Capital Treatment of a Securitisation Position

What SRT means:

• SRT requires the bank to demonstrate that it has transferred a meaningful share of the credit risk of the securitised assets to third parties, so that it is no longer exposed to the bulk of losses. It is a substance test, not a formality.
• Regulators typically look for either (a) a quantitative test - the bank retains no more than a specified share of the risk (commonly the mezzanine tranche must be sold and the retained exposure must be below a threshold), or (b) a qualitative test - the bank can show that its retained exposure is limited and that the transaction is not a disguised financing.

Assessing Larkspur:

• It sold the mezzanine and equity tranches, which is the right direction - the first-loss and second-loss pieces are with investors.
• But it retained the senior AA tranche of USD 45m out of USD 60m - that is 75% of the portfolio by value. The capital benefit depends heavily on the risk weight of that retained senior position and whether the bank is genuinely insulated from losses.
• It also provides a USD 3m liquidity facility and acts as servicer - both create continuing exposure and potential reputational/operational risk.

Likely assessment: The transaction may satisfy SRT if the mezzanine sale is substantial and the retained senior tranche is genuinely low-risk and appropriately risk-weighted. But the regulator will scrutinise whether the 75% retained senior position plus the liquidity facility means the bank has retained the economic substance of the risk. The capital ratio jump from 11.2% to 13.8% is exactly the kind of outcome regulators watch for as a sign of arbitrage.

Retained senior tranche (USD 45m, AA):

• Under the standardised approach, a rated securitisation exposure is risk-weighted according to its external rating. An AA-rated senior tranche typically attracts a low risk weight (in many frameworks around 20%, depending on the applicable securitisation hierarchy).
• The bank must apply the securitisation framework's hierarchy - use the external rating where available, and only fall back to other approaches if not. It must confirm the rating is from an eligible agency and is current.
• The bank should not treat the retained tranche as if it were the underlying mortgages; the securitisation rules apply.

Liquidity facility (USD 3m):

• A liquidity facility is a credit enhancement and must be capitalised as a securitisation exposure. Its risk weight depends on its rating and subordination. If it is unrated, the bank must apply the appropriate unrated treatment (e.g., look-through or a conservative weight).
• The bank must confirm whether the facility is genuinely a liquidity facility (short-term, non-loss-absorbing) or in substance a credit enhancement - if the latter, it is treated as a retained risk position.

Information to provide the regulator:

• Full transaction structure and tranche waterfall.
• Evidence of the sale of mezzanine and equity tranches (investor identities, settlement).
• The SRT assessment and the quantitative/qualitative test relied on.
• Risk weights and ratings for the retained tranche and liquidity facility, with agency confirmations.
• Stress-testing showing the bank's loss exposure under adverse scenarios.
• An explanation of the capital uplift and why it is not arbitrage.

The distinction:

• Legitimate risk transfer: Genuine economic risk moves to third parties who bear real loss. The bank's capital relief reflects a real reduction in its exposure. The bank retains only what it can justify (e.g., servicing, a small liquidity facility, a senior tranche it intends to hold).
• Regulatory capital arbitrage: The bank uses the structure to reduce measured risk without reducing actual risk - for example, by retaining the bulk of the economics while dressing the exposure in a low risk weight, or by using a structure whose legal form understates the bank's true exposure (e.g., implicit support, reputational risk, or a liquidity facility that will be drawn in stress).

What Larkspur should do:

1. Demonstrate genuine loss transfer - show that investors in the mezzanine and equity tranches bear the first losses and that the bank has no obligation (legal or implicit) to support them.
2. Justify the retained senior tranche - explain why it is held (e.g., market conditions, hedging) and confirm it is genuinely senior and low-risk, with stress tests showing the bank's loss in adverse scenarios.
3. Address implicit support - confirm there is no history or intention of the bank stepping in to protect investors, which would undermine SRT.
4. Treat the liquidity facility conservatively - demonstrate it is not a disguised credit line.
5. Governance - board-approved securitisation policy, independent review of the SRT assessment, and documented rationale for the capital treatment.
6. Transparency with the regulator - proactively provide the analysis rather than waiting to be challenged. The 2.6 percentage-point capital improvement is defensible only if the risk transfer is real.