In the second of six chapters surveying the synthetic securitisation market, SCI explores the impact of the STS revolution

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 two: the STS revolution
Another key regulatory development for the CRT market was the inclusion of synthetic securitisation in the STS regime in April 2021. The framework has brought welcome standardisation to what has traditionally been a very bespoke asset class.

Andrew Feachem, md at Guy Carpenter, says: “STS has allowed banks to improve the capital efficiency of transactions, which enables them to include exposures that would traditionally have been marginal with respect to capital relief efficiency via SRT.”

Robert Bradbury, head of structured credit execution and advisory at Alvarez & Marsal, concurs that the STS rules have increased efficiency. “It’s somewhat more complicated to achieve, but you can now get better results. Adhering to certain well-defined criteria for certain types of transaction which are simple, transparent and standardised, you are able to achieve a better result from an economic and capital perspective, which means that it is much more economical for the bank. It changes the way tranches work and so changes what investors are offered.”

In 2017-2018, SRTs were largely restricted to tier one banks, such as Santander, Barclays or Deutsche Bank. But that has now changed.

“We are starting to see the tier two, tier three and tier four banks starting to use [SRT],” confirms David Saunders, executive director of Santander’s European securitised products group. “The STS framework will only help. I think we’ll now see a similar rapid growth in the use of SRTs by smaller banks.”

Olivier Renault, md, head of risk sharing strategy at Pemberton Asset Management, agrees that the STS framework has been extremely positive. “A bank that goes through the pain of getting the STS label benefits from more capital relief for the same amount of tranche base and therefore cheaper cost of relief. We were seeing a lot of banks that were sitting on the sidelines, looking at this market, and thinking the cost of capital is marginal.”

He continues: “Suddenly, for the same trade, they are getting more capital relief and therefore it is becoming more attractive. We see, in particular, medium-sized banks under the standardised approach have started issuing on the back of this EU regulation.”

The numbers remain small, but are still growing. Renault says: “There were 55 banks that had issued by the end of 2021. I wouldn't be surprised if, at the end of 2022, we had 65 banks doing deals. [Such an] increase is to a large extent driven by this change in the STS framework.”

Although some standardised banks are still expected to execute CRTs with supranationals, such as the EIF, market participants agree that they now have much more choice.

Insurer exclusion
Nevertheless, Seamus Fearon, Arch MI evp, CRT and European markets, identifies one key outstanding issue – the exclusion of insurers from the STS label. “It was disappointing that effectively an insurer couldn't be a participant on STS structures. Given the capital needs that the European banking system will require, as we see the introduction of Basel 4, insurance will be an important tool. Having insurance play a role in the STS structures will be crucial. We're hopeful that that will be looked at again, as discussions continue.”

Feachem agrees, but notes that the current lack of unfunded STS synthetics is not preventing insurers from joining the market. “STS still accounts for a minority of synthetic issuance and there are funding solutions available if needed in the near term. However, we do not view the current rage of funding solutions as an efficient use of (re)insurers’ balance sheets. As we also see in a couple of major jurisdictions, there is scope for this rule to change, allowing unfunded STS with (re)insurers.”

Feachem believes that enabling the participation of (re)insurers, in addition to the already qualifying supranational entities, in STS synthetics will increase liquidity. He suggests that it could also level the playing field between private and public sector financial institutions participating in SRT.

EBA consultations
Other outstanding issues include latest proposals under the EBA’s consultations regarding the homogeneity criteria and the determination of the exposure value of synthetic excess spread (SES) in STS synthetic securitisations.  

As part of the Capital Markets Recovery Package, adopted by the European Commission in 2020, the EBA is mandated to develop draft regulatory technical standards (RTS) that specify which underlying exposures are deemed to be homogeneous as part of the simplicity requirements for STS. In particular, the proposals adjust the homogeneity factors for on-balance sheet securitisations and more specifically the ‘type of obligor’ related to corporate and SME exposures.

According to the consultation, banks treat large corporate exposures differently from the rest of their corporate book. Consequently, to ensure a consistent and harmonised application of the requirements, it was decided that the ‘large corporate’ definition would be used from the European Commission’s CRR 3 proposals.

The CRR 3 proposals define the term as ‘’any corporate undertaking having consolidated annual sales of more than €500m or belonging to a group where the total annual sales for the consolidated group is more than €500m.’’

Nevertheless, the larger issue with the homogeneity consultation is the inability to mix corporate and SME loans, with seemingly no clear rationale. If left as they stand, the EBA proposals run the risk of encouraging less granular portfolios and less financing to SMEs.

Meanwhile, the 2020 EBA report on SRTs had attempted to tackle divergent regulatory practices for SES. The STS framework, in turn, brought in new capital rules for the treatment of SES in 2021.

This year, in August, the EBA produced a further consultation paper on the treatment of SES – with the aim of contributing to a more risk-sensitive prudential framework. Bradbury says: “They want the market’s feedback on different options. That’s a pretty sizeable uncertainty because they acknowledge that the implementation of the rules has historically differed. They want to try to standardise that.”

But Renault describes the EBA’s proposal as “very disappointing - frankly, not surprising - but very disappointing.” He explains: “At a high level, the EBA’s proposal is to calculate the lifetime loss that the bank expects to be borne by SES and to deduct that from capital, while until now European banks were able to deduct only one year of SES.”

The EBA paper highlights that just one supervisor has so far treated SES on a one-year rolling basis - a different approach to the maximally conservative line taken by others. Renault adds: “If it's a five-year transaction and the investor is not covering the first 1% of losses each year, the bank needs to provision five years of SES. That’s a big capital penalty for the bank. It effectively means that a tool that has been used on dozens of transactions is no longer going to be used by banks and that will reduce the number of transactions in asset classes that tend to have high losses; e.g., consumer or some middle market loans.”

Feachem agrees that under the proposals, the originator will have to hold more capital for transactions incorporating SES. “We can potentially see originating banks rebalancing towards using retained equity tranches compared to the SES feature, which had been a big trend in the past few years, given its asymmetric capital treatment. The relevant RTS that is going through the EU legislative process is attempting to harmonise the treatment of these two features,” he observes.

While there has been a wave of regulatory change over the past few years, the new rules appear to have largely bedded down. Feachem says: “The rules and guidelines for issuers to follow are clear and this gives confidence to new entrants to build out their SRT programmes.”

He adds: “There are still challenges for new issuers to overcome, such as ensuring compliance with reporting requirements, managing portfolio replenishment in practice, and understanding the requirements and constraints of new risk takers, such as the (re)insurers, noting that (re)insurers tend to be constructive and are drawing upon approaches used more broadly in the US CRT market.”

Market standard
At the same time, regulators appear to have a greater understanding and appreciation of synthetic securitisation. Renault says: “There is a market standard now arising in terms of how to design the deal, certainly in Europe. Now regulators understand that this product potentially helps banks reduce risk and lend to the real economy.”

Saunders concurs: “What you’ve seen is a convergence in structures. Of course, each deal has its own bespoke elements, but you’ve seen a lot more standardisation of structures in the past few years. The greater the clarity and certainty for issuers, the more likely they are to do these transactions and the less likely they are to be rejected.”

The appetite for SRT is expected to continue to grow among both issuers, investors and (re)insurers. “Other than a blip in relation to Covid, there has been consistent growth. We are about half where we were in 2021 already, but the market is skewed to Q3/Q4; many more deals are happening towards the end of the year,” says Saunders.

He adds: “We see more and more investors coming into the space and we are starting to see newer, smaller issuers coming in. Everything points to continued growth.”

Nevertheless, Bradbury suggests that the European CRT sector remains a “two-speed market”. The larger banks know exactly how it works and which levers to pull, have regular contact with the regulators and know the most relevant investors.

He says it’s a different world for non-IRB banks. “The smaller banks are generally less familiar with how the technology works. There are fewer investors able to focus on and execute the relevant kinds of transactions.”

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.*