Don't Let Basel III Endgame Trap You: Free Up Capital with SRTs for Large Exposures
Attract investment, target risk, and stay ahead of regulations
Problem: Basel III Endgame via CRR3 tightens regulations, limiting lending capacity and capital. Equity issuance is expensive.
Solution: Significant Risk Transfers (SRTs) offer a way to optimize balance sheets. Attract capital without issuing shares and directly target concentrated risk.
Time is Now: Get ahead of CRR3's output floor phasing in from 01 Jan 2025.
Proven Tool: SRTs are established for managing credit risk. They free up capital for lending and growth.
Beyond Granular: SRTs can handle concentrated portfolios too. Diligent underwriting unlocks new investor pools.
Future-Proof: Proactive risk management with SRTs is crucial in a volatile environment.
Significant Risk Transfer (SRT) transactions are now accepted as integral tools for banks in managing their credit risk and capital requirements. As the overall regulatory environment tightens, these instruments offer banks a means to optimise their balance sheets. This allows greater lending capacity while adhering to prudential regulations and protecting depositors from risk. This article explores the unique considerations for SRTs with concentrated portfolios versus granular portfolios, highlighting the importance of underwriting and long-term asset class appetite. We also discuss the implications of phasing in CRR3 for European banks, and its impact on the existing regulatory landscape for SRTs.
Wasted effort? Regulators must act to align CRR3 with their evident favour towards SRTs
European regulatory authorities have spent considerable time and effort over the past decade drafting and calibrating securitisation regulations since the implementation of Basel III via the Capital Requirements Regulation (CRR) in 2013. 2017’s Securitisation Regulation has been regularly complemented through additional regulatory technical standards and guidelines from the EBA resulting in a broadly complete regulation by the end of 2023[i]. However, the phase-in of CRR3 implementation from 1 January 2025 – in particular the output floor – is set to force a recalibration of these regulations to avoid impacting European banks’ access to external capital from SRTs.
Several competing factors in the final version of CRR3 mean that there is again an element of uncertainty for banks in the SRT market until the output floor is fully phased in from 1 January 2030. The output floor has primarily been designed to mitigate potential modelling risks arising from IRB models of banks underestimating the risk of loans in severe economic events by mandating a minimum overall capital requirement for the bank based on the standardised risk weighting model (SA). This complements the existing leverage ratio requirements which mandate a minimum capital level based on fully un-risk-weighted assets.
There is a clear political willpower to resolve this headwind. For example, one of the CRR3 transitional arrangements[ii] cuts the p-factor (the “non-neutrality factor”)[iii] in half to the end of 2032 when computing the output floor contribution of an internal ratings-based (IRB) securitisation. This was a relatively late addition to the CRR3 text confirming a clear recognition of the issue. Taking into account the overall impact of the output floor on SRT efficiency, making this change permanent and extending it to pure SEC-SA transactions would resolve a key market concern at present.
Attracting investors to take equity risk away from depositors
The EBA and ECB consistently highlight the need to provide consistent and fair regulations with regards the securitisation market to attract private capital to the European banking ecosystem. Deposit-taking banks are not natural holders of equity risk given their obligation to protect depositor funds. The EU is effectively – though not explicitly – lender of last resort via its member states and harmonised deposit guarantee schemes. Thus, investment from non-banking entities into bank-held risk has a clear economic incentive to European regulators.
The equity issuance market for European banks remains challenging, and not a realistic option for many institutions. Average price-to-book values for listed European banks have recently shown improvement since Q4 2023 to c.0.8x following several years of stagnation at between 0.3x and 0.6x, though remain severely lagging their US-peers[iv]. Additionally, in the current high-rate environment AT1, T2 and TLAC issuances are more expensive now than at any other point since the implementation of the current capital stack. SRTs remain one of the few viable broadly available options for banks to improve their overall capital position without downsizing lending volumes or closing off other potential revenue streams. They also benefit from precise provision of capital and risk sharing to target assets as opposed to capital issuances requiring the implicit underwriting of the entirety of a bank’s balance sheet.
Learning from history?
Despite this backdrop, securitisation regulations up to present remain too conservatively calibrated. This is understandable from a political perspective with the after-effects of the global financial crisis (GFC) from 2007 still being felt today. However, outside of US sub-prime CDOs, senior securitisation tranches of any kind have only extremely rarely suffered losses. Loan underwriting standards – or lack thereof – played a major role in the GFC, and generally lessons have been learned from this across European banks. The push towards data transparency and integrity through innovative technologies and solutions helps further mitigate this sort of esoteric risk, noting however that no system can be entirely infallible.
The Simple, Transparent and Standardised (STS) securitisation standards designed to reward such an approach with lower capital requirements are helpful to an extent, but again suffer from an overly conservative implementation. STS reporting requirements require banks to establish a new reporting function, involving a not insignificant amount of cost and complexity to an already burdensome process. Additionally with certain aspects of STS regulation still to be formally adopted by the European Commission, there is a risk that certain elements of drafting may be revised so banks would have to rely on the implementation of grandfathering provisions to ensure ongoing eligibility for STS treatment.
Banks shouldn’t ignore risk mitigation potential for concentrated portfolios
Current regulations are not particularly sensitive to portfolio granularity, with the SEC-SA risk weighting formula not even including granularity as a variable and sensitivity in the SEC-IRB approach often outweighed by other factors. Regulatory authorities have the ability to not grant SRT recognition for portfolios which are overly concentrated or have significant correlation risk, but for the most part granularity is rather an economic underwriting consideration for investors in SRTs.
While SRTs are generally executed on more granular portfolios, this opens the door for banks to explore SRTs on their larger exposures resulting in more concentrated portfolios. Due diligence on such portfolios is then more reliant on traditional loan underwriting from a long-term perspective rather than statistical analysis of a broader pool. In turn, this expands the available pool of capital beyond specialised SRT investors to long term investors. Investment into concentrated portfolios can therefore be more focused on economic risk transfer rather than regulatory arbitrage, which should also help increase regulatory comfort with such transactions. While diversification in an asset pool can provide a certain risk and pricing benefit for SRT investors, diligent underwriting can unlock the same benefit on more concentrated portfolios.
From a bank’s perspective, being able to manage risk effectively on their more concentrated positions through the market cycle is of critical importance. Indeed, there have been several recent risk events for banks resulting from single concentrated borrowers, but relatively few resulting from correlated risks in granular portfolios given their inherent diversification benefits. Directly reducing concentration risk through a targeted approach such as an SRT would help free up risk limits for additional lending, thus generating additional revenue and helping the bank achieve its natural function of allocating capital to the economy to drive growth.
SRTs have earned their place as one of the key tools for banks to optimize their balance sheets and risk management of lending portfolios. So far, SRT portfolios have predominantly been granular with concentrated loan risk being retained by banks. However, the investor universe has evolved and is now better placed to provide the meticulous underwriting and bespoke solutions required of concentrated risk. As CRR3 phases in, the regulatory landscape will evolve to continue to promote SRTs. In an increasingly volatile macro and geopolitical environment, banks must proactively manage all parts of their balance sheets using precise and bespoke solutions.
Contributing authors: Thomas Chambers & Ruben Figueiredo
Primary Contact Details: +44 (0) 203 872 1682 / TChambers@akinngroup.com
[i] All planned regulatory technical standards and guidelines have been drafted by the EBA and submitted to the European Commission for adoption into law, aside from STS guidelines for on-balance-sheet securitisations which remains under development.
[ii] CRR3 Article 465(7)
[iii] The p-factor is broadly intended to introduce correlation risk to regulatory risk weight models for securitisations through increasing tranche risk weights compared to the underlying portfolio.
[iv] ECB Financial Stability Review, May 2024