In Practice: US SRT Structures Require Cross-Practice and Cross-Geography Legal Expertise
Market outlook
SRT involves transferring credit risk on pools of loans from financial institutions to third parties, such as credit funds, pension funds or, more recently, insurers, through swaps, credit-linked notes, risk sharing agreements or insurance policies. These transactions are used by banks and other regulated entities as a strategic tool for managing risk, achieving capital efficiency and raising funding. Prospective capital charges under the reforms proposed by the Basel Committee for Banking Supervision (Basel) are increasing incentives to issue in the US, while the various bank collapses seen during 2023 are also expected to push smaller players to engage.
It is expected that the return of large US banks to the SRT market as seen at the end of 2023 and beginning of 2024 will trigger additional growth and bring other protection sellers to the market, in addition to the traditional funds which have been investing in synthetic securitisations for several years. Given regulatory uncertainties in the US and the fact that US deals often involve thicker tranches, US deals require additional structuring in order to achieve the desired economic return and law firms are recognising the importance of assembling interdisciplinary teams to provide comprehensive advice to market participants navigating this less well-charted territory.
One of the main regulatory uncertainties relates to the Basel capital burden to be applied to US banks. Although regulators unveiled an aggressive proposal in July 2023 (which would require certain lenders to hold up to 16% more capital), certain Federal Reserve Board Governors in March 2024 suggested that the final Basel Endgame implementation could depart significantly from the July proposal. While this would potentially lessen any increased capital charges on banks, this is not expected to reduce US bank activity in the market.
SRT structures in the EU and the UK
In Europe, SRT has been increasingly used as a capital management tool over the last five years, including by small banks using a standardised risk model. In the days after the 2007-2008 financial crisis, when such transactions were still regarded as niche, originating banks had adopted a structure whereby the bank would transfer the default risk of the portfolio of credit exposures to a special purpose vehicle (SPV) set up by the bank. This SPV would issue credit linked notes (CLNs) to investors to raise cash in order to collateralise its credit protection obligation. The SPV structure has now been largely replaced in the EU and the UK with more banks proposing directly issued CLNs. Direct issuances are more straightforward to implement and, in their more common unsecured format, provide immediate funding benefits. While the SPV structure is still in use, it has been relegated to instances in which the credit risk of the bank appears weaker.
SRT structures in the US
In the US, SRT structures seem to have come full-circle in a short amount of time. Under the capital regulations, a synthetic securitisation must use financial collateral, an eligible guarantee or an eligible credit derivative as the credit risk mitigant. The Federal Reserve Board clarified in its FAQs published in September 2023https://www.federalreserve.gov/supervisionreg/legalinterpretations/reg-q-frequently-asked-questions.htm. that SPV CLNs are effective in achieving SRT and considered whether directly issued CLNs would satisfy regulatory capital requirements in all circumstances. The terms of directly issued CLNs often refer to a hypothetical derivative contract but there is no actual credit default swap contract that is entered into as part of the transaction. Further, while the bank issuer receives the cash proceeds from the CLN issuance, it does not technically meet the requirement that the transaction use financial collateral, an eligible guarantee or an eligible credit derivative as the credit risk mitigant. However, the Federal Reserve Board has indicated that it is willing to recognise directly issued CLNs for capital relief on an ad hoc basis through a “reservation of authority” process. The Board has already done this for certain banks subject to specific conditions and caps on the aggregate notional amount of portfolios across SRT transactions. As a result, any directly issued CLNs will have to be considered on a case-by-case basis by regulatory counsel to ensure that credit risk is effectively transferred. Banks will therefore need to ensure that aggregate portfolios across deals stay below the cap, which can be a challenge for banks with large balance sheets. As a result, US market participants may prefer a structure using a credit default swap (CDS) between the originating bank and an SPV set up by an investor, with the SPV getting funding in order to collateralise the CDS either by issuing CLNs to the investor’s funds and other third parties, or receiving other forms of financing.
SPV-issued CLNs raise multiple regulatory and tax concerns, for example relating to the Commodity Futures Trading Commission (CFTC) rules (often an issue in transactions which do not contain replenishment mechanics permitting the bank to add new risk exposures over time as the initial exposures amortise), potential registration by the asset manager of the SPV as a commodity pool operator, margining requirements, conflicts of interest rules, the Volcker rule and US tax considerations relating to the nature of the risk transfer instrument. These multiple issues are often considered by legal counsel in cross-practice teams to ensure the transaction structure complies with regulations.
Cross-border considerations
In addition to the various regulations which may be applicable in the US and associated compliance requirements, advice from legal counsel with experience in UK and EU SRT, and trans-Atlantic dialogue between regulators, is also crucial. The lessons learned during years of structuring risk transfer transactions in the EU and UK will save invaluable time in responding to US prudential regulators seeking to address concerns around the strength of risk transfer and protection obligations warranting capital relief, including in light of termination rights and the importance of maintaining the economic efficiency of the transaction for both banks and investors.