For a more in-depth introduction to this complex and evolving topic, our recent report, CRT and SRT trades: an introductory guide for issuers and investors,2 provides an overview of the key issues for originators and investors.
The primary motivation for a bank/originator to enter into CRT transactions is to reduce the amount of regulatory capital that it has to hold against its underlying loans. There may be other drivers, such as managing concentrations of risk to certain sectors/borrowers. From an investor’s perspective, CRT transactions provide attractive risk adjusted- returns and an opportunity for portfolio diversification.
Traditionally, SME and corporate loans have been the main underlying assets for CRT deals, but the market is utilizing this risk transfer technology across other asset classes, including fund finance assets. Within the fund finance asset class, subscription line or “capital call” loans are a particularly attractive asset class for CRT transactions because, on the one hand, they have high risk weights under regulatory capital rules but, on the other hand, there have historically been low rates of default in this product. This presents opportunities for both bank lenders/originators and investors and, indeed, there have been a number of CRT transactions referencing subscription line or “capital call” loans recently. A pool of asset-backed or net asset value (“NAV”) or hybrid loans can also be packaged up using a similar CRT structure.
What are CRT transactions?
CRT transactions typically take the form of credit-linked notes (“CLNs”) issued by the bank/originator or a special purpose vehicle (“SPV”), or fully funded credit default swaps between the bank/originator and the investor(s). In a bank-issued CLN, the bank/originator will issue a CLN off its balance sheet to investors referencing certain underlying assets—the CLN will contain a hypothetical credit derivative or other credit risk transfer instrument that allocates losses on the reference assets between the investors and the bank/originator. In an SPV-issued CLN, there is a credit default swap or other credit risk transfer instrument between the bank/originator and the SPV, with the SPV then issuing notes to investors that reference such risk transfer instrument. In some jurisdictions there may be other structures available, such as bilateral financial guarantees, that achieve the same result.
Broadly speaking, all CRT deals have the following common characteristics:
- The bank/originator will transfer credit risk in respect of one or more tranches of the underlying assets to one or more investors. If an asset in the portfolio defaults or writes down, resulting in a loss to the bank/originator, the investor compensates the bank/originator for that loss (or a portion thereof) if that loss is allocated to the portion of the portfolio that the investor is protecting.3
- Unlike true-sale securitization structures, the underlying assets continue to be legally owned by the bank/originator and the bank/originator typically continues to service the assets as it had prior to the CRT transaction.4
- The proceeds of the underlying assets are unlikely to be used to directly fund the return to the investors—instead the bank/originator pays some kind of fee or coupon for the credit protection. However, the investor has exposure to the underlying assets because they compensate the bank/originator if there are losses
Regulatory perspective
Europe
Given that their central objective is capital relief, CRT trades are fundamentally a creature of regulation. In the EU, there is an established securitization framework and the market has a good understanding of the applicable regulatory requirements on both the issuer and investor-sides, which include risk retention and investor due diligence obligations respectively. However, the European Commission recently launched a consultation (the “EC Consultation”) seeking feedback on a wide range of issues from stakeholders in virtually all areas of the market—including investors, rating agencies, data repositories and even supervisory authorities—to see where the barriers to a deeper, stronger securitization market in the EU are and what quantitative difference removing those barriers could make. The EC Consultation, which closes in early December, offers the EU CRT market a rare opportunity to push for real change at the prudential and regulatory level.
U.K.
The regulatory landscape in relation to CRT in the U.K. has remained relatively similar to that in the EU since Brexit but we are starting to see some divergence. At the time of writing, developments in the U.K.’s securitization regime are largely form over substance but there may be more substantial divergences between the U.K. and EU regulatory frameworks in years to come. The U.K.’s Prudential Regulation Authority (the “PRA”) launched its own consultation (the “PRA Consultation”) hot on the heels of the EC Consultation. Amongst other changes, the PRA declared a policy change to permit wholly unfunded CRT transactions, bringing the U.K. position into line with the EU on this point. One of the key existing differences between the EU and the U.K. securitization regulations at the moment is the ability for EU originators to obtain additional capital relief if they are able to satisfy the requirements for “simple, transparent and standardized” (or “STS”) securitizations. Currently, there is no STS regime for synthetics in the U.K. and to judge from the PRA Consultation there are no imminent plans to introduce one.
United States
Any U.S. bank looking to execute a CRT transaction may have to navigate a number of legal and regulatory issues, such as the Volcker Rule, the Dodd-Frank Wall Street Reform Act and potentially insurance recharacterization risk to name a few. The nature of the regulatory issues will depend on the structure of the CRT transaction.
The regulatory capital landscape in the U.S. is also more nuanced than it may be in the EU/U.K.. In the U.S., bank capital rules are codified in Regulation Q (Capital Adequacy of Bank Holding Companies, Savings and Loan Holding Companies, and State Member Banks) (“Regulation Q”).5 On September 28, 2023, the Federal Reserve Board (“FRB”) released certain FAQs on the use of CLNs under Regulation Q. The FAQs provide that properly structured CLNs issued by SPVs are capable of being synthetic securitizations under Regulation Q and that the related collateral is capable of being a credit risk mitigant that can reduce the bank’s capital requirements under Regulation Q. The FAQs also provide that CLNs directly issued by banks do not satisfy the requirements of a synthetic securitization under Regulation Q. However, the FRB has stated in the FAQs that directly issued CLNs may be capable of achieving capital relief under Regulation Q if the FRB grants relief under its reservation of authority powers. Where the FRB has granted relief to a bank under its reservation of authority, it has generally provided that the relief applies to all substantially identical bank issued CLN transactions up to an aggregate outstanding reference portfolio principal amount of the lower of the bank’s total capital or USD20 billion.
Basel framework
Over-arching the local rules applicable in each jurisdiction is the implementation of updates stemming from the internationally agreed principles of the Basel Framework. The latest set of changes, known as Basel 3.1 in Europe and the U.K. and Basel Endgame in the U.S., is at various stages of implementation across the globe. While there remains a degree of uncertainty as to final implementation in most jurisdictions, Basel Endgame is a particularly hot topic in the U.S. As has been well documented, the U.S. bank regulators have proposed significant changes to the U.S. bank capital rules. The original proposed rule changes from July 2023 would have significantly increased the capital requirements for the largest U.S. banks—some estimates suggested the capital requirements of each of the largest U.S. banks would increase by 19% under the proposal. On September 10, 2024, FRB Vice Chairman Barr announced that the U.S. bank regulators intend to publish a “watered down” version of the proposed rule but there is significant uncertainty regarding the timing and substance of any re-proposal for a variety of reasons, including the outcome of the recent U.S. election. It therefore remains to be seen what impact any reforms will have on the U.S. CRT market.
Market developments
EU and U.K.
In recent years issuance has climbed steadily both in terms of numbers and volume of deals.6 In particular, the European market is thriving, with issuances strongly increasing by volume and number of trades, and the outlook remains positive in the U.K. too. Recent market estimates have predicted that risk transfer transactions will be a USD200bn market in Europe by the end of 2024, up from USD189bn in 2023.
As mentioned above, there is a sense that the EU’s policymakers are genuinely keen to unleash the potential in Europe’s securitization market and market participants wait with interest to see how this plays out and whether the EC Consultation will lead to significant, tangible change. In recent years, more first time originators have come to market while established originators are coming to market more frequently than they were even five years ago—indeed numerous originators now even have CRT programs to streamline issuances. Originators used to be based predominantly in western and southern Europe, but the market is now flourishing in CEE and the Nordics as well. We expect to see increased issuance from both established and new originators in the years to come.
The U.K. is home to a significant number of experienced originators and investors. It remains to be seen what effect, if any, post-Brexit divergence will have on this market in the long term but there is no suggestion that market appetite will diminish any time soon.
United States and Canada
The nascent U.S. market has, given the FRB’s regulatory clarity and U.S. banks’ responses to the regional banking crisis in 2023, grown steadily in the last couple of years. There are now established U.S. bank CRT issuers and a variety of regional banks are also utilizing CRT transactions.
There is growing confidence and optimism in the U.S. that CRT transactions can increasingly become a widely used tool for capital management across the full spectrum of banks, from U.S. GSIBs to regional banks, supported by a broad pool of investors interested in this market and an expanding range of underlying assets. There is also hope that new market participants (e.g., insurers) may enter the U.S. CRT market as investors, however certain changes would be required to allow for that under the current U.S. regulatory landscape. A key factor in the development of the U.S. CRT market will be how the proposed reforms to the U.S. regulatory capital regime unfold in the future.
Canada has also seen strong issuance in the last two to three years, with numerous established issuers and several new banks issuing CRT transactions on a variety of assets in the last 18 months.
Fund finance
As the CRT market has grown globally, participants have frequently sought to reference subscription lines and other fund finance assets, with reports of further deals in the pipeline. Indeed, historically low defaults and conservative borrowing rates on subscription line loans mean that portfolios of these assets represent particularly attractive collateral for end investors in CRTs. For investors without the infrastructure to originate fund finance loans, CRTs can also offer exposure to the market at an attractive risk versus return profile with steady cashflows in today’s higher interest rate environment—typically a fixed spread over a floating rate for tenors of up to seven years.
The rapidly expanding NAV loan market has the potential to present similar opportunities. Although the private nature of the NAV financing market means that data on performance is hard to verify, the combination of typically low LTVs (except for credit funds), more mature assets with a proven track record and diversification of collateral, together with higher spreads, presents a compelling investment opportunity via CRT trades for the right assets. In addition, recent moves towards greater transparency and dialogue between parties in NAV financings via the Institute of Limited Partners’ (“ILPA”) NAV-Based Facilities: Guidance for LPs and GPs, as well as, for example, Fitch and KBRA’s rating methodologies, are pushing the market towards a greater understanding of different NAV financing structures, underlying assets and associated risks, which are fundamental to undertaking a successful risk transfer trade. Ratings in particular have the potential to accelerate the growth of CRTs referencing NAV facilities.
Footnotes
1. This bulletin uses the term CRT for the sake of simplicity. CRT is currently the predominant term used for this product in the U.S. Market participants in Europe and the U.K. tend to prefer the term “SRT” (i.e., significant risk transfer) although some use SRT and CRT interchangeably. In Europe and the U.K., “SRT” is a technical term for a certain form of capital relief, although it is often used colloquially for any type of credit risk-sharing trade regardless of the actual capital treatment. We also see similar labels for this type of product, such as “synthetic risk transfer”.
2. CRT and SRT trades an introductory guide for issuers and investors.
3. Splitting a portfolio of loans into “tranches” (effectively slices of credit risk) for these purposes means determining the order in which losses are allocated. By way of example, if a bank retains the credit risk on the junior and senior tranches of a portfolio while an investor sells credit protection on the mezzanine tranche, no losses will be allocated to the investor until the losses exceed the size of the junior tranche. The investor will then bear the credit risk on any further losses suffered in respect of the portfolio of loans until the aggregate amount of losses exceeds the size of both the junior and mezzanine tranches, at which point the bank will suffer the losses.
4. While it is possible in some jurisdictions to do a CRT transaction using a true-sale securitisation, this bulletin focuses on those structures that provide an indirect exposure to the underlying assets. In a true-sale securitisation, the bank will sell the entire portfolio of loans to an SPV, which will then issue CLNs referencing that portfolio.
5. 12 C.F.R. Part 217. Note that the Federal Reserve’s capital adequacy requirements are found in Regulation Q. Banks supervised by the FDIC or OCC must comply with very similar capital requirements under 12 C.F.R. Parts 324 or 3, as applicable.
6. In 2023, banks, working with investment funds, pension funds and credit insurers, executed 89 synthetic CRT securitisations globally, protecting EUR18.5bn in first loss and mezzanine tranches in underlying pools of loans worth EUR207bn, according to the IACPM’s latest synthetic securitisation survey on CRT transactions. The protected amount is higher than in 2022 when banks participated in CRTs covering EUR16.3bn of first loss and mezzanine tranches in underlying pools of EUR213bn assets. Source: International Association of Credit Portfolio Managers.
