Key Takeaways

  • Market participants employ four main credit risk transfer (CRT) structures - bank-issued CLNs, SPV-issued CLNs, CDS, and participation interests - each of which carries a different risk, regulatory, and funding profile that investors should evaluate carefully before committing capital.
  • Due diligence, credit event scope, and recovery rights are critical areas for asset managers to consider; failing to address them at the outset can materially erode returns.
  • The U.S. Basel 3 re-proposal may impact banks' CRT structuring decisions.
  • Recently introduced regulatory developments in the EU and UK could affect significant risk transfer (SRT) markets, including, for example, proposals for the European Central Bank to perform a pan-European approval role for SRT transactions.

Credit risk transfer (CRT) transactions (also known as significant risk transfer (SRT) transactions outside the United States) are structures that market participants in the U.S., UK, the EU and (increasingly) Asia use both as a form of credit risk management as well as a form of investment. For banks, government-sponsored enterprises (GSEs), regulated institutions, and other lenders, CRTs optimize regulatory capital usage, manage concentration limits and offload credit risk.

Given the diversity of the CRT market (different banks/issuers, regulatory regimes, asset classes, and documentation architecture), we set out below a brief guide on (i) how CRTs are generally structured and (ii) key considerations for asset managers. We also consider the impact of recent regulatory developments in the U.S. and UK/EU on CRT/SRT markets.

Common CRT Structures

There are generally four main CRT transaction structures.

  1. Bank-issued Credit-Linked Note (CLN) - A bank issues a note to the investor, either bespoke or off an existing program. The bank pays principal and interest, but payment is linked to the credit performance of a specified reference entity or portfolio. If a defined credit event occurs (e.g., failure to pay, bankruptcy or restructuring), the investor may receive reduced principal or a substitute delivery/settlement amount, effectively assuming the referenced credit risk. The CLN is typically a debt security, either privately placed or offered in the capital markets (and accordingly subject to selling restrictions). However, the terms relating to credit events are often modified from standard ISDA terms (see Credit Default Swap (CDS) below).
  2. Special purpose vehicle (SPV)-issued CLN - Unlike a bank-issued CLN, an SPV-issued CLN is issued by a bankruptcy-remote vehicle formed by the bank. Investor proceeds are typically invested in cash collateral (or debt issued by the bank), and the SPV enters into a credit default swap (discussed below) or guarantee with bank that is looking to transfer the reference credit risk. Because of the SPV's bankruptcy-remoteness, if the CLN proceeds are invested in cash equivalents, then the investor's primary exposures are the referenced credit risk, rather than the bank's balance sheet (although the bank may, in certain circumstances, remain responsible for making certain payments such as fees and SPV maintenance expenses).
  3. Credit Default Swap (CDS) - A derivatives contract under which a protection buyer pays a periodic premium to a protection seller (the investor) in exchange for coverage of losses arising from specified credit events  in respect of a reference entity or obligation (e.g., failure to pay, bankruptcy or restructuring). As derivatives contracts, CDSs are heavily regulated (e.g., pursuant to the Dodd-Frank Act in the U.S. or EMIR in EU), and the parties' onboarding process for derivatives transactions may take time.
  4. Participation interest sale - A seller transfers an undivided economic interest in a loan or other financial exposure (e.g., a funded or unfunded position) to an investor. The seller remains the lender of record, services the loan and manages the borrower relationship, while the investor receives its share of principal and interest (and bears the corresponding credit risk) based on the reference loan's performance.

Each structure has unique features, including:

  • Nature of the instrument - Whether the investor holds a debt security (CLN), a derivatives contract (CDS) or a participation interest, with resulting differences in regulatory treatment, accounting classification and transferability;
  • Credit risk - Whether the investor assumes the credit risk of the bank directly;
  • Funding timing - Whether the transaction is fully cash-funded at closing, or the investor funds only after a credit event occurs;
  • Events of default - The scope of triggers that permit the investor to terminate the CRT transaction; and
  • Back-leverage - Whether the investor requires back-leverage and, if so, the form of instrument the back-leverage lender requires the investor to hold.

Given these structural differences, investors should carefully evaluate any CRT transaction presented by a bank at the outset to ensure alignment with their commercial goals and risk/reward appetites.

Key Investor Considerations

Beyond structure and pricing, several key considerations arise for asset managers when negotiating and finalizing a CRT transaction.

  • Due diligence - Conduct rigorous due diligence on the referenced asset pool (on a blind or sample basis, as appropriate) that is commensurate with the diligence an investor would perform if acquiring the assets directly. Results will inform negotiations, including, for example, the representations required from the bank.
  • Scope of credit events - Banks may require certain credit events in a manner that allows them to comply with applicable regulatory capital regimes (and the form of the structure may also dictate the scope of credit events). Investors may want to consider employing a third-party independent verification agent to verify whether a credit event has occurred and whether the bank has serviced the reference asset in accordance with agreed servicing standards.
  • Investor reports - Banks will often provide regular status updates, but scope, frequency and formality are negotiable. Written reports provided more frequently (e.g., monthly or quarterly) with granular detail enable investors to better anticipate credit events and, where applicable, exercise control or direction rights to maximize recoveries.
  • Scope of and deadline for recovery - Consider what qualifies as a recovery amount in a credit event scenario, as cumulative recoveries reduce the investor's payout. Transaction documents should clearly specify the long-stop date after which recoveries can no longer reduce the investor's settlement amount. Consider if there should be an interim recovery feature with subsequent true-up payments.
  • Acquisition rights - Investors may want elevation rights to acquire the referenced assets directly - for example, where the bank's workout strategy diverges from the investor's preferred approach or where the investor believes it can achieve better outcomes by managing the distressed exposure itself.

By conducting thorough due diligence and anticipating these common issues, asset managers can position themselves to negotiate favorable terms.

Reforms in the United States

U.S. banking regulators recently released a re-proposal of certain amendments to the Basel 3 regime in the United States, after a controversial initial proposal in 2023. The proposal establishes the “SEC-SA” framework for risk-weighting securitization positions that will impact banks' CRT structuring decisions. Although it remains to be seen which parts of the proposal will survive in the final rule, the current proposal significantly raises the risk-weight floor for resecuritization exposures. Such a change could materially increase capital charges on those exposures.

However, the proposed change also lowers the risk-weight floor on senior securitization exposures from 20% to 15%, which may make it more attractive for banks to retain senior securitization exposures. Among other things, the re-proposal establishes the concept of an “eligible prepaid credit protection arrangement,” which may generally facilitate certain direct-issuance CLN structures. This approach may ease some of the regulatory burdens involved in directly issued CLNs and drive further issuance in this space.

Reforms in the UK and the Europe

Recent and ongoing reforms in Europe and the UK are aimed at making SRT transactions more attractive to investors and originators. In Europe, there are proposals for the European Central Bank to perform a pan-European approval role for SRT transactions that will be more principles-based than the current rules. New changes to the insurance regulatory regime will also make it more attractive for insurers to invest in the senior tranches of the SRT transactions that are structured as securitizations. In the UK, the Prudential Regulatory Authority has proposed a carve out for transactions that involve the resecuritization of the senior tranche of an existing securitization manufactured by a bank. If implemented, this may open up SRT transactions on securitized lending.