EBA plans could cut benefits of synthetic securitization

The EBA has been consulting on the rules since September, with a public meeting late last year. The market is still waiting for final guidelines, and it is not clear whether these will be accepted across Europe and the UK.

The rules will toughen up the treatment of risk transfer trades for institutions inside the ECB’s Banking Union, after a couple of years of relative openness and support from regulators, which has encouraged the market to grow rapidly.

Spain’s CaixaBank, for example, was only able to issue its €2bn Gaudi Synthetic 2015 deal in early 2016 because the ECB, rather than the Bank of Spain, was in the driving seat. Hard numbers are almost impossible to come by in what is an intensely private, often bilateral market, but bankers close to these deals estimate 2016 and 2017 have been some of the busiest years for the market.

The SSM has been willing to engage with banks looking to do deals early on in the structuring process, giving feedback on features and giving credit portfolio managers the confidence that their risk transfer deals will be given regulatory recognition.

It has followed the provisions in the Capital Requirements Regulation closely, rather than adding its own views.

This is in stark contrast to the UK. The UK’s Prudential Regulatory Authority takes the harshest approach in Europe to approving capital relief deals, and, crucially, will not give banks approval that their deals will achieve regulatory relief before execution.

That means structurers and portfolio managers cannot be sure that a risk transfer deal will cut capital costs. The PRA has never formally noted down its list of requirements for recognising risk transfer deals in regulatory capital, but treats each issue case by case — meaning that structurers and banks are only willing to use the most conservative structures.

“The PRA will not pre-approve transactions, which has made the UK banks very cautious in structuring,” said Jeremy Bradley, head of asset risk transfer at Lloyds. “It would be a brave head of portfolio management that would introduce some of these more complicated features without knowing that they’d be accepted.”

That hasn’t stopped UK firms being extensive users of the risk transfer markets, however — just before the end of last year, Lloyds issued two trades, Cheltenham Securities, which hedged a corporate loan book, and Weatherby, which was focused on commercial real estate. Santander UK issued one. Standard Chartered and Barclays have issued transactions covering billions of loans in the past.

But this reflects, in part, a highly concentrated banking market, with experienced treasury teams and a long history in the market.

Two features are particularly important to issuers — time calls and pro-rata amortisation.

Both of these features are common and uncontroversial in the cash funding securitization markets, where the main driver of a deal is usually placing the senior notes, but can make a huge difference to capital relief deals, where the aim is placing the junior or first loss risk.

If a capital relief deal amortises sequentially — meaning senior notes pay down first — then it becomes less and less efficient over time. The portfolio being protected shrinks down, but the placed tranche stays the same size, and so does the fairly hefty coupon (some recent deals have been priced with coupons of Libor plus 10%).

The PRA insists on sequential amortisation, but the EBA will allow pro-rata amortisation under its draft guidelines. This means that protection will shrink over time in line with the portfolio.

It’s a qualified support for the structure though, with the regulator suggesting that poor performance switches deals to sequential paydowns, much as in many cash securitizations.

Another way to boost efficiency in risk transfer deals is a call. If a deal has a replenishment period, allowing new exposures to be added, keeping the portfolio the same size, then once this is over, issuers can call the deal, reissuing it if necessary.

That’s been largely allowed by the ECB’s Single Supervisory Mechanism — but it’s controversial in some quarters, and the EBA rules could make it worse.

The EBA, unlike the UK’s PRA, does not ban time calls outright, but it has proposed to limit them to the remaining weighted average life of the assets.

In other words, the assets in a portfolio will still pay down extensively before an issuer can call a deal.

Other difficult issues include using excess spread to protect investors — once again, an uncontroversial feature in cash funding securitizations. But trapping cash flows for the benefits of external investors makes the deal a less pure portfolio hedge, and reduces the likelihood that investors will actually pay out when the bank suffers losses.

Regulators have long had concerns that risk transfer markets are being used to flatter bank capital ratios — without a commensurate transfer of risk. The Basel Committee published a paper on “high cost credit protection” in 2011, seeking to ban transactions which paid out so much in coupon that the fund was never really at risk. One notable example of such a deal was the trades between Barclays and UniCredit in 2008, which were litigated in the UK High Court in 2012.

Though the EBA paper does cut the potential benefits of using the market, any impact ought to be a long way off. The consultation will be followed by firm guidelines, and, perhaps, changes to European rules.

“The EBA published its consultation when we were well advanced in the marketing process,” said Alan McNamara, head of capital structuring at Bank of Ireland. “There’s things in the paper that aren’t very clear, but that’s the nature of discussion papers. The EBA will have to recommend to the Commission, which will have to make a regulation — so we’re talking maybe about 2019 or 2020 before there’s much effect, but we’d expect to get more clarity as discussions progress.”