Synthetics sweetener teases European banks

As structural woes resolve, regulators remain split on preferential capital treatment for STS deals

Europe’s economies are in need of something sweet to help perk up their post-pandemic listlessness. And as the European Commission seeks ways to revive them, banks have been quick to point to a possible solution. Balance sheet synthetic securitisation – an increasingly popular technique that transfers credit risk off bank’s balance sheets – could help, say bankers.

For them, there is some good news. Europe’s banking watchdog, the European Banking Authority, recently completed its feasibility assessment of the STS label – denoting simplicity, transparency and standardisation – for balance sheet synthetic securitisations. And it has softened its stance on some of the structural features it had previously considered excluding from the classification. Designed to denote high-quality status, the STS label could help boost the market, say banks, as the associated capital relief would enhance the economic ease of issuance.

But there’s also not-so-good news. Having considered whether it would be appropriate to award lighter capital charges for STS deals, the EBA’s verdict is a non-committal ‘maybe’.

Without preferential capital treatment, banks and investors are downbeat on the chances of the STS label reviving balance sheet synthetic securitisations – and with them the opportunity for banks to engage in more lending to cash-strapped businesses.

“Preferential capital treatment for STS is essential,” says Ian Bell, chief executive of Prime Collateralised Securities (PCS), a company that verifies whether so-called ‘true sale securitisations’ meet the STS requirements. “It has no benefit whatsoever without the capital treatment. It is a complete waste of time. Investors aren’t looking for a label – they are already sophisticated enough to understand these deals,” he says.

In September 2019, the EBA launched a consultation on extending the STS label enjoyed by true sale securitisations to cover balance sheet synthetic securitisations.

Banks holding true sale securitisations that meet the STS label can benefit from lighter capital and liquidity requirements for those investments under Europe’s Capital Requirements Regulation.

The CRR allows banks to deduct from their total credit risk-weighted assets the amount of risk transferred – as long as local supervisors agree the deal achieves significant risk transfer.

Investors aren’t looking for a label – they are already sophisticated enough to understand these deals

Ian Bell, Prime Collateralised Securities

Synthetic deals have thus become increasingly popular among European banks as a means of reducing their capital requirements – transferring the credit risk on a portfolio of loans to investors.

But preferential capital treatment for synthetics is currently limited in the CRR to those deals transferring credit risk on small and medium-sized enterprises, which represent a mere sliver of the synthetic market.

Capital compromise

The EBA’s final paper goes so far as to recommend the STS label for asset classes with specific synthetic criteria, but it is not a full-hearted endorsement of preferential capital treatment.

“The EBA doesn’t make a straight recommendation for beneficial capital treatment for synthetic securitisations,” says Anna Bak, an associate director at the Association for Financial Markets in Europe. “It considers the advantages and disadvantages of this possible capital treatment, and this is kind of a step forward, as before they didn’t have any recommendation on the capital treatment.”

Rather, it states the analysis within the EBA’s paper “could justify” a different regulatory capital treatment for deals qualifying as STS. It reasons that they have less risk of losses unrelated to the underlying portfolio – such as a quirk in the structure causing unforeseen losses. This possible preferential capital treatment for synthetics would work similarly to the capital reduction STS true sale securitisations receive, but only for the senior tranches held by banks. This is an uncontroversial deviation, as banks retain only the senior tranche while non-capital regulated investors buy junior and mezzanine tranches.

However, the EBA then caveats its recommendation with several concerns, including that it would be a deviation from international standards agreed by the Basel Committee on Banking Supervision. It also says the EBA’s analysis is based on limited data and experience with the STS label, inhibiting the ability to fully analyse the impact of introducing the label to the synthetic market.

The EBA doesn’t make a straight recommendation for beneficial capital treatment for synthetic securitisations

Anna Bak, Association for Financial Markets in Europe

Three separate sources told Risk.net that the final recommendation is a compromise, designed to resolve divisions between European banking supervisors on synthetics. The EBA board consists of all the European national regulators, so disagreement between member states can sometimes translate into inconclusive advice to the Commission.

Some regulators want to encourage the use of synthetics to alleviate the capital burden on banks, while others remain cautious around encouraging the use of a product that played a significant part in the financial crisis.

“We are concluding with pros and cons rather than a straight positive or negative recommendation,” says Slavka Eley, head of banking markets, innovation and consumers at the EBA. “We do not disclose internal discussions, but of course the conclusion was based on the type of outcome which was comfortably supported by the vast majority of members around the table. So we are being quite transparent on all pros and cons of preferential capital treatment while specifying how such preferential treatment could work.”

Slavka Eley

Sources largely agree the STS label would only be a boost to the synthetic market if banks are able to receive preferential capital treatment. Investors already scrutinise such structures heavily and would still need to undertake those assessments even with the benefit of an STS label. Conversely, some see it as unwise to try to encourage new investors to rely only on the STS label and not undertake that assessment.

“Investors [in junior tranches] have to do extremely extensive due diligence before they invest in synthetic portfolios,” says Rob Koning, a director at industry group the Dutch Securitisation Association. “They are the ones that are first loss compared to a triple-A investor in asset-backed securities. So against that background, I would really doubt an investor would see much benefit in getting additional STS certification, because they still have to do a lot of work on the transaction.”

Capital reduction for senior tranches retained by originating banks would mean more deals would become economical for banks to issue. For a transaction to be profitable, the capital costs of the bank retaining 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.

A further strike against having the STS label without the preferential capital treatment is that STS deals result in higher operational risk capital charges, which stem from the risk of regulatory penalties.

Issuers of trades that are given the STS label, but which later turn out to be non-compliant, can face a hefty 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 receive a temporary ban from using the STS classification.

Convincing case?

The significance of the EBA report is that it will inform the EC’s thinking around possible future legislative proposals for introducing the STS regime to synthetic securitisations.

But most sources were unsure which way the EC will resolve.

“I have no idea what the EC will decide on this, but I am hopeful they will give preferential treatment,” says a senior structurer at a European bank. “They have asked the industry what they can do to help banks continue to lend through this crisis. One of the things we responded with was to grant preferential capital treatment to STS synthetics. So let’s see what they say.”

If the EC does propose preferential capital treatment, they will struggle to get agreement with the Council and the Parliament

Rob Koning, Dutch Securitisation Association

Some sources were optimistic. PCS’s Bell says the lack of a straightforward “no” from the EBA makes it easier for the EC to justify awarding preferential capital treatment, as they won’t be seen to be going against the advice of the technocrats.

“In my view, the EBA has done enough in its paper to allow the EC to support better capital treatment without blowback from parliamentarians that the EC hasn’t followed the advice of the EBA,” says Bell. “I am relatively sanguine on whether the EC will propose better capital treatment.”

And it’s not just the EC that needs to be convinced. Any EC proposals would need the blessing of the European Parliament and Council of the EU. Within those legislatures, there are also proponents who sense the long shadow of the financial crisis in these products.

“If the EC does propose preferential capital treatment, they will struggle to get agreement with the Council and the Parliament,” says Koning. “In the parliament, there is a lot of emotional resistance against everything that has to do with synthetic due to memories of the financial crisis. In the council there are some countries that are not that supportive either.”

Take the money

If preferential treatment is eventually awarded, it is expected banks will be able to comfortably structure most of their deals to meet the criteria. The EBA report recommends the label be inclusive to some of banks’ favourite structural features. For example, deals that contain so-called excess spread will be able to qualify – a feature the EBA had at first suggested barring from the STS label.

Banks sometimes collect a spread between the coupon payable to investors and the yield on underlying assets and earmark it to pay junior tranche holders for the expected losses on the portfolio.

The final EBA report permits excess spread, but only if the deal relies on a “use-it-or-lose-it” mechanism. This involves a fixed spread, which is collected annually and which can never be higher than one-year regulatory expected loss on the portfolio. Once the payment period comes to an end, any excess spread that hasn’t been used to cover losses is given to the bank and the excess spread is accumulated again during the next payment period. This process is repeated until the end of the deal’s life.

A further expansion of acceptable STS features is that the EBA allows more forms of credit protection to qualify. Its previous discussion paper had proposed to limit suitable forms of credit protection from private investors to those backed by collateral – either by the investor transferring risk-free debt securities to a trust or entity set up to hold securities at maturities of three months, or to deposit cash to a third-party bank.

The EBA had limited the criteria so as to extinguish counterparty credit risk from the deals. Some investors in the market do fear taking on the bank’s credit risk and so insist upon collateral being held at third-party custodians.

But some banks with higher credit ratings prefer investors to deposit cash with them. Kaikobad Kakalia, chief investment officer at private debt manager Chorus Capital Management, says depositing the cash at the bank improves the economics of the deal for banks, as it eliminates the capital charge they would receive from the counterparty credit risk they have to the custodian.

“If the cash collateral is held by a third-party bank, the issuing bank has counterparty risk on the deposit holding bank,” says Kakalia. “This must be risk-weighted, and the RWA add-on reduced from the RWA relief the bank is able to claim on the transaction. However, investors are unlikely to allow a low-rated bank to hold the deposit. The investor’s deposit will need to be held by a suitably rated third-party bank, or instead collateralised by the issuing bank, with a suitably rated pre-agreed list of bonds.”

Banks with lower credit ratings, however, are unlikely to be able to benefit from the inclusion of this form of credit protection, as investors would be too nervous of taking on their counterparty credit risk.

An exclusive club

But not every form of credit protection used in the market can qualify as STS. The EBA’s final report forbids unfunded guarantees to be present in STS deals, unless provided by a counterparty receiving a 0% risk-weight under the CRR. Essentially, that means the multilateral European Investment Fund is the only entity likely to provide unfunded guarantees that would qualify for STS. But unfunded guarantees are a method widely used by insurance companies, which may now be excluded from investing in STS synthetic securitisations.

“It is potentially a missed market segment,” says Robert Bradbury, a managing director at advisory firm StormHarbour Securities. “There is a lot of insurance demand for this product, in part because it has become more standardised. The product has evolved to a point where it is well understood and is no longer unknown to insurance companies. There are a number of insurers and reinsurers who have executed primarily mezzanine transactions but also some first loss through unfunded structures.”

Giualiano Giovennetti, a managing director at Granular Investments, an advisory firm for insurers investing in synthetic securities, says if insurers have to start posting collateral, it will lower the returns policyholders can receive, as insurers would have to start finding cash to meet collateral demands.

“Insurers could start posting collateral, but it is not the insurance model,” he says. “The insurance model is about pooling risks together, and if you start cash collateralising each of your risks it doesn’t work any longer – you will be doing collateralisation at the expense of the other policyholders. It can be compared to a bank being requested to hold its depositors’ money in cash.”

There is a lot of insurance demand for this product, in part because it has become more standardised

Robert Bradbury, StormHarbour Securities

Pablo Sinausia Rodriguez, a policy expert at the EBA, says the reason unfunded protection is limited to counterparties with a 0% risk-weight is to reduce the counterparty credit risk present in the structure. The EBA’s report says the presence of counterparty credit risk can affect the extent to which credit risk on the loan portfolio has been transferred to an investor, because there is a risk of the investor defaulting and not being able to cover losses on the deal.

“For unfunded credit protection, we only allow it to be done with 0% risk-weight counterparties, and that is for the purposes of keeping these transactions simple, because counterparty credit risk will increase the complexity in the transaction,” says Sinausia.

Giovennetti of Granular Investments argues that this approach ignores existing capital requirements for counterparty risk, which an originating bank would face if its synthetic securitisation deal uses unfunded guarantees.

“Banks already have capital charges for counterparty credit risk, so this STS penalisation is double counting, which eventually causes arbitrage risks,” says Giovennetti.

He gives the example of an insurer that borrows from a bank in order to provide a funded guarantee for a synthetic securitisation. This would comply with the STS requirement for a funded guarantee, thereby lowering the capital requirement. But the bank lending to provide the collateral would in reality have created the same kind of counterparty risk in the system as an unfunded guarantee.

For banks, however, the almost total ban on unfunded guarantees is not a huge blow, as insurers represent only a tiny fraction of the investor base in the market. According to the EBA’s final report, insurance companies bought 0.9% of the total volume of distributed tranches between 2008 and 2019.