Synthetic Securitisation

A synthetic securitisation is a financial arrangement in which a bank retains ownership of a portfolio of loans or assets but transfers the credit risk associated with specific portions of that portfolio to external investors. In contrast to traditional securitisation, synthetic securitisation involves the transfer of credit risk alone, without the investor assuming market risks associated with the underlying exposures - such as interest rate discrepancies retained by the originating bank. As the reference assets remain on the originator’s balance sheet, there is no requirement to affect a legal transfer to a Special Purpose Vehicle (“SPV”), thereby avoiding the need to address contractual transfer restrictions. This structure not only reduces transaction costs but also facilitates faster execution. Consider a scenario in which a bank holds a portfolio comprising 2,000 consumer loans. In a standard synthetic securitisation arrangement, the bank may retain the initial exposure by absorbing the first 10 defaults. The subsequent layer of risk - covering the next 190 defaults - can be transferred to external investors, who assume this tranche in return for a risk-adjusted return. Any losses exceeding this 200-loan threshold would revert to the bank, which continues to bear the residual risk. This structure allows the bank to manage its risk exposure and regulatory capital more efficiently without selling the underlying assets.

Synthetic securitisations gained traction in the early 2000s, peaking in popularity just before the 2008 global financial crisis. Between 2008 and 2011, activity in the European synthetic securitisation market slowed significantly, with only a limited number of deals taking place. The initial surge in synthetic securitisation was largely influenced by the introduction of stricter capital requirements under the Basel III framework. In response, banks began exploring various strategies to manage their loan portfolios, which were increasingly burdened by high capital charges. Since 2020, the market has seen even stronger momentum, driven by broader regulatory endorsement of synthetic securitisation structures and the associated capital relief benefits for banks. Growth has been particularly robust since 2021, following the inclusion of synthetic securitisations within the Simple, Transparent and Standardised (“STS”) framework.

Under the STS framework, synthetic securitisations must meet a defined set of criteria to qualify for preferential regulatory treatment. These include requirements related to simplicity, standardisation and transparency, as well as additional safeguards specific to synthetic structures, such as provisions for mitigating counterparty credit risk and ensuring robust structural features. The overarching objective is to enhance investor confidence and facilitate the broader use of securitisation as a risk management tool, without compromising financial stability.

From a structural perspective, synthetic securitisation typically involves the use of credit derivatives - most commonly credit default swaps - to transfer the credit risk of a defined tranche of a loan portfolio to third-party investors. The originating bank continues to service the loans and retains legal ownership, while the investors receive periodic premiums in exchange for assuming the risk of default on the reference obligations. In the event of a credit event, the investor compensates the bank for the losses incurred on the protected tranche, thereby absorbing the agreed-upon risk.

This mechanism allows banks to achieve capital relief under the Capital Requirements Regulation, provided the transaction meets the significant risk transfer (“SRT”) criteria. The SRT assessment is conducted by the relevant supervisory authority and is critical in determining whether the bank can derecognise the transferred risk for regulatory capital purposes. The capital relief obtained through synthetic securitisation can then be redeployed to support new lending, thereby enhancing the bank’s capacity to finance the real economy.

The appeal of synthetic securitisation lies not only in its capital efficiency but also in its operational flexibility. Unlike traditional securitisation, which necessitates the legal transfer of assets and the establishment of an SPV, synthetic structures can be executed more swiftly and with fewer legal and administrative hurdles. This makes them particularly attractive in jurisdictions where asset transfer is legally or operationally complex.

Nevertheless, synthetic securitisation is not without its challenges. The complexity of structuring and documenting such transactions, coupled with the need for robust risk modelling and ongoing monitoring, requires significant expertise and infrastructure. Moreover, the reliance on derivative instruments introduces counterparty risk, which must be carefully managed through collateral arrangements and other risk mitigants.

Despite these challenges, the outlook for synthetic securitisation in Europe remains positive. The European Commission has acknowledged the strategic importance of revitalising the securitisation market as a means of deepening capital markets and supporting economic growth. Recent consultations have highlighted the need for a more proportionate and risk-sensitive regulatory framework, with stakeholders calling for simplification and greater alignment with market realities.

As the regulatory framework continues to evolve, synthetic securitisation is poised to play an increasingly prominent role in the European financial system. By enabling banks to manage credit risk more effectively and optimise capital deployment, it offers a valuable tool for enhancing financial resilience and supporting sustainable economic development.

For more information on the above, or to find out how Cafico International can assist your business, please contact Rolando Ebuna.