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Milan’s Banca Sistema closed its first significant risk transfer (SRT) in the second quarter of this year, a deal referencing a type of consumer credit that is unique to the Italian market — cessione del quinto dello stipendio (CQS) loans, which are repaid directly from the borrower’s salary. It is a type of asset that has been referenced in SRTs before, but Banca Sistema’s transaction stands out as the first to be done on an unfunded basis.

Two insurance companies provided the credit risk protection, which took the form of an insurance policy covering the mezzanine tranche of a €600m portfolio of CQS loans.

“We found a large interest from the insurance market with this type of transaction, and we were very pleased with the way the tender went,” said Diego Lignana, head of corporate strategy and structured finance at Banca Sistema.

Lignana and Nicolò Fiorio, head of retail finance at Banca Sistema, discussed with 9fin why and how they went down the unfunded route for their first SRT. Much of it comes down to the bank’s capital management priorities and the expansion of the unfunded SRT market generally, but the nature of the uniquely Italian underlying collateral also played a role.

Freeing up capital

Banca Sistema has €4.5bn in assets and specialises heavily in factoring loans, which make up 60% of its business, according to the bank’s Q1 group presentation. CQS loans and their close cousins, cessione del quinto della pensione (CQP) loans, which are for pensioners rather than salaried workers, make up a further 26%. The rest of its book is state-guaranteed loans to small and medium-sized businesses (8%) and pawn loans (6%).

Banca Sistema has a history of doing cash securitisation on assets including CQS loans, but those were done for funding purposes. The switch to synthetic securitisation and the choice of underlying assets were driven by a desire to put capital to work as efficiently as possible.

“The bank has other areas of business, and at the moment the CQ return is below standard with respect to the other asset classes we have,” said Lignana. “The purpose of this transaction was to free up as much capital as possible from this asset portfolio, at the cheapest cost, in order to employ it more efficiently.”

Banca Sistema is not the only Italian lender that has zeroed in on its CQ portfolio as a target for SRT. A number of smaller banks and even non-banks have issued SRTs on consumer loans this year, including CQS loans. IBL Banca did so in a funded synthetic format, while non-bank financial intermediaries Agos Ducato and Creditis Servizi Financiari did so in the form of cash securitisations.

“A lot of banks are going down this active capital management solutions route in order to respond more effectively to ever demanding regulatory requirements,” said Lignana.

Unlike the others, however, Banca Sistema opted for an unfunded deal, seeing a good match between the assets it wanted to securitise and the demands of the insurance sector.

“We went down this road because we think this type of transaction structure fits particularly well with the type of underlying asset, salary-backed loans in the form of CQS or CQP,” said Lignana.

Going unfunded

In SRT, banks obtain protection for a portion of the credit losses on a portfolio in exchange for coupon payments to investors. The transaction can either be funded, meaning investors provide the cash to cover any losses up front, or unfunded, where an insurer provides a guarantee similar to a credit insurance product.

Funded SRTs receive better capital treatment and are well suited to first-loss tranches and riskier assets, but can be more expensive for the bank buying the protection. Unfunded SRTs can be cheaper but are better suited to low-risk, long-duration assets — a description that fits CQS and CQP loans.

Unfunded SRTs also currently do not qualify for the simple, transparent and standardised (STS) label, which a securitisation can earn by meeting certain criteria, and which confers better capital treatment for the bank.

European regulators are consulting on whether to extend the benefits of STS treatment to unfunded SRTs. For now, however, it is not available for such transactions and therefore was not an option for Banca Sistema’s unfunded CQS deal. On the plus side, that meant that the bank did not have to go through the onerous STS application process.

Italian jobs

CQS and CQP loans, collectively known as cessione del quinto loans, are special consumer credit products provided for under Italian civil law, which are considered to be relatively low-risk, making them well-suited to unfunded SRT.

The typical CQS product is a trilateral agreement between a customer, the customer’s employer, and the financial institution. The employer pays up to a fifth (quinto in Italian) of the customer’s monthly salary directly to the lender to repay the loan. A CQP loan is similar but a pension provider takes the place of the employer. These CQS and CQP loans carry a 35% risk weight on the bank’s balance sheet.

“It's a type of product that has a very low if not insignificant credit risk because the underlying asset is already protected by life insurance and potential job loss insurance,” said Lignana. “The pensioners and most of the employees are in the Italian public administration, so the risk of them losing their job or the employer not paying their salary/pension is very limited.”

There is a further option for some public sector employees, known as a payment delegation, which allows the assignment of a further 20% of their salary, taking the total borrowing capacity up to two-fifths of the salary. These loans are classified as unsecured and have a higher risk weight of 75%.

“In general, the delegate payment is only issued as an additional loan on top of an existing CQ loan, so it's a minor part of the portfolio,” said Fiorio. In a typical CQS portfolio, the average percentage of delegate payments is around 10%, which means that the average risk weight is around 40%.

“By implementing this SRT structure, we were able to get this RWA down below 20%,” said Fiorio.

Appetite for duration

CQS loans typically have a 10-year contracted duration, though many clients refinance their position before the end of the contractual term, and therefore the average expected duration is around 55 months.

The risk profile and duration attracted the attention of insurance investors, many of whom look for lower-risk assets and are able to hold them for longer than credit fund managers, who often have limited fund durations.

The CQS asset class is also already well known to many insurance companies in Italy because of the mandatory insurance that is issued for every loan covering the risk of job loss and death of the borrower.

“The result was freeing up capital at a reasonable cost because of these features,” said Lignana.

Marsh McLennan (MMC), a large insurance broker with experience in structuring, arranging and placing unfunded SRT transactions, acted as arranger and placement agent, distributing the deal to the two insurance companies with a joint team pulled together from its subsidiaries Guy Carpenter and Marsh.

The transaction took around six to eight months to complete and was approved by the regulator on 25 June.

Ready to go again

In addition to structuring the SRT itself, much of the preparation was around structuring internal processes and policies for the transaction and setting up regulatory reporting for accounting the risk weighted asset of the underlying assets.

Additionally, time went into defining the portfolio management strategy and “a lot of time and effort was put into rationalising the process and explaining it to investors,” said Fiorio.

Now that Sistema’s SRT infrastructure has been put in place, it would be much easier for the bank to do a second transaction, if it feels the need to do so, but Lignana said there was nothing concrete in the works yet.

“Having built this type of experience we have now acquired the capabilities to execute other transactions of this type,” said Lignana. “Whether we do another synthetic SRT, on this or other asset classes, will depend on our capital management needs. For now, we have nothing planned.”