The Big Idea
New Fed guidance on credit-linked notes
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Banks this week got a clearer picture of how they might use credit-linked notes to transfer risk to outside investors and reduce regulatory capital, thanks to newly released comments from Fed staff. The comments came in a September 28 post on the Fed website and suggest the Fed wants to see specific features in a CLN to grant capital relief. In particular, CLNs issued out of a special purpose vehicle should trigger capital relief while those issued directly by the bank without an SPV may not. A lack of clear guidance from US bank regulators has limited use of CLNs in the past, but the recent comments from the Fed may give new life to the sector.
Credit-linked note transactions
CLNs involve the issuance of notes to external investors in exchange for cash. These transactions are synthetic as the reference assets, usually a pool of loans, remain on the bank’s balance sheet. If there are credit losses on the loans, the principal amount due on the notes is reduced. Because of this external credit protection, banks may be able to reduce the required capital for a given portfolio by 60% to 80%. For residential mortgages carrying a 50% risk weight, this can be reduced to a 20% risk weight, and for other commercial and consumer loan types carrying a 100% risk weight, this may also be reduced to a 20% risk weight. There have been several CLN transactions issued in the U.S. over the past few years (Exhibit 1).
Exhibit 1: CLN transactions by U.S. banks
Source: Bloomberg, Santander US Capital Markets LLC
In some synthetic securitizations, the bank transfers the risk of a reference pool to an SPV, which then issues the CLNs and receives cash. The bank then enters into a guarantee or credit derivative with the SPV, and the cash is viewed as collateral supporting the SPV’s performance of that guarantee or credit derivative (Exhibit 2). This structure generally meets Fed requirements to achieve regulatory capital relief.
Exhibit 2: SPV issuance structure
Source: Santander US Capital Markets LLC
Alternatively, banks may not use an SPV and issue CLNs directly out of the bank. Here, while substantially and economically similar to the SPV structure, it is less clear that bank-issued CLNs meet the definition of a synthetic securitization. To recognize the credit risk mitigation of the synthetic securitization, the credit derivative must be executed under standard industry documentation, which has not always been the case with bank-issued CLNs.
Perhaps more importantly, the credit risk mitigant usually requires collateral such as cash. With a bank-issued CLN, the cash is considered by regulators to be property owned by the bank, but not collateral for the credit derivative as required by the synthetic securitization rules. This is a distinction that some market participants may find to be without economic substance, but regulators view this as very important, and therefore bank-issued CLNs do not automatically qualify for capital relief.
While not meeting the letter of the law, the Fed does recognize that direct-issued CLNs may substantively transfer risk in the same manner as SPV-issued CLNs, and therefore a bank may request a reservation of authority under the capital rules to achieve relief. In this case, better to ask for permission than forgiveness.
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