A worked synthetic securitisation from the bank's side: capital released at its own target, the true cost of protection, and the two ceilings.
A bank can pay up to the margin at which the after-tax cost of protection equals its cost of equity on the capital released: margin ceiling = cost of equity × capital released / (notional protected × (1 − tax rate)). On the fictional Northwall 2026-1, protection on 266 million releases 223.9 million of capital, so at an 11.5 per cent cost of equity the ceiling is 12.91 per cent over the reference rate. The bank pays 10.50 per cent and keeps 2.41 points of room.
Worked in full in Significant Risk Transfer by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Northwall Bank, from Significant Risk Transfer, buys credit protection on the junior tranche, 0 to 7.00 per cent, of a 4,000 million corporate loan portfolio. It sells 266 million to a credit fund, deducts the 14 million it retains, and keeps the senior at a 35.34 per cent risk weight. The fund posts cash collateral and receives the reference rate plus a margin. Every figure is illustrative.
| Input | Value |
|---|---|
| Portfolio exposure | 4,000 |
| RWA before the trade | 3,077.08 |
| Senior notional, risk weight | 3,720 at 35.34% |
| Protection sold to the investor | 266 |
| Retained slice, deducted from CET1 | 14 |
| CET1 target | 13.50% |
| Cost of equity | 11.5% |
| Margin on the protection, over the reference rate | 10.50% |
| Reference rate earned on collateral | 2.50% |
| Tax rate | 25% |
Step 1: capital released. Capital is measured at the bank's own target, not at the 8 per cent minimum, because that is the capital it actually holds.
Before: 3,077.08 × 13.50% = 415.4
After: 3,720 × 35.34% × 13.50% + 14.0 deducted = 177.5 + 14.0 = 191.5
Capital released = 415.4 − 191.5 = 223.9, with 57.3% of RWA gone
Step 2: the cost of protection. The coupon is 13.0 per cent on 266, or 34.58. But the collateral the fund posted earns the reference rate, 6.65, so the net cost is the margin and nothing else: 27.93, or 20.95 after tax. Quoting the coupon overstates the cost by 23.8 per cent.
Step 3: the ceiling. The trade creates value as long as the after-tax cost is below what the shareholders require on the capital it frees.
Margin ceiling = 11.5% × 223.9 / (266 × (1 − 25%)) = 12.91%
At 10.50%: cost of equity on the release 25.75, after-tax cost 20.95, value created 4.81 a year
Excel: =CoE*Released/(Sold*(1-Tax))
A second ceiling is softer: the margin at which return on equity is unchanged. Profit before protection is 71.97, which gives a return on equity of 12.99 per cent on 415.4 of capital. The margin that holds return on equity at 12.99 per cent on the smaller capital base is 14.59 per cent. Use the stricter of the two. A bank that only watches return on equity will accept trades between 12.91 and 14.59 per cent that lift the ratio and destroy value.
At the 10.50 per cent actually paid, return on equity rises from 12.99 to 17.25 per cent, a gain of 4.26 points.
Both ceilings leave out the losses the investor now absorbs on the junior tranche: profit after the trade still bears the full expected loss of the pool. Counting that transfer would raise the ceilings, so the figures here are conservative.
The ceiling is proportional to the cost of equity, so the bank's hurdle sets the price as much as the market does.
| Cost of equity | Margin ceiling | Room at 10.50% |
|---|---|---|
| 9.5% | 10.66% | 0.16 |
| 10.5% | 11.79% | 1.29 |
| 11.5% | 12.91% | 2.41 |
| 12.5% | 14.03% | 3.53 |
| 13.5% | 15.15% | 4.65 |
The CET1 target works through the capital released. The cost of protection does not depend on the target, but the release does, and more than proportionally, because the deducted slice costs 14 million of capital whatever the target.
| CET1 target | Capital released | Margin ceiling | After-tax cost per euro released |
|---|---|---|---|
| 10.5% | 171.1 | 9.86% | 12.24% |
| 12.0% | 197.5 | 11.39% | 10.61% |
| 13.5% | 223.9 | 12.91% | 9.35% |
| 15.0% | 250.4 | 14.43% | 8.37% |
At a 10.5 per cent target the ceiling, 9.86 per cent, is below the 10.50 per cent margin: the same trade destroys value for a bank that manages closer to its minimum. If the transaction qualified as STS, the senior would weigh 20.35 per cent, the release would rise to 299.2 and the ceiling to 17.25 per cent, 4.34 points more room from a label.
The usual mistake is to compare the pre-tax cost per euro of capital released with the cost of equity. Here 27.93 over 223.9 is 12.47 per cent, above 11.5, and the trade looks uneconomic. The protection premium is tax-deductible and the cost of equity is an after-tax return, so the right comparison is 9.35 per cent after tax against 11.5. The related error is to use the full 13.0 per cent coupon, forgetting that the collateral earns the reference rate back.
The opposite error is to measure the release at 8 per cent. It understates the capital released for any bank running above the minimum, and it ignores that the deducted slice consumes capital at par whatever the target. That second point is worked in should a retained 1250 per cent position be deducted or risk-weighted?, and the senior risk weight that drives the release is derived in how to calculate the SEC-IRBA risk weight of an SRT tranche.
Both ceilings, the bargaining range against the investor's floor and the STS column are live formulas in the free workbook for this case.
The margin. In a funded synthetic securitisation the investor posts cash collateral that earns the reference rate, which offsets that part of the coupon. On Northwall the coupon is 13.0 per cent on 266 million, 34.58 a year, but the collateral returns 6.65, so the net cost is 27.93, the 10.50 per cent margin alone. Using the coupon overstates the cost by 23.8 per cent.
Multiply RWA before and after by the bank's own CET1 target and add any deducted retained positions to the after figure. Northwall holds 415.4 before and 191.5 after (177.5 on the senior plus 14.0 deducted), releasing 223.9. Measuring at 8 per cent understates the release for any bank running above the minimum.
Because the premium is deductible and the cost of equity is an after-tax return. Northwall's pre-tax cost per euro released is 12.47 per cent, above an 11.5 per cent cost of equity, which suggests the trade is uneconomic. After tax it is 9.35 per cent, comfortably below, and the trade creates 4.81 million of value a year.
This article is one calculation from Significant Risk Transfer. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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