Following their consultation last August the EBA has just published the final draft regulatory technical standard (“RTS”) on the capital treatment of synthetic excess spread.
Although a seemingly exceedingly dry and technical subject, the impact of this paper on the European banking industry should not be underestimated. In the last few years, synthetic securitisations have become a key capital management tool for an increasing number of European banks. Without such a tool, the risk of the exiguity of bank capital, in the near future, constraining the credit available to European borrowers was substantial. The regulatory treatment of synthetic excess spread was likely to play a key part in the availability of this tool, especially for asset classes with higher default rates but higher yields.
PCS has yet to read with care the entire RTS, but our preliminary take is that the EBA has allowed a derogation from capitalisation for synthetic excess spread that is the lesser of the actual cash excess spread generated from the securitised assets and one-year expected loss.
This is a sensible result for which the EBA should be commended. First, PCS has always accepted that synthetic excess spread can be abused to provide disguised credit support. Therefore, capitalisation of excess spread at some level has always been a legitimate prudential requirement. But if the excess spread contracted in the synthetic securitisation is less than or equal to the excess cash generated by the assets, there can be no disguised credit support since the issuer is only providing the investor with the benefit of cash it actually receives. It is an uncontroversial fact that banks need not allocate capital against revenue.
The RTS also provides for a cap on the amount of synthetic excess spread that can benefit from the derogation equal to one-year's expected loss. This reflects the STS criterion and thus avoids what could otherwise have been a perverse result of tilting the field in favour of non-STS securitisations.
Finally, the RTS allows grandfathering of existing trades, avoiding an unnecessary dislocation in the banking sector's capital management.
So, by exempting synthetic excess spread below actual cash received from capitalisation (up to one year expected loss) but capitalising anything above, the EBA has provided, in our opinion, the right balance between meeting legitimate prudential principles and not unduly punishing equally legitimate uses of actual excess spread. In our estimation this sophisticated and grounded approach should allow synthetic issuance to grow whilst avoiding the possibility of abuse.
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