Demonstrating significant risk transfer discussed

How to demonstrate significant risk transfer (SRT) was a hot topic at SCI's Capital Relief Trades Seminar last month. Panellists discussed the importance of having robust governance and risk management processes in place, as well as what to avoid when preparing to execute a capital relief transaction.

Articles 243 and 244 - which correspond to traditional (cash) and synthetic securitisations respectively - are the relevant sections of the CRR to consider when demonstrating significant risk transfer, according to Ramnik Ahuja, director in the bank treasury team at Deloitte. "They cover mechanistic tests, such as how much of a tranche is required to have been transferred to third parties," he explained. "If the capital structure of the transaction includes mezzanine tranches, at least 50% of the risk-weighted exposure amount associated with mezzanine tranches needs to be transferred. If there are no mezz tranches, then at a least 80% of the first loss tranches must be transferred, where the first loss tranches refer collectively to those that are either 1250% risk-weighted or deducted from capital of the originator."

Jeroen Batema, ceo, Open Source Investor Services, stressed that proving significant risk transfer means defining what risk is actually being transferred and demonstrating that robust models have been employed across the entire life of a deal, including the impact of prepayments and downgrades and so on. "Please leverage on your stress test and IFRS lifetime allowance framework and include the guys within your institution preparing these statistics as early in the process as possible," he said.

Executing a capital relief transaction is a long and resource-heavy process. To prepare, Steve Gandy, md, global head of ARCO notes and structuring at Santander, recommended that the various issuer stakeholders (risk management, capital, treasury, accounting, operations) are linked up - each with their own expertise - so that they all understand how an SRT transaction works and how it impacts the securitised portfolio.

"It is important to have a good governance process that defines internal committees who have sign-off, how far up the chain it goes and how much involvement risk managers need," Gandy added. "Be careful to identify and avoid any aspect of the deal that could be construed as implicit support by the originator, especially in the area of clean-up call options. Equally, be careful not to include provisions that obligate the originator to reacquire losses on any impaired assets."

The concept of commensurate risk transfer is another aspect to be aware of, as this is increasingly being considered by regulators across Europe. Ahuja suggested that there are three key elements at the heart of demonstrating commensurate risk transfer: the institution's understanding of risk (in other words, an issuer's own existing risk management processes need to be demonstrated robustly); consistency of internal capital and risk assessments (what is the issuer's own view around economic capital and how it has measured the risk associated with the assets); and economic substance of the transaction (ensuring that features such as call options, protection coupon and portfolio yield are taken into account).

While the UK PRA focuses on commensurate risk transfer, other regulators focus on different nuances of the rules, leading panellists to call for a consistent approach to capital relief trades across Europe. In particular, Gandy pointed out that a methodology for estimating expected and unexpected losses for standardised portfolios is necessary, as there is no specification in the CRR.

"The industry needs guidelines for defining worst-case scenarios, for which originators must demonstrate an adequate level of protection. A consistent approach is necessary to reduce the arbitrage that currently remains between jurisdictions," he suggested.

Regulatory calls appear to be another controversial issue. The panellists agreed that further clarity is needed around whether an originator has the right to call a deal if it is no longer rated or no longer achieves accounting derecognition, or if a regulator changes its mind about whether capital relief is achieved.

The EBA is due to release a report in 2017 on different practices observed in transactions claiming significant risk transfer, with the aim of establishing guidelines that it is hoped will provide more consistency. The authority is expected to focus on six major issues, including whether time calls are permitted and when, and in which circumstances synthetic excess spread can be used to cover losses.

Batema noted that he favours principles-based over rules-based practices because each capital relief transaction is different. He added that the European Datawarehouse initiative should be embraced by the capital relief trade community, as its data templates facilitate harmonisation, and further he encouraged standardisation of documentation.

CS