KOREA CAPITAL MARKET INSTITUTE

Asset-backed securities (ABS) are one of the critical financial tools for private sector firms and financial institutions. However, Korea’s ABS market is known to have some problems such as low transparency of unregistered securitization, lack of compatibility of the institutional framework, and failure to provide diverse financing tools. Aiming to deal with those issues, Korea’s government unveiled its measures to improve Korea’s ABS market on May 18, 2020, under which to make substantial improvement on the overall regulatory framework including a legislative reform to rebuild an efficient market whose growth depends on investor confidence. Such regulatory improvements proposed under the measures are expected to address the aforementioned issues while helping the market enhance efficiency and regain investor confidence. However, some market participants are raising concerns that the measures might increase burden on issuers and discourage market activities. At this particular juncture, this article looks into key issues around the measures, from which to derive desirable directions for facilitating the ABS market and improving the market’s soundness. 


Measures to improve Korea’s ABS market

Korea’s ABS market can be divided into two parts: registered securitization based on the Asset-backed Securitization Act; and unregistered securitization sitting outside the law, such as asset-backed commercial paper (ABCP), and asset-backed electronic short-term bonds. Registered and unregistered ABS are similar in size, with each of them totaling around KRW 200 trillion. The registered segment primarily includes collateralized debt obligations (CDOs) that pool together and securitize corporate bonds and other collateralized bonds such as mortgage, auto loans, credit card loans, and mobile phone installment loans. On the other hand, unregistered securitization is based on real estate project financing and time deposits whose transfer is not subject to “special case” treatment. 

Registered securitization based on the Asset-backed Securitization Act is subject to various legal restrictions such as the originator requirement, a ban on a subsequent or additional issuance, and a prior approval for a securitization plan from the Financial Supervisory Service. Such a cumbersome procedure helped push up the demand for unregistered securitization that produces the same effect with a simpler procedure. Although there were significant changes in market conditions, regulatory improvements made thus far have yet to reflect those changes. Hence, registered securitization fails to meet a wide array of demand in the market, whereas the loosely-regulated unregistered segment fails to provide sufficient information on the securities issued in the market. And this could give rise to potential risk. Against the backdrop, the government came up with the measures for an all-out regulatory reform including a legislative reform, aiming to facilitate the market and enhance transparency.
 
More concretely, the measures are seeking to lay a foundation for more active corporate financing by expanding the investor base of securitization, diversifying eligible assets, allowing for more diverse securitization structures, and overhauling the asset manager requirement. Also included are establishing a basis for securitizing intellectual property rights, and streamlining the registration procedure. 

Alongside with those measures, the government is also pushing for enhancing the soundness of the ABS market. As part of that effort, the government will introduce a risk retention rule for preventing conflicts of interest in securitization. Furthermore, it plans to bolster disclosure of credit rating agencies for enhancing the quality of ABS ratings, and to improve the accuracy of data used for rating. Also included in the move is building an integrated information system that also covers unregistered securitization, aiming to enhance transparency in the ABS market. 


Improvements in registered securitization

The measures to improve asset securitization include a diversity of detailed policy actions including a legislative reform. First, originator eligibility will be loosened. An originator is an institution that owns an asset and securitizes it for raising capital. The Asset-backed Securitization Act and the Enforcement Decree stipulate a list of eligible institutions that could be an originator of an ABS. The proposed measures will not only abolish the uniform credit rating requirement for originator eligibility, but also expand the eligibility criteria to a broader range of institutions such as the government, municipalities and microfinance institutions. Furthermore, the proposed measures will diversify securitization structure: for example, more than one asset owners will be allowed to transfer their assets for issuing ABS together.

Also, a more diverse assets will become eligible for securitization. Under the current Asset-backed Securitization Act, eligible assets for securitization are loosely stipulated as bonds, real estate and other property rights. Legally, most assets with property rights can be securitized. In practice, however, assets eligible for securitization should be a property right that can be registered and transferred: For securitization, an asset should be transferred via either a trade or an exchange, and such a transfer should be registered with the regulatory authority. In short, assets that are mostly securitized tend to be those whose value could be measured, whose ownership could be transferred to a special purpose vehicle (SPV), and whose cash flows are somewhat predictable. This led to many issues when securitizing assets such as intangible property rights and account receivables. To get around those issues, a new structure such as bridge loans was introduced. This round of measures include a legislative reform that will redefine the eligible asset for securitization, which helps broaden the eligibility criteria to more assets such as intangible property rights and account receivables. Under the measures, an authoritative interpretation will be given for addressing legal uncertainties around the issue, which will pave the way for a pilot project of securitizing intellectual property rights. 

If materialized, those regulatory improvements are expected to help enhance the diversity and size of the registered ABS market. Among others, an expansion in originator eligibility will help boost financing of the government, municipalities and low-rated private sector firms via the securitization structure. Notably, this will give low-rated firms more financing opportunities because they will be able to use their own assets. Also, a structure for more than one originators will enable many firms to securitize their account receivables, which will function in effect as a multi-seller ABCP structure. This will certainly help more small to medium sized firms to raise capital more easily. Also, innovative firms that own intellectual property rights will be able to use their cash flows for financing. 


Introducing the risk retention rule

This round of measures will introduce a series of policy actions that could address conflicts of interest arising from the nature of ABS structure and enhance market confidence. Aiming to improve global regulatory compatibility, the measures will also devise an originator risk retention rule. It has been during the global financial crisis that the rule has been first adopted to address the problem where an originator has no incentive to properly manage the asset once the inherent risk is transferred to the market. Transferring the whole credit risk to investors could lower the incentive for the originator to carry out proper loan screening. Rather, this might predispose the originator to lend more aggressively and to increase the size of securitization in a hope to boost investment return, which would further decrease the incentive to keep an eye on underlying assets after securitization. In a move to address that issue, most jurisdictions with an active securitization market including the US, Europe, and Japan have opted for a rule that obliges originators to retain a certain level of risk. However, details related to risk retention regulation vary widely across countries. While allowing for various methods of risk retention, the rule exempts or relaxes risk retention requirements for certain assets, for example, qualified residential mortgages; qualified assets such as commercial real estate loans, commercial loans, and auto loans; and mortgage-backed securities sponsored by government-sponsored enterprises. Japan also has a flexible risk retention rule. By contrast, Europe’s rule is somewhat stronger in that it obliges originators to confirm their retention of 5% or more of risk before carrying out investment. 

Impacts of risk retention rules on the market are quite different across nations. In the US, this seemed to have partly contributed to boosting the ABS market, whereas Europe’s market has been stagnant since the global financial crisis. Thus far, Korea has delayed adopting the risk retention rule, citing the rule’s possibility of increasing originators’ burden and thereby contracting the ABS market. However, it’s hard to delay the adoption further for three reasons: First, there’s a regulatory gap between Korea and other countries as Korea lacks a tool to properly control issues arising from conflicts of interest in securitization; second, this may create a confusion about which regulation to apply when a domestic originator issues ABS in another country; and third, the departure from global standards is already creating disadvantages. It was against that backdrop that the government unveiled its plan to adopt the retention rule in a way that minimizes market shocks. More concretely, the proposed risk retention rule allows for diverse risk retention methods, while obligating originators and lead managers to comply with the rule, to disclose detailed information, and to compute the risk retention ratio based on the nominal value. Just as is in the US, securitization structure and underlying assets that have low credit risk or less likelihood of conflicts of interest will be subject to exemption or a relaxed rule.
 
Under such a flexible risk retention scheme, the risk retention rule will have only a limited impact on the ABS market. Originators are expected to have a slight, if any, increase in their burden because most originators securitizing pooled debt obligations in Korea already have a certain level of risk. Furthermore, the rule has an exception for assets with high credit worthiness, or originators with low potential conflicts of interest, and the adoption of the rule is less likely to be onerous to originators.  


An integrated information system for securitization

In Korea, there’re many differences between disclosure of registered and unregistered securitization. Registered securitization is subject to detailed disclosure standards that regulate how to register a securitization plan, etc. In the secondary market, SPVs disclose relevant information via their business reports. A securitization plan consists of contents that are necessary for investors to grasp the nature and risk inherent in ABS, for example, information related to transaction counterparts, the nature of underlying assets, securitization structure, and credit enhancement. However, the problem is that some parts of the plan are redundant and unnecessary while the plan lacks key information such as an originator’s track records. In the meantime, unregistered securitization depends entirely on random information: even some basic information on securities is not disclosed. For example, ABCP and asset-backed electronic short-term bonds meeting certain requirements are treated as a privately placed bond, and exempt from registration of a securitization plan and a registration statement. Although Korea Securities Depository (KSD) provides issuance information on those two types of securities via SEIBro, that information is far from sufficient to find out the overall securitization structure. 

In addressing that issue, the government is planning to build an integrated information system with KSD. The system will cover the whole ABS market including both registered and unregistered segments, while collecting and providing crucial information on securitization, such as the issuance, issuers, underlying assets, and credit enhancement. Those pieces of information will be collected by KSD from relevant organizations, for example, the Financial Supervisory Service, credit rating agencies, KSD, securities firms leading such deals, and Korea Financial Investment Association, etc. After collecting information from those organizations, KSD will integrate it under its single platform. 

Building such an integrated information system will greatly improve transparency of securitization information. The largest benefit from collecting and providing information on unregistered securitization could be an improvement in the market’s capabilities to accurately gauge and effectively address market risk. Detailed information on unregistered securitization, including the nature of underlying assets, transaction counterparts and credit enhancement will certainly help investors make a rational, informed decision and build confidence in ABS and the market. 


Towards a successful regulatory overhaul

The measures pushed by the government are meaningful: If materialized, they could address the long-held problems in Korea’s securitization system and thus promote financial and non-financial firms to finance more via securitization, and the resulting market transparency could improve investor confidence in ABS. 

For the measures to produce intended policy effects, further effort should be made for a legislative reform. The proposed changes such as a broader scope of originators, multi-originator structure and a new definition on assets will require an overhaul in the relevant law and the enforcement decree. 

Also proposed is a flexible risk retention rule that reflects opinions from a broad-ranged market participants. A rigid, uniform rule as is in Europe will significantly lower originators’ incentive to issue ABS, which might contract the ABS market. Hence, regulators should thoroughly review the current status of individual originators and their assets, and carefully gauge their impact on the market for devising a sophisticated, flexible risk retention rule fit for Korea’s market.  

A desirable direction towards an integrated information system is to bring in as many market participants as possible, which will help the system to collect more accurate information in time for providing it efficiently. Toward that end, it’s needed to overhaul regulation under which relevant organizations provide information. Moreover, securitization information should be adjusted to suit the need of relevant stakeholders. Also necessary is a platform for efficiently disseminating such information.

Among others, Korea’s ABS market infrastructure needs improving. For example, a multi-seller ABCP program will enable more than one firms to pool their account receivables for financing, and financial firms to securitize those account receivables at a discount at all times. Another idea worth considering is to establish a body that effectively collects and manages intellectual property rights while controlling cash flows. This is critical for successful securitization of intellectual property rights. 

In short, successful improvement in Korea’s securitization market will require an overhaul in relevant laws and regulation, an improvement in securitization market practices ensuring the proposed securitization structure, and proper infrastructure for market facilitation.