Securitisation in the banking sector: Unlocking financial potential
Saudi Arabia Focus
Rafiq Jaffer Partner,Banking & Finance
Muhammad MithaSenior Counsel,Banking & Finance
Ambreen BidiwalaSenior Counsel,Banking & Finance
Banks and finance companies use securitization to enhance balance sheet management, expand credit availability, lower costs, and spread risk across a wider range of investors.
Securitisation has provided a key source of long-term funding to US, European and increasingly to GCC banks and finance companies. Banks and finance companies use securitisation as a device for improved balance sheet management. The key advantages include, increased availability of credit, while decreasing its costs and dispersed and redistributed credit risk to a broader and more diverse investor base. In a typical securitisation involving a bank or finance company, three things occur: firstly, a portfolio of assets (eg a home mortgage portfolio or credit card portfolio) is sold in a ‘true sale’ to a bankruptcy remote special purchase vehicle;
secondly, the special purpose vehicle issues bonds with different tranches, backed by the asset itself and the payment streams associated with it (i.e ‘asset-backed’); and; thirdly repayment of debt comes from the cash flow generated by the asset pool rather than the originator’s cash flows.
The typical portfolios of assets that are most conducive for securitisation are those that are similar in nature – having the standard documents, similar financing structure and similar tenors. The ideal assets include; credit card portfolios, home mortgage portfolios and personal loan portfolios containing the requisite homogeneity. The Saudi Central Bank (SAMA) has issued standard contracts including personal finance commodity murabaha for personal loans and real estate Murabaha and real estate Ijara for home mortgages. These standard contracts contain provisions that facilitate the customer consents and data disclosure required for securitisation. The only entities that can originate such financing transactions are banks and finance companies licensed by SAMA.
The first piece of the puzzle is to set up a special purpose vehicle into which the originating bank or finance company can transfer the portfolio of assets. A special purpose entity or SPE must be established and licensed under the Rules for Special Purpose Entities issued by the Capital Markets Authority (CMA). SPEs can be used as a vehicle for securitising financing assets. An SPE is required to have the following roles to operate under the Rules for Special Purpose Entities (a) Sponsor; (b) Trustee; and custodian.
A sponsor of an SPE that issues asset-backed debt instruments, is required to be a Saudi joint stock or limited liability company, a capital market institution licensed to carry on securities business, a local bank or a finance company. The trustee of the SPE must be a capital market institution licensed by the CMA to carry on custody business. The trustee of the SPE may also be the custodian. The custodian must be a capital market institution duly authorised by the CMA to carry on the activity of custody.
Securitisation has long been a key source of long-term funding in the US and Europe; GCC banks and finance companies are now increasingly to turning to securitisation as a device for improved balance sheet management.
The second component is to achieve ‘true sale’, being the legal transfer of the portfolio of assets, from the originating bank or finance company to the SPE. The Civil Transactions Law was issued in 2023 (“Civil Code”) and covers, amongst other things, general principles governing contract formation, execution, termination, assignment and transfers.
Article 238 of the Civil Code states that a creditor may transfer its rights to a third party except where a specific provision of law or contract restricts such transfer. The creditor is not required to obtain the consent of the debtor to transfer such right unless there is a specific requirement to seek consent. Article 240 of the Civil Code requires the assignor / transferor to notify the debtor of the assignment. The assignment takes effect if accepted by or communicated to the obligor by any “legal means of notification”. Therefore, a notification of the assignment to the underlying obligor is sufficient and consent may not be required. Where consent is to be obtained, transfer of rights vis-à-vis third parties only occurs if the acceptance or consent is dated and written.
Articles 255 to 258 of the Civil Code deal with novation of a contract. Specifically, Article 255 of the Civil Code recognises the replacement of one contracting party with another party. This provision states that the novation is valid where the existing contracting party consents to the transfer of the entire contract to a third party. It is possible to obtain consent in advance to novate a contract by incorporating suitable consent provisions in the relevant contract or to seek specific consent if the relevant contract does not contain a suitable provision to transfer. Where advance consent is built into the contract, a subsequent notification of the transfer of contract to a third party would be sufficient.
Further, Article 256 of the Civil Code states that where the third party i.e. the transferee accepts the transfer, the transferor entity would be released from its rights and obligations under the relevant contract.
Once the steps for assignment or novation (depending on the nature of the pool of financing assets being securitized) as set out the provisions of the Civil Code (discussed above) are carried out, the transfer of the relevant portfolio from an originator to an SPE would be seen as a legal transfer and treated as a true sale.
The third component deals with tranching of the bonds. This is done in order for differing quality of bonds possessing differing credit ratings to be issued. For example, an asset portfolio consisting of financing transactions that an originator bank having investment grade ratings can be grouped into one issuance of bonds and those consisting of financing transactions with borrowers having sub-investment grade ratings can be put into a another. Each tranche of bonds will have differing priorities as to payment of principal and return/coupon and carrying differing return rates. The more senior tranches will have the right to priority of payment over more junior tranches, but the more junior tranches will carry a higher rate of return.
While this is a fairly new concept for the GCC region, tranching of bonds is now possible under the Bankruptcy Law. Therefore, in the event that the value of the portfolio of assets were to decline as a result of payment defaults, the senior transches will get priority and be paid out first followed by junior tranches.
For further information,please contact Rafiq Jaffer, Muhammad Mithaand Ambreen Bidiwala.
Published in April 2024
