In the second of six chapters surveying the synthetic securitisation market, SCI explores recent regulatory developments in SRT

IACPM’s latest risk-sharing survey notes that 2022 highlighted not only a substantial growth in SRT product utilisation by banks, with €200bn in new issuance, but also some structural changes in the risk-sharing activity of banks. Nevertheless, a number of regulatory challenges remain outstanding.

SCI’s Global Risk Transfer Report examines how the risk transfer community is addressing these issues – through regulation or structural enhancements – and the fallout from the turmoil in the US bank sector in March. It also explores the new frontiers that are emerging across jurisdictions and asset classes.

Chapter 2: Regulatory developments
At the end of 2022, several regulatory challenges remained that threatened to undermine the future viability of synthetic securitisations. These challenges included homogeneity criteria and the determination of the exposure value of synthetic excess spread (SES) in STS synthetics, as well as the looming introduction of the Basel 4 output floor in Europe. The EBA and the European Commission have this year sought to address these issues, reflecting concerns voiced by market participants in what many believe to be a recognition by European policymakers of the importance of SRT to the broader economy.

For example, the initial parameters proposed by European regulators for the SSFA risk weighting and output floor would have made nearly all - but certainly non-STC, non-mortgage - SRT securitisations uneconomic. But lawmakers appear to have listened to industry concerns and have provided a solution: changing the formula used to calculate tranche risk weights for the purpose of the output floor, thereby removing the negative impact and aligning the treatment of securitisation with other debt instruments.

“One very dark cloud has been lifted from the SRT market and that is the treatment of securitisation under Basel 4 in the EU, which was a significant concern for the industry,” confirms Olivier Renault, md and head of risk sharing strategy at Pemberton Asset Managers. “There's been intense advocacy to make sure that the regulators understand that the way the EU implementation of Basel 4 was drafted would have potentially led to most transactions being completely inefficient. The issue was the capital charge on the retained senior tranche, which under the Basel 4 output floor was multiple times higher than the current capital charge, so capital relief would have been mostly or totally eliminated.”

He adds: “Now that this cloud has been lifted, European banks can start issuing with confidence, given that they have a stable regulatory framework and that the efficiency of the transaction is going to persist for the foreseeable future. That is going to drive a lot of supply, so we expect the story will be one of continued growth.”

P-factor proposal
Under the changes, regulators are proposing to halve the p-factor, meaning that risk weightings applied to the more senior segments of the capital structure do not ascend as rapidly. The p-factor is the model used for risk weighting in securitisations, dealing specifically with the exponential decay function. 

“Unsurprisingly, we are concerned that the debatable but reasonable concept of capital non-neutrality has metastasized into rules that make risk transfer a non-starter. If SEC-IRB capital is 10%-15% higher than IRB capital, the market can manage. When it is 100% higher, the benefits of SRT securitisations become difficult to believe. Certainly the decision to reduce p-parameters to as low as .25 under STC securitisations is helpful,” observes Matthew Moniot, md and co-head of credit risk sharing at Man GPM.

The p-factor solution is a transitional measure, applicable only until 2030. European policymakers have mandated the EBA and the European Commission to review the securitisation capital framework more broadly and produce a report by the end of 2027. In the longer term, however, a fundamental rewrite of the securitisation capital framework may be necessary - potentially requiring the global rules to be rewritten, not just the EU rules.

“Halving the p-factor is a really good fix, [although] there needs to be a more permanent solution at some point. The outstanding question is whether it is creating a less even playing field between the standardised banks and IRB banks,” suggests Renault.

The p-factor has only been halved for IRB banks for the calculation of the output floor, not for standardised banks. Consequently, the solution leaves SA banks at a competitive disadvantage.

Jack Thornber, broker, structured and bespoke solutions at The Texel Group, notes: “While the halving of the p-factor is undoubtedly a welcome development for IRB banks, mitigating some of the damage that would otherwise have resulted from the introduction of the output floor, it does nothing to assist standardised banks or to close the gap between standardised banks and their IRB counterparts.”

Robert Bradbury, md and head of structured credit execution at Alvarez & Marsal, agrees: “The direction of regulatory travel in the last five years has been for standardised and IRB banks to come closer together. This pulls them apart again as we head into Basel 4: so smaller banks have definitively less efficient access to SRT than IRB banks. This is no different than it has been previously, but remains an area that could potentially be improved – the real economy does not benefit from a two-speed SRT market.”

Indeed, incentivising CRT for smaller banks would arguably feed the benefits through to the real economy faster. There are several ways this inequality could be addressed, Bradbury suggests.

“One action to support standardised banks could be some kind of regulatory support or incentive for green or ESG SRT. That could look like changes to risk weight floors or to the p-factor,” he says.

He adds: “It could be just lightening the reporting thresholds. You could have a lighter version of STS, so that it would be easier to get STS for green assets. That would be relatively straightforward and would incentivise people to securitise green assets - and even potentially encourage investment by smaller banks in more ESG assets in the first place, due to the improvement in capital recycling efficiency.”

Homogeneity criteria and SES
This year, the EBA also published final draft RTS on homogeneity criteria and synthetic excess spread (SES) for STS synthetics in February and April respectively, although at the time of writing the rules have yet to be formally adopted by the European Commission. While the number of transactions with SES is relatively small, the new rules are helpful for portfolios with higher incomes and higher losses.

For example, the yield on a consumer finance portfolio might be 10%, but there might be a 2% loss. Unless SES is available, that 2% loss makes the hedging of a junior tranche very difficult.

“For a four-year transaction, if your expected loss is 2% per annum, investors will expect the 0%-8% tranche to be fully eroded by losses, even in the base case scenario. Attaching the hedge above 8% would not bring any capital relief for the bank, but attaching below requires paying investors a very high spread that would compensate for these expected losses,” Renault explains.

He continues: “SES bridges this gap by letting the bank retain the annual expected loss (2% per annum in this example) and investors only cover risk above the expected loss. It is less risky and therefore investors should be willing to accept lower spreads.”

While SES can be helpful in certain circumstances, it can also effectively be replaced by retained first loss tranches. “For A-IRB bank portfolios, RWA goes up, driving compression to foundation and standardised approaches. This is especially true in mortgages. So, the bigger question is what will Sec Reg models do to retained tranche risk weightings and where is the inflection point? That’s more pertinent to the SRT market than there being a big change to the portfolio RWAs to begin with,” observes Moniot.

Jon Imundo, md and co-head of credit risk sharing at Man GPM, comments: “I think we’ll see more mezzanine issuance and higher attachment points for retained risk.”

Meanwhile, a desire for greater homogeneity in STS cash transactions geared towards inexpensive funding is understandable. But Moniot indicates that the benefits of greater homogeneity are less clear for synthetic equity and mezzanine deals.

“Multi-class transactions, for example, improve portfolio diversification. Additionally, some asset classes, such as CRE, are otherwise not likely to be granular enough to support stand-alone issuance. Regardless, these transactions tend to be negotiated between the buyer and seller of protection,” he observes.

ESMA templates
One thorny regulatory issue yet to be resolved, however, is the European Commission’s revision of securitisation disclosures relating to the reporting requirements under Article 7 of the Securitisation Regulation. An overhaul of the ESMA templates to provide clarity on which criteria issuers need to meet and which processes they need to follow would make entering the market more straightforward, for example.

“Until late last year, if you had a non-EU/UK issuer of a securitisation, the market interpretation was that you didn't have to fulfil the full extent of the Article 7 disclosure requirements. The effect of that revision for Canadian issuers and US issuers, who have investors deemed to be EU investors, is there is a requirement to have disclosure on the underlying reference portfolios and the levels of ESMA templates - which isn't necessarily easy to achieve,” notes Edmund Parker, partner and global practice head of derivatives and structured products at Mayer Brown.

The ESMA templates are widely held to be onerous. They are also not specific to SRT transactions and were designed to protect less sophisticated investors than those in the SRT market. As such, although EU-based investors still have to request ESMA templates from issuers for regulatory reasons, the content is largely ignored.

The templates are not only irrelevant, they are frustrating, according to Renault. “In a large corporate pool, it's over 150 fields that need to be populated for each loan. It's hugely time consuming and onerous for information that most investors will just archive and not look at because they receive the precise information they need outside the templates.”

This has an important impact, he warns. “It creates an uneven playing field between European and non-European investors. For example, if a European investor wants to do a securitisation transaction with a US bank, they will have to ask the bank to give them the ESMA template. If the bank instead places it with a US investor, it doesn't need to supply them with this information.”

But recently – thanks to industry advocacy - there have been signs of progress, with the European Commission asking ESMA to reconsider the application of its templates and potentially make a distinction between public securitisations (where information should be standardised and available to everybody via these templates) and private securitisations (where a few very sophisticated investors are involved, who know exactly what they need). Market participants agree that for the latter, the scope of the templates should be reduced or, ideally, that no templates should be required at all.

“These discussions could take another year or so. But at the moment, EU-based investors are at a competitive disadvantage versus non-EU-based investors for all these types of securitisations,” Renault argues.

Parker suggests that the situation is bedding down though. “Even though we haven't had the new ESMA templates yet, the market - although not happy - seems to be getting more comfortable with providing ESMA level disclosure.”

UK questions
Away from the EU, the UK Financial Services Markets Bill and the Edinburgh reforms introduced in December 2022 highlighted securitisation as something that the UK government is seeking to encourage. More recently, PRA and FCA consultations published this summer proposed or agreed with what SRT market participants regard as sensible changes, which should facilitate securitisation in the UK and keep the rules aligned with the EU. Furthermore, the tone from the PRA continues to be broadly positive on SRT.

The PRA’s Basel 3.1 consultation in November 2022, for instance, specifically highlighted that the authority is aware of the problems posed by the output floor. At the time of writing, the PRA delayed by six months the implementation date of the final Basel 3.1 policies to 1 July 2025 and also delayed the publication of near-final policies on credit risk, the output floor and reporting and disclosure requirements to 2Q24, in order to support firms in their planning processes.

“It remains to be seen whether the UK PRA will follow suit with Europe and introduce similar measures to lessen the impact of the output floor,” says Alan Ball, director, structured and bespoke solutions at the Texel Group. “The PRA has historically had a tendency to ‘gold plate’ regulatory requirements around CRT transactions, such as when it previously required even IRB banks to secure external tranche ratings. Such an approach post-Brexit risks putting UK banks at a competitive disadvantage, arguably for little to no gain.”

Ball continues: “That said, the divergence from the European landscape may also provide an opportunity to set a best-in-class example of how to encourage and foster a diverse and thriving risk-sharing landscape for banks that ultimately benefits the real economy.”

In July, the UK Treasury published a draft of the statutory instrument intended to replace the EU Securitisation Regulation, described as ‘near final’. Upon examination, however, many market participants fear that, as currently drafted, the instrument could create difficulties for banks issuing CRTs.

A key concern is that the FCA may erroneously flag some private SRT deals as public deals, making such deals more complicated, more costly and ultimately less attractive. Although banks are expected to push back, if the proposal is implemented, many feel that it will represent an operational burden, though few feel that the measure will ultimately curtail further issuances.

“This is not something I follow closely, but if the UK wants to be competitive, UK regulators or lawmakers should implement an STS framework for the UK for synthetic securitisations. They will also need to fix the Basel 4 floor, as the EU just did,” Renault concludes. “They have given some positive noises that they're willing to listen to the industry and to come up with a potential solution, but they haven't put anything forward yet to my knowledge.”

Despite this uncertainty, two to three smaller UK banks are anticipated to start engaging in CRTs next year.

SCI’s Global Risk Transfer Report is sponsored by Arch MI, Man GBM, Mayer Brown and Texel. The report can be downloaded, for free, here.