The European Banking Authority has just launched a consultation on the treatment of "synthetic excess spread" or "SES".
The issue of the capital treatment of synthetic excess spread in the context of synthetic STS securitisation is a topic that is as arcane as it is important.
We will not review here the arguments and possible approaches as this would take way more space that is appropriate for a news item. To summarise, though, in a synthetic securitisation the originator and the investor can agree to an amount which will be deducted from any losses suffered on the securitised pool before the investor is required to make a protection payment. This is designed to replicate synthetically the effect of "excess spread" in a cash deal, where a lender does not suffer real cash losses if the interest paid on performing assets is sufficient to compensate for losses on the defaulting assets. Since this amount is just an agreed number (rather than, as in a cash deal, the actual cash received from borrowers) it is called "synthetic excess spread".
Synthetic excess spread is controversial and viewed with suspicion by regulators as it can, in theory, be used to generate regulatory arbitrage.
During the passage of the amendment to the Securitisation Regulation that ushered in synthetic STS, some voices were raised advocating the banning of any use of SES in STS synthetic transactions. Many, including PCS, argued that this was unnecessary and illogical since the device, properly deployed, only replicated synthetically a totally uncontroversial aspect of true sale securitisation. The compromise chosen by the legislators was to allow it but impose a capital cost on its use. We expressed the view at the time that this was the wrong answer and that a perfectly good answer had been suggested by the EBA itself in its original report which we were happy to endorse. But there we are.
Having chosen the solution of a capital cost for the SES, the legislators then left it to the EBA to come up with an amount. This consultation, deadline 14 October, solicits the market's views on the proposed EBA approach to calculating that amount. PCS will, of course, be responding.
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