Current status of capital relief trades discussed

Representatives from Chorus Capital, Citi and Clifford Chance recently discussed the current status of capital relief trades during a live webinar hosted by SCI (view the webinar here). This Q&A article highlights the main talking points from the session, including the impact of regulatory changes, the emergence of new assets and jurisdictions, and investor requirements. For a broader and more in-depth exploration of the RWA management space, attend SCI's Capital Relief Trades Seminar in London on 22 November (click here for details).

Q: Beginning with an overview of the regulatory framework for capital relief trades, what is the current status of the reform efforts in the European securitisation markets?
Tim Cleary, senior associate at Clifford Chance: The European securitisation markets have seen quite a lot of change over the last few years. There have been various proposals released by a number of bodies, including the Basel Committee and the European Commission. The reform efforts have been directed primarily at true sale securitisation and regulatory capital/balance sheet relief transactions have been left to one side, given they weren't viewed in a particularly favourable light by regulators.

The two key pieces of regulation currently going through the EU process are the Securitisation Regulation and the accompanying amendments to the CRR. What has attracted the most attention is the introduction of the STS framework and the proposed adjustments to risk weights for securitisation positions.

The latter is of more significance for capital relief trades, as synthetic securitisation is currently excluded from the STS proposals.

A key feature of risk transfer transactions is that the originating bank will almost always hold the senior tranche of the capital structure, while placing the mezzanine and possibly the junior tranches with investors. Consequently, the risk weights that apply to senior tranches are important in terms of the economics of the trade for the bank and therefore the viability and efficiency of the transactions overall.

The European Commission published its reform proposals last year and the European Council has since added its comments. The European Parliament is currently going through its process of reviewing the proposals and suggesting its own amendments. The special rapporteurs have published their recommendations and there's also an ongoing process where MEPs are adding their opinions.

The most interesting point to note so far from those amendments is that there may be an expansion of what people are starting to refer to as Article 270. In the Commission's draft, there was a special provision for banks holding the senior tranche of synthetic SME securitisations, where if the protection on the mezz or junior tranches was provided by government entities or multilateral development banks, the originating bank would be able to get a more favourable capital treatment on the senior tranche. This was seen as a provision to benefit certain types of transactions that the EIF, in particular, has been involved in to support the SME sector.

At the end of last year, the EBA published a report on synthetic securitisation that came out of a lengthy consultation process to consider whether the STS proposals should be extended to synthetic securitisation. The EBA ultimately did not recommend doing this. However, it did recommend that the senior retained tranches of some types of synthetic transaction, primarily relating to SMEs, should be accorded the same capital treatment as a corresponding position in a STS securitisation. Specifically, it was trying to build on the Article 270 provision and the key point there was that where private investors provide cash collateral for their obligations as protection sellers, that should enable the transaction to qualify for this treatment.

Some of the reforms before the Parliament do attempt to incorporate some of those ideas. For example, while the Commission's proposal was for SME exposures to account for 80% of a portfolio, some MEPs have suggested that this should only require 60% of the portfolio to be exposures to SMEs.

It's unclear whether these proposals will survive the negotiating process between the Parliament and the Commission, but there does seem to be some positive movement in the regulation of synthetics. If you look at where capital relief trades and synthetic securitisations are now, versus where they were a couple of years ago, it's quite similar to where traditional securitisation was a couple of years ago, after three or four years of rehabilitation of that as a product.

There are a number of other very technical amendments in the proposals, of which the most significant are the changes to the standardised approach, where SEC-SA is being put forward as a replacement for calculating the capital requirements for synthetic securitisations, as well as changes to the hierarchy for the application of the internal ratings-based approach versus the external ratings-based approach.

Another noteworthy aspect is the grandfathering arrangement in terms of when the new regulations will start to apply. At the moment, banks have the ability to continue to apply the existing capital requirements until the end of December 2019, but it's an 'all or nothing' election.

A bank wishing to grandfather its positions must therefore apply it to all outstanding securitisations at the time the new regulations come into force. Whether a bank chooses to do this would depend on whether it is beneficial to its overall portfolio.

Finally, there is another potential reform coming down the line. The Basel Committee is proposing to introduce specified capital floors for certain types of exposures, the effect of which undermines some of the benefits of the IRB approach.

Q: Is the 20% risk retention proposal by the MEP Paul Tang ever likely to be implemented? Could the current 5% be increased?
TC: It is impossible to say. Certainly the securitisation industry has reacted fairly strongly against this proposal.

Q: What are the implications of these reforms for capital relief trades from a commercial perspective?
Olivier Renault, EMEA head of financial institutions solutions at Citi: As a reminder of how capital relief is calculated, let's take an example where a bank has a €1bn portfolio and a 50% risk weight, so the risk-weighted assets tied up in the portfolio would be €500m. Assuming that the bank is operating with a core equity tier one ratio of 10%, the portfolio would tie up €50m of capital while it remains on balance sheet.

The bank decides to hedge the mezz and junior piece, say the 1%-6% tranche, via a capital relief transaction. The bank would keep the first €10m of risk and hedge the next €50m and retain the super-senior tranche (the remaining 94% of the capital structure).

The way a bank would typically calculate the capital benefit is by removing the €50m risk-weight from its balance sheet and then recognise on its regulatory balance sheet the three tranches created via the capital relief trade. The capital charge on the €10m first-loss piece is deducted on a one-to-one basis; if the mezzanine piece is collateralised by cash, it shouldn't carry any risk weight; and there is a small capital charge on the super-senior portion (of around €6.5m in this example). By hedging this mezzanine piece (which arguably contains most of the risk of the portfolio), the bank moves from €50m of capital tied up to €16.5m of capital.

In terms of what the regulations are changing, a big driver of the sector's growth over the past few years has been regulation related to the underlying assets themselves and to banks in general. The first big change is that under Basel 3, banks are required to hold more and more capital.

While a CET 1 ratio of 10% may have been comfortable for many banks a few years ago, they are now looking towards a 12% CET 1 ratio. What that means is that by executing the same transaction, a bank will free up more capital just because the portfolio itself is consuming more capital - €60m rather than the €50m in the example.

Another positive impact is the fact that risk weights associated with these portfolios are rising and we're seeing various initiatives from the regulators to push up risk weights, in particular for banks under the IRB approach. This increases the capital benefit of executing a capital relief trade.

However, the negative impact is the change to the securitisation risk weight, especially the formula for calculating how much capital should be retained for senior tranches. In theory, this will more than double from 1 January 2018: in the example, the capital charge against the super senior could jump to €20m. In addition, to achieve a relatively low risk weight on the super senior tranche, it will have to attach at a higher point, thereby requiring the bank to hedge a thicker mezz or first-loss piece - which implies more risk transfer and therefore more cost for the bank.

The forthcoming securitisation risk weights will claw back much of the capital savings from other regulations that were linked to the capital increase on the underlying portfolio.

Finally, the big uncertainty is regarding risk-weight floors and how they will be treated in the context of capital relief transactions. Depending on how the regulations are finalised, the calculations could remain as they are in my example and the risk-weight on the underlying portfolio is increased, which could have a positive impact on the growth of the sector.

Alternatively, if regulators require banks to calculate the risk weight of the retained pieces - in particular, the super senior - and floor that at 70%, say, of a standardised capital risk weight, it could have a very detrimental impact on the market and make many transactions uneconomical. But implementation could be a few years away yet and we won't have any clarity for a number of months.

Kaikobad Kakalia, cio at Chorus Capital: When a bank issues a thicker tranche and in turn transfers more risk, the cost should not proportionally increase. The incremental cost to hedge the additional amount to free up capital should be much lower than for a thinner tranche. The weighted average cost of the new tranche will be lower.

Q: With respect to recent transactions, is the mezz tranche placed with investors rated? How do investors normally price these tranches?
TC: There have been no rated transactions in this space since the financial crisis. Further, where the tranche is placed with investors (in other words, not retained by the bank), the bank does not need it to be rated under any of the CRR models. It does not appear that investors in this market are particularly interested in having the tranches rated.

OR: In terms of pricing, investors look at relative value in other structured credit asset classes (for, example CLOs or bespoke tranches), but the pricing of these transactions tends to be range-bound. Given that these transactions are illiquid and relatively complex and limited external leverage is available, they rarely are executed below 9% spread.

On the other hand, when spreads reach 12% and above, many opportunistic investors start to step in and take market share. So, in practice, most of the activity is in the 9%-12% spread region.

KK: Investors employ various techniques to price these tranches. Fully disclosed portfolios may be priced using tranche correlation pricing models. More granular and non-disclosed portfolios tend to be priced using the discounted cashflow methodology or by benchmarking to previous issuances.

Q: Differences in views on and the application of significant risk transfer remain among policymakers. How is the implementation of these rules diverging across various regulators from a practical perspective?
TC: Rather than a divergence in approach, it's more a lack of convergence of approach. Before the introduction of CRR, the capital requirements directive was implemented at the national level by each member state, so there was some variation between states as to exactly what rules applied in that jurisdiction. There was also the effect of national regulators each applying their own national rules, leading to further differences of approach on various issues.

When CRR was introduced in early 2014, in theory such divergence should have been swept aside because, as a piece of European regulation, CRR has direct effect in all member states in an identical manner. But at that time, as the various national regulators implemented the rules, some divergence was expected. Most recently, there's been a further level of convergence, due to the single supervisor (the ECB) effectively taking over the regulation of most of the banks in the eurozone - certainly the ones that tend to be involved in capital relief trades.

Nevertheless, there is still a dialogue between the ECB and each member state regulator, so banks are talking to both their national regulator and the ECB. So, the differing national views continue to be reflected in the transactions that banks are executing.

It appears that the regulators take a case-by-case approach to each transaction and each bank, and evaluate them on their merits and individual circumstances. Consequently, there is quite a bit of difference between deals - some will have certain features that appear unproblematic to one regulator but are problematic for another regulator.

The regulators also have an element of discretion as to whether to recognise significant risk transfer, which is what banks need to achieve to benefit from the capital reduction.

Areas that tend to see some divergence include credit events, where there are differing views as to whether restructuring needs to be included as a credit event, or whether defaulted obligations under Article 178 of CRR need to be classified as credit events.

Another area of divergence is time calls, which is important for maintaining the efficiency of the transaction. Most regulators seem to be accommodating towards some time calls, but certainly not all.

Amortisation mechanics go hand-in-hand with time calls. There has been a trend in recent years towards pro-rata amortisation, given that sequential amortisation can reduce the efficiency of a capital relief trade.

It appears that regulators are becoming more comfortable with pro-rata amortisation, although there is variation in its implementation. For example, there may be threshold levels where the pro-rata amortisation switches to sequential if losses rise above that threshold.

Another aspect that seems to be coming back into favour is the use of excess spread as a way of reducing losses for investors. This was quite common pre-financial crisis.

Finally, the use of external ratings - even when a bank is applying the supervisory formula - is another area of divergence, although it seems that only one regulator is an outlier here. It requires banks to obtain external ratings for the senior tranche and that obviously impacts the ability of a bank to execute a capital relief trade.

Q: How do you view the Australian regulator's punitive treatment of these transactions?
OR: I have a number of colleagues in Australia, who are very focused on this topic, and what I've heard from them is that historically a big focus for Australian banks was the establishment of master trusts and on cash securitisations because they're typically in good shape capital-wise. A number of Australian banks have commented in the past few months that they don't see much support for capital relief trades from their local regulator, but it's also a topic that they haven't brought up very recently.

Consequently, it may be worth the industry explaining how these transactions have moved on from a few years ago - the fact that they are now all cash-collateralised and are genuine risk transfer deals. Linked to this, I would like to highlight the European Banking Authority's great work over the past few years in trying to harmonise a set of quite diverse regulations across Europe and listening to originators and investors, as well as local regulators in trying to frame rules that are consistent. The Australian regulator could speak to the EBA and learn from the process.

Q: Capital relief trades have traditionally involved large corporate loans and SME exposures, but other types of portfolios are increasingly being securitised. Which new assets and jurisdictions are emerging?
TC: Traditionally, the capital relief trade space has been a market for European banks, primarily because the EU implemented Basel 2 through the Capital Requirements Directive and made it possible for banks to execute these deals. But we've also seen many transactions where European banks have securitised non-European portfolios - for example, North American or Asian loan portfolios - and may not be looking to obtain capital relief at the local or subsidiary level, but instead at the consolidated group level.

Historically, the largest jurisdictions have been the UK, Germany, Switzerland and, pre-crisis, the Netherlands. The regulators in these jurisdictions were relatively familiar with these trades and the big banks were fairly frequent users of the structures.

In the last couple of years, transactions have begun to emerge from a number of other jurisdictions, such as Italy, France and Spain, as well as Portugal, Austria and the Czech Republic. We've seen some interest from Ireland and Scandinavia too.

We're also beginning to see interest from non-European banks, although they are a bit behind the curve because their domestic regulators don't have the same history with these transactions as European regulators. But perhaps this will change in the future.

In terms of asset types, historically the market was dominated by large corporate and SME loan portfolios and trade finance portfolios. These assets tend to be difficult to securitise using true sale techniques.

In the last couple of years, we've seen an expansion into more esoteric assets, such as derivative portfolios, commercial leasing and agricultural portfolios. These assets aren't particularly suited to cash securitisation.

OR: We've gathered a database of capital relief trades executed since 2010 - which isn't an easy task, given that the market comprises mainly bilateral or small club deals. But we've been able to find information on over 125 transactions executed since 2010 and we estimate that this represents over 90% of the entire market.

Last year saw three times as many deals as in 2010-2011 on average, with around 30 executed in 2015. These deals were done by three times as many originators as in 2010-2011, suggesting that this market is expanding not only in terms of deal volume, but also in terms of participants.

Last year also marked a record in terms of the number of countries where originators are based. It's no longer just banks bringing repeat deals, as was the case a number of years ago.

A small half of the transactions across the 125 deals are large corporate portfolios (mainly disclosed or partially disclosed pools) and another small half are blind pools of highly granular portfolios, such as trade finance assets or emerging market and SME loans. The remaining 10% or so is made up of more esoteric assets, such as shipping loans or project finance loans and real estate.

Q: What should banks be aware of when investors analyse a new asset class or jurisdiction?
KK: First, banks shouldn't underestimate the learning curve. If it's a new asset class or jurisdiction, investors will have to get up to speed with that.

Corporate and SME loans in the main jurisdictions are fairly straightforward to analyse now, but new asset classes makes it more complex. Investors need a lot more information; they need substantial data on the bank's underwriting and credit modelling capability, as well as performance statistics on the portfolios. Having this to hand in order to get investors up to speed is crucial.

Assuming the new jurisdictions aren't part of the eurozone (because gradually more and more eurozone countries are issuing), one key challenge investors face includes currency. If the currency the bank wants to issue in is not a major currency, hedging the currency can be costly and operationally problematic. Most investors aren't able to take currency risk, especially given the volatility in currencies these days - a major swing in currency can wipe out a year's return - so having to hedge this becomes quite a costly and painful exercise.

Depending on which jurisdiction an investor is contemplating, there may be political risks to consider, in addition to the credit risks an investor is taking in the portfolio.
But the main point is how to price the risk. From a bank's perspective, it is seeking efficiency in terms of cost of capital and these aspects need to be considered.

Q: We're now seeing not only synthetic trades to free up RWAs, but also cash transactions, as issuers seek to improve their leverage ratios and balance sheets. What are the drivers behind this trend?
OR: Banks don't only care about risk-weighted assets, they also care about the leverage ratio and for some the binding constraint is not the CET 1 ratio but absolute balance sheet size versus capital. Synthetic risk transfer deals don't help in this respect because they free up RWA, but they don't shrink the size of the balance sheet.

To shrink the balance sheet, banks need to sell the loans or execute a full capital structure cash securitisation. But this isn't practical for many asset classes because many loans originated by banks aren't easily transferrable - there may be legal constraints or banking secrecy issues with the transfer. However, for asset classes such as mortgages or other consumer assets, it is often possible and we've seen a number of full capital structure deals executed in the past few years.

The other benefit of bringing a cash securitisation is that you'll receive funding from the deal. Not many banks need funding these days, but for some financing companies consolidated within a banking group, the funding element may also be a driver.

Q: What are the latest developments in terms of legal structures for these trades?
TC: The main area where we see development from a legal perspective is around collateral and that reflects the fact that historically cash collateral was held by the protection buyer. As ratings have become more of an issue for banks in recent years, a number of investors are seeking to avoid that bank risk and this often involves a form of non-bank collateral, such as government securities. This, in turn, results in complex structuring to avoid significant haircuts on the collateral or maturity mismatches between when payments fall due and the collateral would naturally pay.

The other area is whether people choose to do a traditional synthetic securitisation involving an SPV issuing notes and selling protection to the bank or to do a simpler structure. We're seeing an increasing number of purely bilateral transactions between the bank as protection buyer and the investor as protection seller, but they aren't necessarily structured in note format - they use a CDS or a financial guarantee, coupled with a collateral arrangement. Another structure gaining in popularity is the bank issuing a CLN itself: rather than having an SPV in the middle of the transaction, the CLN references the portfolio and effectively embeds the protection that way.

Q: Typically, what do investors require when investing in a capital relief trade?
KK: In my experience, different investors will have different approaches to transactions and partly that's due to the firm's background. For example, if they started by investing in corporate credit or ABS, that would generate a bias in their approach to analysis. An ABS investor would naturally prefer granular pools, whereas a corporate credit investor would prefer more disclosed portfolios with less granularity and the ability to do bottom-up credit work on those names.

At Chorus, we have a slight bias towards the latter. We like less granular corporate loan transactions because it allows us to do fundamental credit work in addition to understanding the bank and its processes. We can therefore help banks with portfolios that cannot be made granular.

Roughly 40% of our investments are in large corporate loan deals and over 50% are in the more granular SME portfolios, so we appreciate directional macro investments and portfolios where a statistical approach can be used to analyse the risk.

As an investor, we are meant to invest the majority (50%-60%) of our capital in European credit. We have about 20%-25% in North America and the balance across certain countries in the Asia Pacific and the Middle East regions.

However, more important than the geographic spread is the type of portfolios we're taking exposure to. This is probably common for many investors in this space, but we only invest in portfolios that are core to the bank we are partnering with and we call them risk-sharing transactions because we expect an alignment of interest with the originating bank. The portfolio also has to be performing (at the point of origination), where the bank values the relationships and wants to do more business with the borrowers.

Liquidity, on the other hand, is not a concern for us. We raise capital via closed-ended vehicles that typically have a life of seven-plus years, so we're able to invest in long-dated portfolios. At this point in time, we have investments from 3.5 years out to 6-7 years.

We like to have some influence on portfolio selection: this isn't so much about pricing but about shaping the portfolio - the ability to pick certain geographies and industries within the universe of transactions we look at is key. Transactions that diversify our risk effectively are attractive for us and are, in turn, more attractive to our counterparty banks because we price them more efficiently.

We value stable performance and so we target deals with low expected volatility rather than targeting the highest returning deals. We'd rather invest in a safer transaction at a lower price.

Finally, we like to hear that banks are building a platform because it suggests that they intend to become a regular issuer and remain in the market through cycles. We spend a fair amount of time getting to understand a bank and their motivation and objectives, how information is shared internally, as well as how they originate and risk manage their loans. It's a waste if we only ever do one transaction with that bank.

Q: A number of insurers are interested in participating in capital relief trades. Is this likely to be a continuing trend?
TC: We are starting to see insurers looking at capital relief trades not as an investment, but rather as a line of insurance business. There has been relatively little activity in this space for portfolio-based transactions at the moment, but we expect this interest to continue.

Q: The availability and quality of data is a major impediment to executing capital relief trades. How should issuers approach this issue?
OR: Data is definitely an issue. I know of several banks that had to shelve or delay transactions due to the lack of data or poor quality data.

Data requirements will be different depending on whether a deal concerns a pool of granular assets or a pool of large project finance loans, for example. In either case, it will take an originating bank a long time to gather the data.

For a blind pool, where investors undertake statistical due diligence rather than loan-by-loan analysis, they will typically require a whole credit cycle of historical data - ideally representing 10 years of performance. If possible, it needs to be stratified by rating bucket or industry and so on. This is often difficult to produce for banks with legacy IT systems or that are the result of mergers.

One piece of advice for banks considering a capital relief trade is don't wait until the last minute to gather this data because it could take weeks, if not months, to clean it and present it appropriately. If a bank doesn't intend to issue a transaction right now, but it might do in the future, they should already be collecting the data as it comes along and ensuring that their IT systems are set up correctly because it will ultimately save a lot of time.

Q: How do capital relief trades compare relative to simple AT1 issuance?
OR: They are quite different. AT1s would typically be executed at lower coupons than RWA management transactions, so that you could argue that RWA management transactions are more expensive, but by definition AT1 bonds do not contribute to the CET1 ratio. On the other hand, RWA management transactions reduce the denominator of the capital ratio and therefore increase all capital ratios from CET1 to total capital.

From an investor's standpoint, an AT1 investment requires taking a view on the overall solvability of the bank and its ability to maintain sufficient capital over time, so that it does not defer coupons or take write-downs. An investment in an RWA management transaction is much more focused on the performance of a specific portfolio of the bank, so the risks are very different.

KK: From the perspective of banks, these transactions generate capital capacity at the core capital (CET1) level, whereas AT1s by definition only add to total Tier 1 capital. From an investor perspective, risk-sharing transactions generate exposure to a pre-identified portfolio of credit exposures on a bank's balance sheet, whereas AT1s generate exposure to a bank's entire balance sheet, with some subordination provided by CET1.

An investor in CRT trades is exposed only to the credit risk of the portfolio, with minimal counterparty risk. However, an investor in AT1s is exposed to all the other risks (market, operational, regulatory, business etc) that accompany a lending and trading-oriented balance sheet. Coupons on AT1s may be withheld if the bank is sub-threshold on SREP requirements, whereas the coupon on CRT transactions must be paid and may only be adjusted for losses on the tranche that the investor is exposed to.

TC: Capital relief trades and AT1 issuance are in some ways flip-sides of the same coin. A bank that is facing capital constraints can either raise more capital or reduce its risk-weighted assets. In deciding which approach to take, the bank will need to consider the economic costs of each approach.

CS