Synthetic securitisations and Europe’s capital sweetener

Regulator weighs high-quality label for synthetic deals, but without favourable capital treatment

  • Banks use balance sheet synthetic securitisations as a risk transfer tool to spread the exposure of a lender’s loan portfolio.
  • The European Banking Authority is preparing a report on whether these synthetic securitisations should qualify for a high-quality label, meaning banks don’t have to hold as much capital against retained senior notes.
  • Risk weights for senior positions in securitisations increased in January this year, making it more expensive for banks to issue the transactions.
  • The Basel Committee on Banking Supervision does not allow synthetics to qualify for its own version of the high-quality securitisation label.

Hit TV series Westworld features a futuristic theme park filled with synthetic humanoids programmed to act out specific roles in a story. The show asks the ethical question: should the synths be treated like humans?

European financial authorities are grappling with their own synthetic conundrum. Should balance sheet synthetic securitisations be treated like other, cash deals? Specifically, should they qualify for a regulatory label designed for high-quality securitisations, which lowers the capital requirements for banks and insurers?

Financial institutions would welcome lighter capital treatment for synthetic deals that achieve the simple, transparent and standardised (STS) label, as they adjust to stringent new risk weights for securitisation under incoming regulation.

“A key reason people are keen to get STS for synthetics is because it preserves some of the efficiency that the old framework used to have with lower risk weights,” says Robert Bradbury, a managing director at advisory firm StormHarbour Securities.

Investors and issuers say synthetics won’t benefit much from the STS badge alone, and struggle to see the point of the label if there is no favourable capital treatment.

“I was surprised by the fact synthetics could get STS but without preferential capital treatment,” says Thomas Wilson, a director of securitisation and covered bonds at Rabobank. “I don’t think it would have much of an impact if there was no preferential treatment. The benefit of STS is mostly for the bank in terms of capital. I don’t think the current investors are looking for an STS-like stamp.”

Regulators are yet to make up their minds. Christian Moor, principal policy officer at the European Banking Authority, told an industry conference in June that most European regulators had accepted balance sheet synthetic securitisations can qualify for the STS label, but were undecided as to whether exposures to qualifying transactions can benefit from the lower capital requirements.

“In the regulatory community in Europe, most of the regulators accept it is technically possible to create criteria for balance sheet synthetics,” Moor said. “The question is now whether they receive preferential capital treatment or not. Should it just be the framework but not the capital? Those are the things we are still discussing and hopefully by September you will see the first indications in our discussion paper.”

Revenge of the synth

Lenders use balance sheet synthetic securitisations to transfer the credit risk on a portfolio of loans to investors. Banks can deduct from their total risk-weighted assets the amount of risk transferred, as long as local supervisors give their blessing to the deals in accordance with bank capital laws enabling significant risk transfer.

The instrument can take many forms but a common method used by banks is to buy protection from a special-purpose vehicle on an underlying loan portfolio using a credit default swap or financial guarantee. The special-purpose vehicle then issues credit-linked notes in tranches. Investors buy the junior tranches, while the bank retains the senior tranches.

Synthetic securitisations containing portfolios of debt from small and medium-sized enterprises (SMEs) are one of the most common loan types. Such deals can already benefit from lower capital requirements under the STS regime. To do so, they must meet a strict set of criteria (see box: A helping hand to SMEs).

A likely reason for European regulators’ foot-dragging over whether to apply lower capital to synthetic STS is that doing so would create a deviation from standards drafted by the Basel Committee on Banking Supervision, agreed between European representatives and their foreign counterparts.

The committee’s final standards published in July 2015 only allow true sale securitisations to qualify for the Basel version of the STS label, known as simple, transparent and comparable, and explicitly bar structures that transfer risk through credit default swaps or guarantees.

Assessing the arguments for and against at the June industry conference, Jana Kovalcikova, a policy expert at the European Banking Authority, said: “On the one hand, we have put out data that shows the performance of synthetics is similar to traditional and also that [they have] good performance and low default on senior tranches. On the other hand any preferential treatment will not be Basel compliant. As a prudential regulator we always want to take into account Basel developments and it is very difficult to move away.”

A helping hand to SMEs

In a bid to help support economic activity within the politically important SME sector, Europe’s lawmakers allow financial institutions to apply lower capital treatment to SME synthetic securitisations under certain conditions. The conditions are laid out in amendments to the 2013 Capital Requirements Regulation.

They include the following:

  • the bank’s positions must be senior
  • underlying exposures must follow clear eligibility criteria
  • active portfolio management of the underlying exposure is not allowed
  • interest payments must be based on generally used market interest rates
  • issuers must provide data on dynamic and static historical default and loss performance for exposures that are substantially similar to those being securitised
  • more than 70% of the borrowers in the pool must meet the European Union’s definition of an SME

Under the new Securitisation Regulation, which came into effect in January 2019 and is meant to revive Europe’s moribund securitisation market, the EBA must report back to the European Commission on whether the STS label is feasible for balance sheet synthetic deals. The report will be the first step towards synthetics becoming eligible for STS.

Once the EBA has published its report, the European Commission must present legislative proposals to the Council of the EU and the European Parliament for an STS label for synthetics. Getting the nod from parliament and council may be difficult as securitisations – particularly synthetics – bring back ugly memories of the 2008 financial crisis.

“I’m curious to see how this will go in the legislative process,” says Wilson of Rabobank. “Sympathy for the product may not be there amongst everyone in EU legislative bodies and also I’m very curious to see whether STS for synthetics will be introduced for all asset classes or whether it will remain very political only sticking to SME type transactions, which is very well possible.”

Hints of an SME-only label for synthetics are already present in the current Securitisation Regulation text, which explains the commission should draft its legislative proposal “with a view to promoting the financing of the real economy and in particular of SMEs”.

Limiting the STS label to SME portfolios will prevent other asset classes from benefiting from the preferential treatment capital treatment that the label might bring. Although SME portfolios are the most common loan types in synthetics, the credit risk of large corporates is also securitised synthetically. Loan documentation often doesn’t allow banks to transfer the loan of a large corporate to another party, which leaves synthetics as the only avenue since true sale securitisations transfer the whole loan to an investor.

Other loan types securitised through synthetics but not to the same extent as SME and large corporate loans, include trade finance and project finance.

Weighting game

In practice, the Securitisation Regulation hikes the capital requirements for asset-backed securities. Under previous rules, where risk weights for the senior tranche of a securitisation are calculated using the internal ratings-based approach, there is a floor of 7%. The new regulation more than doubles this floor to 15%. For deals that meet the STS criteria, the floor drops to 10%.

“With the revised formula in place at the start of this year, the new risk weight floor is normally 15%, which is quite an increase from a 7% floor and is quite burdensome for the economic benefit of these transactions,” says Wilson of Rabobank.

Capital relief for banks forced to hold senior tranches of synthetic securitisations could provide a boost to the economics of issuing such deals. For a transaction to be profitable, the capital costs of holding senior notes and the coupon paid to junior noteholders must be lower than the cost of capital for the credit risk on the loan portfolio being transferred.

“Preferential capital treatment makes the transaction more cost-efficient for banks and banks are therefore likely to issue more transactions, in turn providing greater scale and choice to investors like us,” says Kaikobad Kakalia, chief investment officer at private debt manager Chorus Capital Management.

The move would have limited financial value for investors such as Chorus, though.

STS with lower capital requirements is useful for us in an indirect way because it incentivises more volume,” Kakalia says. “However, there is very limited direct benefit for us as an investor.”

Some even suggest that the injudicious use of the STS label could leave banks exposed to extra costs in the form of increased operational risk capital from the risk of regulatory penalties.

Issuers of trades that are given the STS label but later turn out to be non-compliant can face an administrative sanction from their local supervisor of no less than €5 million ($5.6 million) and up to 10% of their total annual net turnover. They could also be given a temporary ban from classing a securitisation as STS.

“If there is more risk associated with applying for an STS label from banks possibly being fined if they make a mistake, it could introduce operational risk and banks would have to resource some capital for that risk,” says Mascha Canio, head of credit and insurance linked investments at pension fund manager PGGM. “If that is the case, STS may actually lead to an increase in capital, which is obviously not going to be helpful.”

Mixed incentives

Regulators are enthusiastic about the residual benefits that the STS badge might confer on synthetic securitisations, even without capital relief. Issuers and investors are less excited.

At the June conference, Kovalcikova of the EBA said an STS label could promote greater standardisation between structures banks use. Bradbury of StormHarbour Securities points out how this could advantage banks: “If the market became more standardised, the various regulators would have less need to adjust requirements for acceptable risk transfer practices and this in turn would likely help banks to do capital planning more effectively.”

Most sources agree that more standardisation is desirable in the synthetic market but question whether STS alone would achieve that as banks have little other encouragement to issue STS-compliant synthetics if there is no preferential capital treatment.

“The only reason why STS is useful is because it helps the bank reduce its cost of capital and in turn creates an incentive for the bank to issue more transactions,” says Kakalia at Chorus Capital. “I would not expect a bank to feel incentivised to structure a transaction to meet STS requirements if they are unlikely to get any capital benefit.”

Even if the STS label stimulates greater activity in the market, some warn about the dangers of new, inexperienced investors relying on the official imprimatur without performing due diligence on deals.

“In general it is good to have more investors in this market but I don’t think it is very prudent for less knowledgeable investors to begin investing in these types of transactions solely as a result of a synthetic STS label,” says Rabobank’s Wilson.

Increased activity could also drive down prices for the product, which may affect the make-up of the investor base. Lower returns could ward off hedge funds and specialist credit funds that currently invest in the market. Bradbury of StormHarbour Securities suggests the vacuum would be filled by large insurers and real money firms – investors that are more likely to offload the risk at times of volatility.

“In the event of a more serious shock or a downturn, this tool might become unavailable quickly because those investors are typically more sensitive to wider market movements,” he says.

Contradiction in terms

There is a creeping suspicion that synthetic STS is a paradox: synthetic securitisations are, by nature, complex yet the STS label is designed as a badge of simplicity and standardisation.

“All risk transfer trades are fairly bespoke. ‘Simple’ criteria for synthetics is therefore somewhat of a misnomer,” Bradbury says. “What they mean is that there shouldn’t be any features which are, if you like, highly bespoke.”

The EBA hopes to tackle this contradiction by addressing three areas for STS compliance, which Kovalcikova outlined at the conference. First, measures to mitigate counterparty credit risk in the structure. Second, acceptable structures for transferring credit risk, which was among recommendations in a discussion paper published by the EBA in 2017. Third, a synthetic-adapted set of the original STS criteria.

Investors and issuers agree the first condition is necessary and is already ingrained in most – if not all – synthetic deals as neither party is interested in the risk of the other failing to pay its obligations.

“We actually don’t deposit our capital with the bank that is issuing the risk-sharing transaction because we believe in taking the credit risk of the underlying portfolio and not taking the credit risk on the bank itself,” says Canio of PGGM. “We would certainly be supportive if that is one of the criteria in STS.”

PGGM funds the full notional amount of the investment into a separate account, which the bank can draw on if the investor becomes insolvent. The cash is then invested in highly rated government bonds – for example US Treasuries or German government bonds – and held by a third-party custodian.

In practice, Bradbury says most risk transfer deals would already comply with aspects of the STS rules. For example, most trades reference asset pools that are fairly homogenous, as required under the Securitisation Regulation. And very few existing deals reference exposures that are already suffering credit impairment at the time the synthetic securitisation is issued, which is forbidden for STS transactions.

But there is wider uncertainty about whether an adapted set of STS criteria will work for synthetics, particularly disclosure requirements.

Issuers are wary of disclosing deal information because it often contains data that is sensitive to the bank. They make an exception for investors, who receive a wealth of information on the portfolio, loan origination, underwriting credit modelling and risk management processes.

“There is significant disclosure in these transactions, because without it we would have insufficient information to do our analysis and price the transaction,” says Kakalia of Chorus Capital. “However, these transactions are typically private. If you are not the issuer and you are not the investor then the trade is not available for you to look at.”

As viewers of Westworld understand, synthetic androids may look and act like humans, but eventually their differences become evident.

Excessive spread

Synthetic securitisations use special-purpose vehicles (SPVs) to structure transactions. These SPVs often accumulate some of the excess spread between the coupon payable to noteholders and the yield on the underlying assets. This is sometimes used to pay junior tranche holders for expected losses on the portfolio as set out in offering documents.

The junior notes take a hit only on unexpected losses. This use of excess spread allows the issuer to avoid paying a double premium to investors for both expected and unexpected losses.

The EBA has raised multiple concerns over the use of excess spread, including that it may hide the risk retained by issuers in synthetics and erode the effectiveness of the risk transfer.

In response, the EBA has made several recommendations. First, excess spread should be capped at one times expected annual losses, to make sure it is not used to cover unexpected losses as well. Second, issuers should not syphon off any excess spread that hasn’t been used to absorb losses in a single year, but should leave the excess spread in place and make an adjustment each year if necessary. Third, originators should deduct the excess spread from their regulatory capital, as if the bank were holding a first-loss tranche.

The second and third restrictions will potentially eliminate the inclusion of a so-called ‘use-it-or-lose-it’ mechanism in SPVs, which allows banks to take back any spread not used to cover losses. This mechanism has previously been accounted for as future income by some issuers.

“Most of the investors and issuers I have spoken to that use the ‘use-it-or-lose-it’ are of the opinion that excess spread is something that you don’t hold capital against, as it is future margin income, and therefore it should not be deducted from your capital once you do such a transaction,” says Thomas Wilson at Rabobank.

Others claim the rules mean banks must cherry-pick higher quality assets with lower expected loss rates to securitise. This will limit the size of the excess spread required in the SPV, to avoid a larger deduction from regulatory capital.

“Some issuers potentially have whole programmes of risk transfer securitisations where their use of excess spread will change completely,” says Robert Bradbury of StormHarbour Securities. “There are some banks who believe that the excess spread limitations incentivise focusing on better quality assets with lower expected loss, which is not necessarily a consequence intended by the regulator.”

For some issuers, however, the tougher treatment of excess spread will remove a competitive disadvantage, as their local regulators had never allowed such a mechanism to be used in the first place.

Aside from the recommendations on excess spread, other elements of the EBA discussion paper have proven uncontroversial. For instance, regulators expect principal repayments to be distributed to senior noteholders first of all, to ensure that the first-loss risk has genuinely been transferred away from the bank on to the holders of the junior tranches. Issuers would be allowed to distribute payments equally to noteholders – known as pro-rata amortisation – only once certain conditions are met. For example, if cumulative losses are greater than the cumulative expected losses reported by the originator, then the transaction could switch to pro-rata amortisation.

Wilson feels the EBA recommendations are a sensible blueprint for changes to synthetic structures.

“The discussion paper is already quite a good set of criteria and I don’t think we need any further restrictions, for example eliminating pro-rata amortisation completely or eliminating synthetic excess spread for the synthetic to meet a high-quality label,” says Wilson.

Editing by Alex Krohn

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