending or tempt market participants to take advantage of each
other through excess complexity.
Second, APRA expects that Australian A notes will be among the safest and simplest
securitisation investments available globally. This should help restore and protect
Australian access to local and global securitisation markets.
Third, we wish to ensure that credit risk is concentrated in the B notes, and that
these notes are held in expert and properly capitalised hands. These hands will

belong either to the originator, or to non-ADI investors with a good in-house

understanding of the resultant credit risks.
Finally, we want Australian securitisation to be part of the solution, and hopefully
a large part of the solution, to the Australian ADI industrys need to find more term
liabilities. Conversely, we dont want securitisation to create unmanaged liquidity
risks.
In summary, APRA aspires to a securitisation market that is simpler, safer, and over
time larger, than the current prudential arrangements allow.
Thank you for your attention.