Synthetic securitisation: Hedge your risk, relieve your capital
Synthetic securitisation is a credit-risk hedging transaction – i.e. an insurance, which enables regulatory capital relief while fully keeping the legal ownership of the selected assets and, therefore, all related business relationships. This article presents the key features of synthetic securitisation transactions, the EU regulatory framework including recent changes applicable as of 2019, and opportunities for banking institutions and credit investors.
Table 1 – Simplified illustration of post-deal improved RoE via regulatory capital relief
The current European Central Bank (ECB) monetary policy makes liquidity vastly abundant to commercial banks. Liquidity is one aspect of a healthy banking system. Another one is solvency, which can be assessed via the equity ratio. Equity remains scarce for the banking sector given the risk-return profile of the industry. On the one hand the current policy of the ECB improves the liquidity of the system, on the other hand it may at the same time lower the profits of banks1 and, unintentionally, hamper their solvency. In this context, relieving capital is an effective strategy to fully seize market opportunities and improve the return on equity.
Economically, we see synthetic securitisation transactions as insurance contracts (i.e. credit-risk hedging) between originating banks and investors (e.g. pension funds, investment funds, sovereign wealth funds, insurance companies…). The labelling “synthetic securitisation” – although slightly misleading – derives from (1) “securitisation”, since cash flows are reorganised with a hierarchy, and (2) “synthetic”, as no changes in legal ownership of the underlying loans are needed, hence no special purpose entity/vehicle (SPE/SPV) is created.
The capital relief is obtained via the post-transaction reduction in risk-weighted assets (RWA) applied to the reference pool of assets in the securitisation. The securitised assets are protected by the subordinated tranche (known as “junior” or “first-loss”) while avoiding the potentially burdensome constraints (legal, fees, eligibility, licences, consent…) associated with a change of ownership.
Figure 1 – Overview of a synthetic securitisation with first-loss tranche (and no mezzanine)
The hierarchy and risk of financial cash flows are structured following the thickness of tranches (defined by their attachment and detachment points):
- Senior tranche. The safest part of the structure typically retained by originating banks.
- Mezzanine tranche. The risk beyond the junior tranche and before the senior tranche i.e. in the middle. This is typical in the case of guarantees, where the originating bank retains the junior and senior tranches and sells the mezzanine tranche.
- Junior tranche, or first-loss tranche, the riskiest part of the structure.
- Vertical tranche constitutes the risk retention for the originator. The larger the vertical tranche (regulatory minimum of 5%), the more incentives the bank retains in avoiding credit losses. This is a mechanism to limit moral hazard or ensure that the issuer keeps “skin in the game”.
Typically, credit events that would trigger payments from the investors to the originating bank cover the following three situations:
- Failure to pay
The synthetic securitisation market broadly covers two different categories of deals: “first-loss tranches” and “mezzanine guarantees”. Typically, the former involve private sector entities (e.g. investment funds), while the latter concern public sector entities such as the European Investment Bank (EIB) whose guarantees are deemed risk-free by regulators. The sub-prime financial crisis built a bad reputation for “anything securitisation”, and, to some extent, obviously rather well deserved. In recent years, in the context of debates on the appropriate regulatory framework and EU Banking Union efforts, the European Commission and private companies such as pension funds and banks have presented a more flattering picture.
Although the private and bilateral nature of these transactions limits the availability of data, last year witnessed notable transactions. In total, new balance sheet securitisation reached a record high of over EUR 104bn in 2018. The supply side, i.e. the interest of banks in entering into synthetic securitisation transactions, depends on the regulatory treatment of the transaction. Following the changes brought by the EU regulator applicable since January 2019, it is timely to present these transactions and (updated) benefits to bankers and the broader PwC Dealmaker community.
The shades of a bilateral deal
Synthetic securitisation remains an umbrella term that encompasses various types of transactions. Above is a conceptual overview of synthetic securitisation, below we provide a deep-dive into the structuring options and possibilities available to banks.
Balance sheet vs. arbitrage
This article focuses on “balance sheet” synthetic securitisation. For the sake of clarity, let’s briefly describe “arbitrage” transactions, although such arrangements seem to have lost their popularity in the eyes of investors and regulators alike. Such transactions are based on underlying loans not owned by either party, typically highly leveraged (e.g. synthetic CDOs). These instruments were – indeed it seems their popularity is down to the point that using the past tense is more appropriate – not credit-hedging solutions.
On the other hand, a balance sheet synthetic securitisation hedges the credit risk incurred by the originating bank in a similar fashion that one would cover any risks with an insurance policy. The aim is to lower the actual risk of the banking book and to obtain a corresponding regulatory capital relief.
Funded (i.e. cash collateral) vs. unfunded (i.e. guarantee) transactions
While the general difference between funded and unfunded transactions is obvious, in the context of a synthetic securitisation the main consequence is related to counterparty risk. In the case of an unfunded transaction (i.e. guarantee), the counterparty risk may affect the eligibility of the deal (i.e. it would not be deemed as a significant risk transfer, detailed later in this article). Therefore, unfunded deals are usually only granted by public sector entities such as the European Investment Bank. Funded transactions imply the deposit of cash collateral – invested in risk-free instruments – on an escrow account.
Figure 2 – Dimensions of Synthetic Securitisation
Below we list some structuring options that illustrate the large array of features offered by synthetic securitisation:
- Amortisation method (see figure 3)
- Pro-rata: All tranches shrink down proportionally with the amortisation and the thickness of the protection level staying constant over time.
- Sequential: The size of the senior tranche is reduced first as loans reach maturity. Over time, as the portfolio shrinks as per its schedule, the size of the protection grows proportionally.
Figure 3 – Amortisation approaches with senior / mezzanine / junior tranches
- Replenishment feature: the possibility over time to include newly underwritten loans in the securitised pool with pre-defined quality criteria and related conditions
- Time calls: possibility to terminate the contract based on pre-agreed timeline and conditions
- Call option: option for the protection buyer to terminate the protection
- Payment methodology:
- Estimation and balance out: credit event triggers a payment based on expected loss (or agreed amount); once the workout process is completed, payments – if necessary – are made to be equal to match losses.
- Actual: the payment is delayed until the workout process of the exposure is entirely terminated and actual losses are final.
EU regulatory framework
As part of its Union Capital Market Plan the EU Commission wanted to facilitate securitisation to foster lending to the real economy. The “securitisation amendment” or EU Regulation 2017/2401 to the EU Capital Requirements Regulation (CRR) provides the formula that applies to securitisation positions.
The regulatory framework covers two aspects: (1) the eligibility of the capital relief and (2) the magnitude of the relief. The eligibility is covered by the requirements of significant risk transfer (SRT), i.e. required – or forbidden – features of the arrangement that would enable the issuing bank to lower its risk-weighted assets (RWA) post-transaction. The magnitude of this RWA reduction – and therefore actual regulatory capital relief – is also pre-defined in the regulation based on the appropriate risk weighting approaches (IRB, External rating, SA).
Significant risk transfer
To provide its benefits, the transaction must meet significant risk transfer” criteria. This is how regulators want to ensure that credit risk is effectively shifted away from deposit-taking institutions when granting them a capital relief. Below, we summarise contractual/structural examples where SRT compliance would not be met:
- Protection only covers credit losses if a high loss threshold is reached, e.g. a gap between incurred losses and protection
- The investor has the possibility to terminate the protection based on a change in credit quality of the underlying pool of assets before the end of the contract
- The originator can be contractually forced by the investor to change the composition of the securitised pool to maintain some quality criteria
- The cost of the protection is variable and linked to the quality of the securitised assets
Capital relief calculation
Post-transaction, the RWA calculation for the originating bank should be split into three components:
- The retained senior tranche: A regulatory formula for RWA calculation is provided in the CRR amendment. The key impact drivers are the underlying portfolio risk and the size (detachment point) of the junior tranche (and mezzanine, if relevant). A regulatory floor of 15% RW applies to that exposure.
- The vertical tranche: retains its original (i.e. pre-transaction) risk weight.
- The junior tranche: The risk weight is set to 0%.
The regulation provides calculation methods based on the respective IRB, external-rating and standardised approach. Notably SME exposures obtain a more favourable treatment. In the future, the “simple, transparent and standardized” (STS) status available to traditional securitisation might become available to balance sheet synthetic securitisation, increasing the benefits of these transactions.
Hierarchy of approaches
A major overhaul of the hierarchy of risk-weight calculation for securitisation exposure was part of the new regulation. The main objectives were to make risk weights more risk sensitive and to consider the complexity of the structuring, while reducing the reliance on external ratings. In figure 4 below we provide an overview of the RW calculation method hierarchy and a summary of the approaches.
Figure 4 – Hierarchy of approaches for RW calculation (source: PwC analysis)
Economics of a beneficial transaction
Capital management strategy
The strategic vision is the first building block of a successful transaction. Broadly speaking, two general business cases can be drawn:
- Expansion case: need for new capital; and
- Risk reduction case: need to lower banking book risk and/or risk-weighted assets.
For the expansion scenario, the analysis requires the capital management of the bank to assess alternative sources of capital and allocation plans with a focus on profitability. On the other hand, for the risk reduction case, a comparison with other market solutions (e.g. disposal of the assets) would be more appropriate.
The risk reduction case encompasses both – an overall reduction of RWA, but also a strategic concentration reduction for specific sector, country, and asset types as part of exposure steering.
The structuring choice, either a mezzanine or a first-loss tranche, heavily depends on the objectives of the transaction and the related objective in terms of cost/capital relief.
Investors seeking to enter into such arrangements are typically investment funds, pension funds or sovereign wealth funds. One should expect rounds of contractual negotiations (e.g. the definition of the workout process – steps, reporting, timeline… – must be agreed upon between the parties) and an extensive buy-side due-diligence, as the proper assessment of undertaken risk is key to properly price the transaction.
Some contractual features usually have direct impact on pricing, such as the payment approach and amortisation structure. Whether the payment is made right after a credit event occurs or once the workout process is completed, has direct consequences on pricing, primarily linked to the fundamental time value of money and amplified due to the reduction of the securitised pool. The amortisation structure would affect the economics, as – in the case of sequential amortisation – the protection level and premium cost (i.e. cost of the protection) would grow over time.
The selection of assets to be securitised may lead to micro trade-offs between insurance cost, relieved capital and diversity effect of the pool. Within the same asset category, i.e. with the same regulatory risk weight / capital consumption, some exposures might be less risky, hence cheaper to protect for a proportionally similar capital relief. The asset selection optimisation is an important step for a successful transaction. For instance, particularly rewarding securitised assets are those that would be deemed risky by the regulatory framework, while the actual risk priced by the market is much lower. In such a case the capital relief would be obtained in a cost-effective fashion.
Buy-side pricing (i.e. investors / protection sellers) revolves around a typical risk-based approach, where the premium will be a function of the amount of risk protected and expected return for investors. Specific issues related to synthetic securitisation are risk concentration for first-loss tranches (see Figure 5) and related wipe-out risk (depending on the amortisation approach). In practice, the pricing of the premium is similar to the methodology that would be used for a basket of credit default swaps (CDS) taking into account underlying exposure correlation (often via copulas) relying on Monte Carlo simulations.
Figure 5 – Illustrative expected loss distribution for subordinated risk tranches*
A sharp tool for bank steering and portfolio optimisation
The risk-adjusted cost of one unit of relieved capital is the key metric that, once compared to internal (and external) cost of capital, enables a proper estimation of the benefits – improvement of return on equity – of synthetic securitisation for originating banks. Simply put, if the regulatory capital relief is proportionally greater than the cost of the protection, the return on equity of the portfolio is improved.
A bank’s decision to enter such a transaction is based on an assessment of the (1) cost of the protection, (2) regulatory capital relief criteria, and (3) strategic drivers – alternative funding and potential allocation of the relieved capital. Synthetic securitisation is a polyvalent option in the toolkit of bankers when assessing solutions for bank steering.
PwC can help
PwC can assist you throughout the deal process, from feasibility study to deal closing. Synthetic securitisation is a strategic tool for banks. Our experts can perform benefits assessment, pricing, asset selection and optimisation to obtain the maximum value from the transaction. For instance, securitisation-specific services include ensuring the compliance of the structure with risk-retention requirements and documentation/assessment of the proper significant risk transfer of the deal.
Our transaction services expertise enables a smooth deal process via extensive market sounding, bidding administration, supporting application for public sector guarantees, e.g. EIB/EIF, and overall project management, which is key for a successful transaction.
We can support buy-side players, such as investment funds, with financial due-diligence, sourcing and screening of targets, financial benchmarking, and valuation.
PwC’s far-reaching professional network across countries and fields of expertise enables seamless transaction services.
For more information please contact:
Senior Consultant, PwC Austria, FS Deals
References in the article:
 The ECB recently mentioned the issue, June 2019: https://www.ecb.europa.eu/press/key/date/2019/html/ecb.sp190625~6d33411cff.en.html
 REGULATION (EU) 2017/2401 of the European parliament and of the council of 12 December 2017
 This sub-section is based on the very insightful book “Basel IV – The Next generation of Risk Weighted Assets”, editors: M. Neisen and S. Röth, 2nd Edition, 2018 whose team of authors is made of global PwC experts on banking regulation and risk management.