What Is CRS?
In this section we briefly outline:
- What credit risk sharing is
- What purpose CRS serves for banks
- How CRS transactions work structurally
- What the difference is between CRS and so-called true sale securitisation
The purpose that CRS serves for investors is explained in detail here.
What is CRS
In a CRS transaction, a bank buys credit protection on a portfolio of loans from an investor. This means that whenever loans in the portfolio default, the investor reimburses the bank for the losses incurred on those loans up to a maximum aggregate, which is the amount invested. This amount therefore provides credit protection for a slice of the portfolio, which is often called the ‘first loss tranche’. The size of this tranche is typically chosen in a way to cover at least the expected losses on the portfolio as well as a share of unexpected losses. The bank usually retains the rest of the risk, which is called the ‘senior tranche’. A common variation on the above structure is that the bank retains a relatively small first loss tranche of the loan portfolio and buys protection on a so called ‘second loss’ or ‘mezzanine’ tranche from the investor.
During transaction negotiations, the bank and the investor(s) agree on the terms of the transaction, such as the amount the investor is at risk for, the duration of the contract and the loans that are eligible for inclusion in the portfolio. Choosing which loans are eligible can be on a disclosed basis, where the investor knows the exact names of the borrowers, or on a blind pool basis, where the investor does not know the identities of the borrowers. In the latter case the loans are chosen based on a pre-defined set of criteria, such as the type of loans, sector, geography, credit risk, et cetera. Transaction structuring is discussed in more detail here.
In addition, any investor in a CRS transaction will conduct a thorough qualitative and quantitative due diligence of all the relevant aspects of a CRS transaction, which was already commonplace prior to it becoming a requirement under the Securitisation Regulation. This includes gaining an understanding of the nature of the loans in the portfolio, reviewing a bank’s underwriting, monitoring and workout processes related to the relevant lending books, as well as scrutinising the bank’s internal models and historical performance data. This due diligence will enable the investor to get a detailed understanding of the risks inherent to the transaction and price that risk accordingly. Due diligence considerations are discussed in more detail here.
CRS is a form of securitisation also known by its technical term of ‘balance sheet synthetic securitisation’. Securitisation is a technique to allow investors to participate in a portfolio of loans by pooling these and then creating securities for one or more different ‘tranches’ (levels of risk) to suit the purpose of the bank and the preferences of different investors. The ‘first loss’ or ‘equity’ tranche, as the name implies, covers the first losses to occur in the loan portfolio. It therefore has the highest risk, but it will also generate a commensurately higher premium. The ‘senior’ tranche on the other hand only covers losses after the first loss tranche and any other ‘mezzanine’ tranches have been exhausted. The senior tranche is therefore the least risky and also has the lowest premium.
The term ‘synthetic’ comes from the fact that, unlike in a true sale or ‘traditional’ securitisation, the loans being securitised are not sold by the bank but are referenced, which means they remain on the bank’s balance sheet. This way, the bank reduces the credit risk on the securitised loans and remains in charge of managing the loans and the lending relationship with its clients. Synthetic securitisations are often used for hedging the credit risk on loans that cannot easily be sold. Examples are revolving credit facilities, SME lending and trade finance, as these credit facilities often require a large amount of operational handling that a bank is uniquely set up for and which cannot easily be taken over by a non-bank.
The term ‘balance sheet synthetic securitisation’ is included to indicate that the securitised loans remain on the bank’s balance sheet. The technique of synthetic securitisation can also be used to buy credit protection for assets that the buyer does not actually own; these transactions are called arbitrage securitisations. Arbitrage securitisations are not a hedge for the assets of the protection buyer and the benefits for the investor that come from the fact that the bank retains ownership of the securitised loans are not applicable to arbitrage securitisations. Among others for this reason, we do not invest in arbitrage securitisations, but only in balance sheet synthetic securitisations.
Purpose of CRS
CRS is an effective method for a bank to manage its credit risk and associated capital. In a CRS transaction, typically the first loss tranche is transferred to the investor, while the bank retains the remainder of the risk. The amount invested is typically larger than the amount of capital the bank would be required to hold for that portfolio. Because the securitisation offers a close to perfect hedge, the bank has covered materially all risk of potential non-payment of the loans in the portfolio and can therefore benefit from capital relief for those loans.
This freed up capital can then be recycled in order to provide additional lending to real economy clients ranging from individuals to SMEs and large corporates. In addition, by reducing the risk on a bank’s balance sheet and sharing that risk with investors outside of the banking system, CRS increases resilience of banks and thereby contributes to a more sustainable financial system. Finally, the scrutiny associated with a thorough due diligence on a bank’s lending processes, conducted by investors who have reviewed many of the world’s leading banks, can provide a valuable outside perspective on the quality of a bank’s processes and where improvements can be made.
For an investor, CRS provides access to unique and diversifying credit exposures, originated and monitored by leading credit institutions, with an attractive risk-return profile and stable cash flows. We discuss this in more detail here.
CRS is a developing asset class and is still relatively unknown. Due to this unfamiliarity, we often hear the concern that CRS transactions are complex. This is not entirely unjustified as the legal mechanism of the credit risk transfer of synthetic securitisations can be structurally intimidating and difficult to fully grasp at first sight. Because of this, we take the appropriate structure for each transaction into careful consideration (see the section Transaction Structuring for detail).
That said, we believe that CRS is conceptually quite simple: an investor takes credit risk on a selected portfolio of loans from a bank up to a pre-agreed amount. For this credit risk the investor gets a commensurate compensation in the form of a periodic coupon payment. In its essence, this is all there is to it.
The figure below shows the typical outline of a credit risk sharing transaction. Together with the bank, we agree on a selection of loans from a particular lending book on the bank’s balance sheet that is eligible for the risk sharing portfolio. In the figure below an example is displayed for an SME lending book of a bank (left side of the figure). Of this loan portfolio (in the example a € 5 billion selected loan portfolio), we typically invest in the first loss tranche and the bank retains the senior tranche. This is illustrated in the right hand side of the figure. In addition, we ensure there is a strong alignment of interest. We structure this by requiring the bank to continue to hold at least 20% of the total exposure to the credit risks covered by the credit risk sharing. In other words, the bank can only hedge up to 80% of its total exposure to its client. This way, both parties are aligned when any loan in the transaction faces potential payment failure.
CRS vs true sale securitisation
CRS works differently and generally serves a different but complementary purpose compared to true sale securitisation. When a bank grants a loan to a client, it requires both the actual cash to pass on to the borrower (funding), as well as capital to cover for the risk of potential non-payment by the borrower.
In a true sale securitisation, the bank sells a portfolio of loans to a Special Purpose Entity (“SPE”). All income from those loans is then received and owned by that SPE. By selling the loans, the bank receives cash (funding) at the closing of the transaction. The bank usually retains the first loss tranche, and therefore basically all credit risk associated with the loans. The investor usually only bears the risk on the less risky senior tranche. This way the bank benefits from access to attractively priced funding.
As stated above, in a CRS transaction or balance sheet synthetic securitisation, the first losses are transferred to the investor, and with it, virtually all credit risk on the underlying portfolio. However, as the loans are not sold, the only payments a bank receives are make-whole payments for when a loss occurs in the portfolio. Consequently, a CRS transaction is primarily used for credit risk hedging and capital management purposes; not for funding purposes. The following table highlights the key differences between true sale and balance sheet synthetic securitisation (CRS):