In the first of six chapters surveying the synthetic securitisation market, SCI explores the recent regulatory evolution of the sector

Synthetic securitisation, once tarnished by association with the global financial crisis, has long since come in from the cold. The regulatory framework has developed significantly in Europe since the introduction of the new European Securitisation Regulation in January 2019, culminating in the inclusion of significant risk transfer transactions in the STS regime in April 2021. This label has provided CRT deal flow with additional momentum, broadened the issuer base and helped to legitimise the market.

So, how has the landscape evolved since then? While Europe has historically been the centre of CRT activity, what are the prospects in the US and beyond? SCI’s Global Risk Transfer Report traces the recent regulatory and structural evolution of the capital relief trades market, examines the development of both the issuer base and the investor base, and looks at its prospects for the future.

Chapter one: regulatory evolution
The regulatory framework for capital relief trades in Europe has evolved since the implementation of the EU Securitisation Regulation[1] in January 2019, culminating in the inclusion of SRT transactions in the STS regime. But among the most significant regulatory developments is something that isn’t formal regulation at all.

In 2017, the EBA published a discussion paper on SRTs. David Saunders, executive director of Santander’s European securitised products group, says: “Theoretically, it had no application into law or regulation – however, the joint supervisory teams (JSTs) at the ECB have essentially used it as their manual when analysing SRT transactions. It’s almost become de facto regulation.”

The 2017 paper, along with subsequent improvements in the ECB’s approach, helped make the regulatory process for SRT clearer, enabling banks to better understand the various steps they need to take when issuing a synthetic securitisation. In a lengthy section on structures, it provided a number of key points and indicated how banks need to address them in order to gain regulatory approval.

The EBA’s subsequent SRT report from 2020 built on the 2017 discussion paper and the lessons learned since then. Seamus Fearon, Arch MI evp, CRT and European markets, says the report set the scene and the European Commission largely adopted what the EBA had been advocating.

“There was a good coming together of technical grounding and political will to get something done quickly,” he observes. However, he adds: “In comparison to the timeline of the original securitisation framework, it was potentially rushed.”

Robert Bradbury, head of structured credit execution and advisory at Alvarez & Marsal, notes that the 2020 report was useful. “It spells out the specific details of the quantitative tests you can run to demonstrate that you have transferred risk, taking into account all the different factors, such as premium, timings and how your losses are allocated. If you pass all such tests, it’s quite challenging to say the bank has not transferred risk. It’s not an absolutely final result, but it gives a very helpful quantitative backdrop.”

He continues: “It certainly doesn’t guarantee success, as there are qualitative and other transaction aspects to consider, but it lays a very solid foundation for that discussion. The expectation of most parties is that you should probably start with that.”

Kaikobad Kakalia, chief investment officer at Chorus Capital Management, agrees that the guidance on SRT is helpful for issuers to understand how they should structure in order to claim RWA relief from the ECB or their home country regulator. “One of the key differences is the setting of the first call date. Historically, that used to be set at the weighted average life (WAL) of the portfolio. But the EBA is now guiding towards the WAL of the transaction, the portfolio WAL plus the replenishment period,” he says.

He adds: “A typical European SME transaction, which would have had its first call set at three to four years, is now likely to be a couple of years longer if it includes replenishment.”

But the EBA’s proposed treatment for high cost of credit protection creates a meaningful issue, because higher risk portfolios may fail SRT and become more difficult to structure for SRTs, thereby reducing options for banks.

Mistaken assumptions
Indeed, some market participants are critical of the 2020 EBA report. Olivier Renault, md, head of risk sharing strategy at Pemberton Asset Management, says: “When it came out, that was a big deal - except that very little has happened since then. That’s bad, due to lack of clarity, but also good that it hasn't been fully implemented by domestic regulators because some of the details were incredibly impractical.”

He explains: “The high cost of credit protection is an issue because it can create the wrong incentive for banks. It can also be very difficult to apply some of the tests that the EBA is recommending.”

Saunders agrees: “The 2020 report updated the tests and reduced them to two. Unfortunately, they didn’t cover all possible scenarios and there were some mistakes made in the assumptions used when calibrating them.”

He continues: “We ran a number of scenarios to show that they fail for almost every transaction we’ve ever done. That’s presumably not the intention. If the report was ever to be used by the regulator or converted into regulation, these tests would have to be fixed because they are just fundamentally flawed.”

Fortunately, the ECB has agreed a workaround. Saunders says: “Our JST is still using the 2017 paper as part of their supervisory process. The regulator has told us we don’t need to follow the 2020 report.”

Some feel that the report has resulted in a confused picture and that the failure to harmonise regulation across Europe is a huge missed opportunity. Renault says: “The recommendations haven't been turned into regulation, so each regulator can just feel free to incorporate as much of that or as little of this as they want. Even within the ECB, there are different approaches.”

He adds: “The different sub teams take different views. Some sub teams take the view that your transaction needs to comply with all the tests, while others ignore them completely. So, it hasn't led to the desired effect of having a completely equal playing field.”

Such lack of consistency has been described as “painful” when structuring a deal. Renault comments: “It is very difficult to design a transaction on the basis that you don't know which rules we need to comply with.”

While this may be the case, Andrew Feachem, md at Guy Carpenter, notes that “with a well-designed SRT process and full transparency with the regulator, there is a way to navigate through this uncertainty that increases the likelihood of success.”

New options
Regulatory change for the CRT market hasn’t been confined to the EBA’s reports, however. The EU Securitisation Regulation opened up a whole new set of options that didn’t exist previously.

Bradbury says: “It completely changed the way that standardised banks are able to apply securitisation to achieve SRT. It went from a framework in which it was very difficult to demonstrate, typically required ratings and was very expensive and inefficient, to a version in which they can use the securitisation standardised approach, which is much more flexible. Compared to the prior options, it typically gives better results and is more cost-effective.”

A further significant development was the requirement for thicker tranching in order to achieve meaningful capital relief for banks through an SRT. Feachem says: “The banks adapted by issuing dual tranche structures, which also enabled new risk takers to join the market. While the traditional credit opportunity fund investors continued to participate in the junior mezz, the senior mezz tranche appealed to the (re)insurance community and also prompted new funds to be raised targeting lower returns.”

Kaelyn Abrell, partner at ArrowMark Partners, comments: “With institutional and individual investors increasingly relying on private credit as a source of uncorrelated returns, especially in a potentially more volatile market environment, dual tranche structures enable the asset class to potentially align with the objectives of a broader universe of investors.”

Generally, regulations have sought to level the playing field for both SRT issuers and investors. In Europe, under the Capital Requirements Regulation (CRR), there are now well understood procedures that issuers must adhere to in order to execute a successful SRT transaction.

Feachem notes: “This gives confidence to first-time and less frequent issuers to commit the resources required to adopt SRT in their portfolio management toolkit. Similarly for investors, there is a greater appreciation of the features of a transaction needed by the issuer and this helps the due diligence process to be more focused and efficient.”

He continues: “As regulations have evolved, so have the structures. In particular, the implementation of Basel 3 encouraged (re)insurers to become active and for mezzanine focused funds to be raised, and the implementation of Basel 4 is prompting the growth of residential mortgage SRT.”

With banks recognising the benefits of including (re)insurers within their SRT programmes, the flexible combination of funded and unfunded protection within single structures is viewed as a key innovation since 2018. “It has significantly diversified banks' sources of capital relief, improved SRT price discovery and reduced execution risk. There has been an increase in the flexibility, and standardisation, of banks' SRT programme documentation to more readily accommodate this combination of funded and unfunded investors across tranches,” adds Feachem.

Kakalia notes that while some structural elements - such as tranche thickness and the setting of the first call date - are driven by regulatory requirements, “investors can have a meaningful say in the setting of replenishment criteria, risk retention and counterparty risk mitigation features,” thus balancing the needs of the issuer with the investors while accommodating all regulatory requirements.

SCI’s Global Risk Transfer Report is sponsored by Arch MI, ArrowMark Partners, Credit Benchmark and Guy Carpenter. The report can be downloaded, for free, here.

*For more on the outlook for global risk transfer activity, watch a replay of our complimentary webinarheld on 2 November.*