how it works
A short introduction to the regulatory environment and the criteria that allow banks to optimize their capital through credit risk transfer.
The need for capital and its sources
Since the financial crisis, European banks have had to manage their capital with care. While significant recapitalization has taken place, the increasing capital demands from new regulation has kept banks’ excess capital to a minimum.
Banks can improve their capital position in broadly three ways:
- Raising more capital. Low interest rates, high competition and significant costs make bank returns relatively muted, hence issuing new equity is often very dilutive. Issuing capital is also often a permanent decision that is ill suited for time-limited optimizations.
- Reducing their loan book (deleveraging). There is not a large market for secondary loans, and disposing of loans ultimately deprives banks of income and leads to loss of clients. While pruning non-core portfolios makes sense, across-the-board deleveraging does not.
- Transferring risk and thus releasing capital. In this approach, the bank transfers credit risk on good quality assets to a third party and may, following certain requirements, achieve a reduction in their economic and even regulatory capital.
Regulatory capital relief through risk transfer
Banks can reduce their regulatory capital needs through either Credit Risk Mitigation (similar to quota share reinsurance and mostly covered in Title II – Chapter IV of the Capital Requirements Regulation) or (Synthetic) Securitisation (similar to XOL protection and treated in Chapter V). Our focus is on (Synthetic) Securitisation, which is probably the most efficient tool.
A Synthetic Securitisation is a transfer of credit risk by a bank in tranched format to a third party through derivatives (e.g. CDS, Credit Linked Notes) or guarantees (a broad term that can include insurance and financial guarantees). In a synthetic securitisation, the bank transfers the credit risk and pays a fee for that, but retains ownership of the loans, manages the portfolio and receives its interest income.
A “tranche” is a portion of risk that is junior or senior to other tranches, similar to XOL reinsurance. Credit losses are allocated sequentially from the most junior to the most senior tranche. Regulatory capital relief can be achieved if the banks transfer away enough credit risk on its junior tranches. Sometimes, the risk on the senior tranches is transferred, too. The bank will then replace the original capital charge of the loan pool with the lower capital charge required by those tranches that it has not protected. Retained senior tranches will attract much lower capital than the underlying loans, thus creating the capital benefit.
The credit protection can be provided as “funded” or “unfunded”. In the funded format, the guarantor promises to pay losses on a tranche and also posts cash on day one equal to the full amount of the risk covered. Such a protected tranche will attract zero capital. A guarantor with a rating of “A-” or better, such as a re/insurer, does not need to post collateral, however the capital benefit of its protection will be slightly haircut as the bank needs to hold a small amount of capital against the potential risk of default of the guarantor.
Should the credit protection be insurance, reinsurance, a derivative or what? In short, it does not matter but parties must be aware of the implications.
Banks need protection that meets certain regulatory requirement that define a “guarantee” according to the banking regulation, which is different from many other classifications such as accounting and is irrespective of the contractual form. Deals have been executed over many years, in many jurisdictions, in many formats and by many counterparties, either licensed as insurers or not.
There are however consequences from the choice of the format, which all parties should be aware of. For example, the use of derivatives would likely trigger IFRS9 accounting introducing mark-to-market volatility.
Practical aspects to make a deal work
Two key considerations in setting up a synthetic securitisation are:
- The “cost of released capital”: if freeing up €100m of capital is much more expensive than raising €100m of equity, the bank will choose the latter.
- “Significant Risk Transfer” (SRT): Regulators have a complex set of rules under the SRT concept to determine if sufficient risk has been transferred away and therefore whether the transaction can be approved. Without SRT, the protection gives no capital benefit.
A synthetic securitisation from the perspective of the bank therefore comprises of:
- Selection of an appropriate portfolio to protect
- Choice of the number and size of tranches into which divide the risk
- Choice of which tranches to transfer to a third party and what the protection cost will be
- Determining the benefit of the transaction by comparing the amount of capital to be held before and after the transaction, and the cost paid to achieve such reduction.
From the perspective of the re/insurer providing protection, the key steps are:
- Assessing if the bank is a suitable counterparty (e.g. adequate underwriting and risk systems in place, etc.)
- Assessing if the portfolio is adequate, e.g. fitting within the risk appetite, of good quality assets, properly underwritten and serviced, etc.
- Modelling potential losses, determining capital allocation needs, determining a price that satisfies both the re/insurer profit targets and the bank cost of capital needs
- Structuring the transaction together with the bank so as to satisfy all regulatory requirements (e.g. term of the deal, use of call options, exclusions, etc.)
- Monitoring the performance of the transaction and making the necessary adjustment to allocated capital as it progresses