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A closer look at synthetic securitization

A closer look at synthetic securitization

Upcoming edition of News and Views shows need for synthetic securitisation to help banks unleash more SME financing

Published: 25 May 2016

​​​​The European Banking Authority (EBA) last December issued its report on synthetic securitization that brought needed to insight for EU policymakers to discuss in this important policy debate.  

Contained in its report was a measure of support for the limited extension of the prudential treatment granted to simple, standardised and transparent securitisations (STS) to banks that originate and retain certain synthetic securitisation positions on their balance sheet related to loans to small and medium-sized businesses. That move was notable because it rightfully adds some missing pieces to the European Commission's legislative proposal on securitisation.

It stated that the legislative proposal should be modified so as to extend eligibility to fully cash-funded credit protection provided by private investors in the form of cash deposits with the originator institution provided that specific criteria are fulfilled. Although the amount of transactions under the scope of EBA's recommendation is limited, ESBG definitely sees this as a step in the right direction as it will respond to existing needs.

Synthetic securitization: a definition

Synthetic securitisation is defined in Article 242 (11) of the Capital Requirement Regulation, "the transfer of risk is achieved by the use of credit derivatives or guarantees, and the exposures being securitized remain exposures of the originator institution". In layman's terms it's an insurance policy sought by banks to hedge against risk inherent in their SME loan portfolio.

According to the EBA report on synthetic securitization, synthetic securitization realizes the risk transfer by means of a credit protection contract between the originator (the bank) and the investor, leaving the underlying exposures (the loans) in the hands of the originator and on its balance sheet. The banks seeking to securitise get the insurance they need but keep the loans they have generated.

By using this insurance policy, it helps relieve the regulatory capital requirement that every bank's balance sheet must meet. They serve as a way to free up precious capital that can be used to make more loans for SMEs – the backbone of the economy.

Synthetic securitization and the balance sheet

The real challenge is teasing out what synthetic securitised tranche of loans should be allowed to benefit from the STS framework. The EBA advised on the criteria in its December report, specifying on areas such as under which conditions originator banks may transfer the risk of eligible transactions to buyers – more specifically, public or private investors – to benefit from reduced capital charge. The EBA advised the Commission in that same paper to introduce a list of eligibility criteria that take into account the unique nature of synthetic securitization and to include, among eligible transactions, those in which private investors provide credit protection in the form of cash.

The Commission proposal

ESBG supports the European Commission's proposal to develop criteria for identifying STS. We also share the view that a functioning securitisation market – supplementing bank loans as a main financing instrument – is essential to support economic development, and for providing sufficient credit to companies, particularly to small and medium-sized enterprises. This is especially true where banks require a complementary, functioning market that allows them to boost lending, in the event of higher credit demand by corporate borrowers, beyond their capacity of on-balance-sheet lending within the scope available under the Basel III regime.

The European Commission's proposal excludes, however, an important part of the securitisation market necessary for the banking system to place parts of their credit risk exposure to professional investors: synthetic securitisation. Synthetic securitisations are particularly suitable for this purpose, since they only require comparatively straightforward contractual agreements – and no full transfer of title of the underlying loan receivables, regardless of whether these are not desired for reasons of business policy, or downright illegal. Their exclusion would negatively affect banks whose clients are SMEs preferring bank loans – leading to competitive distortions. Instead, the focus should always be on the benefit of a form of financing for the real economy: the issue as to whether a financing constitutes a STS securitisation should not be determined on the basis of the type of funding alone.

In addition, the proposed reduced risk weights for qualifying securitisation will be considerably higher than today. Even a reduction from 15% to 10% for qualifying securitisation would mean an increase of the floor from 7% to 10% compared to the current situation. Left unchanged, these rules would substantially reduce the incentives for banks to participate in securitisation and consequently undermine the role securitisation could play in funding Europe's real economy

Recasting legislation on synthetic securitization

From an ESBG point of view, including synthetic securitisation in the STS framework, which the EBA report called for, could mean two things for the Commission.  The first option for them is to prepare amendments to the proposal for their inclusion and share them with European Parliament and Council for consideration. The other is to prepare a new legislative proposal.

Broadly supported by ESBG, the EBA's report on synthetic securitization should be further evaluated, however, by the European Commission and subject to a public consultation before being proposed to European legislators.

For this reason, ESBG at this stage considers it necessary to include transitional provisions in the STS Regulation. They would require the Commission to adopt a legislative proposal to define criteria to include synthetic securitisation in the regulation scope on the bases of the EBA report. Our banks think the legislative proposal should not come later than six months after the entry into force of the STS regulation.

Why it's important

Digging deeper into synthetic securitisation, there is a bigger game at play.

It means a lot to SME-focused savings and retail banks who make up ESBGs membership – both now and in the future. As the economy shows more sign of improvement, Europe's small and medium-sized businesses will begin to show growing appetite to expand. Entrepreneurs will muster up the courage to open their own business. As demand swells for financing, Europe's savings and retail banks may not have the necessary capital available to embrace that moment.

So far, banks in Europe has stayed close to home when it comes to converting deposits into loans to feed Europe's real economy. In fact, €500 billion in loans to business are currently on the books, according to recent data put together by ESBG. That's a sizable amount. If policy get it right, synthetic securitisation can help member banks unleash even more SME financing.  If not, expect banks to be handcuffed when trying to expand their loan book to help create the businesses and jobs Europeans crave.

Background on the Commission Securitisation initiative

Adopted on 30 September 2015, the Commission Securitisation initiative contains a package of two legislative proposals. First, a Securitisation Regulation that will apply to all securitisations and include due diligence, risk retention and transparency rules together with the criteria for simple, transparent and standardised ("STS") securitisations. Second, a proposal to amend the Capital Requirements Regulation to make the capital treatment of securitisations for banks and investment firms more risk-sensitive and able to properly reflect the specific features of STS securitisations.

With these proposals, the main objectives of the European Commission are to revive markets on a more sustainable basis so that STS securitisation can act as an effective funding channel to the economy, to allow for efficient and effective risk transfers to a broad set of institutional investors, to allow securitisation to function as an effective funding mechanism for some nonbanks – such as insurance companies – as well as banks and to protect investors and to manage systemic risk. 

For more information, contact:​​

Capital Markets Union; Securities; Capital Requirements Directive and Regulation; Capital Markets; SME finance; European Institutions