The potential of structured and project finance instruments in the new economic reality

Development of SF and PF markets in Russia: missed opportunities

In international financial practice, structured finance instruments (hereinafter referred to as SF) are an important source of liquidity and redistribution of risks both for the banking industry and, albeit indirectly, for the real sector of the economy. Elements and principles of securitization are widely used to finance large infrastructure projects, as well as for the construction of local facilities.

The level of penetration of securitization in the financial system of different countries varies depending on the class of assets being securitized and the specifics of local regulation. For example, according to the Association for Financial Markets in Europe (AFME), the total volume of secured bonds issued under European securitization transactions in 2021 amounted to more than EUR 233 bln, of which EUR 86 bln were mortgages, EUR 43 bln were corporate loans and bonds, and EUR 28 bln were loans to small and medium-sized enterprises (SMEs). Thus, according to ACRA’s estimates, the volume of structured bonds issuance in the European market amounted to about 10% of the total volume of corporate bond issues. The total volume of SF instruments in circulation at the end of 2021 exceeded EUR 980 bln. Such popularity of SF instruments is not surprising, given their benefits for credit institutions, investors and the economy as a whole, namely:

• Transformation of illiquid financial assets into debt securities circulating on the financial market;

• Reducing the burden on capital for banking institutions;

• Interest rate risk management;

• Diversification of long-term financing sources;

• Lower dependence on state financing;

• Highly reliable area of investment for market investors;

• The possibility of achieving a higher credit quality of issues compared to the creditworthiness of the originator;

• Increasing the level of transparency of the financial industry;

• Possibility of reducing the cost of funding for a number of financial market players, etc.

Despite this, in Russia, even in the conditions of relative economic stability of recent years, SF instruments are still far fr om realizing their potential. The total volume of structured bonds under multi-tranche securitization deals in Russia in 2021 only amounted to around RUB 45 bln (Fig. 1), or less than 1% of the total volume of issuance of the corresponding types of loans. Of course, historically, such a volume of issues is a good indicator for this market segment, especially considering the decrease in activity in the second half of 2021, caused by the gradual increase in the key rate. Taking into account postponed or canceled transactions, the volume of SF instrument issues could have reached, according to ACRA, up to RUB 115–120 bln, which would have been an all-time record high for the multi-tranche securitization market. However, even with such figures, the extent of development of securitization, determined both by the volume of issues and the share of securitized loans in the total volume of issuance, is very far from its potential. In particular, according to ACRA’s calculations based on statistics from the markets of the EU, US and China, the share of securitization of SME loans, corporate loans, mortgage loans and other assets may reach 15–20%, 8–12%, up to 45%, and 5–7%, respectively. For comparison, the volume of securitized bonds in China already exceeds USD 500 mln¹, even though the Chinese SF segment started actively developing several years after the Russian one.

Figure 1. Volume of Russian securitization deals for different asset classes, RUB bln

* One-tranche securitization transactions guaranteed by DOM.RF.
Sources: Cbonds, ACRA

As for project financing² (PF) bonds, this instrument is relatively new and not well known among market participants. Nevertheless, it is becoming more popular — since 2017, about 22 issues have been placed to a total of RUB 77 bln. PF bonds are of particular interest for financing PPP projects — the number of issues over the past three years has already exceeded the number of issues of concession bonds.

¹ S&P Global — China Securitization Performance 2021.
² For the purposes of this analytical commentary, project finance bonds mean bonds secured by project assets or rights of claim to project finance debt issued by specialized financial companies or specialized project finance companies.

SF and PF in the new economic reality

ACRA does not rule out that the new economic realities may indeed contribute to the development of the PF and SF sectors in Russia. Since the main purpose of these mechanisms is to raise funds to finance lending or project activities, securitization should be considered as a way to connect a wide range of market investors with the real sector of the economy and the social sphere, both through the mediation of banks and directly. The use of SF mechanisms increases the mobility of the economy, facilitating the free flow of funds from the financial sector to the real one and vice versa. The beneficiaries of this process are all its participants.

From the originator or initiator’s point of view, these instruments help diversify funding sources

The introduction of economic sanctions on the Russian economy and its financial system narrows the available sources of financing for the banking sector and, as a result, potentially limits the possibilities of commercial lending to both retail and corporate borrowers. Thanks to the timely actions of the regulator, banks were able to attract a significant amount of funds in the form of deposits, which made it possible to avoid a shortage of liquidity. However, ACRA believes that the diversification of sources of funding is an essential condition for supporting the stability of the entire national financial system. The gradual lowering of the key rate, on the one hand, will make lending more affordable, but on the other hand, will dampen interest in bank deposits. One should also take into account the growing popularity of new forms of investing private savings, for example, in bonds and mutual funds. In the Agency’s opinion, the popularization of SF instruments ensures the diversification of sources of funding for banks, helps to reduce dependence on deposits, and also allows new trends in the private investment market to be taken advantage of. In the current economic conditions, the internal financial market can become a reliable source of additional long-term financing for banks’ lending activities through the issuance of structured bonds.

Against the backdrop of economic turbulence, other benefits of securitization are becoming especially important, for example, the possibility of reducing the burden on bank capital. It is hard to overestimate the importance of this factor — offloading the balance sheet of the originator allows not only to improve statutory ratios, the maintaining of which at a high level is critical in the current environment, but also to free up capital to expand lending. This “unloading” becomes possible due to the actual sale of securitized assets to the balance sheet of the issuer, which is the so-called orphan company that is not related to the originator. However, since within the framework of issuing structured bonds, the originating bank retains the risk of the transaction by acquiring the entire nominal value of the junior tranche, the amount of which reflects the expected losses on the securitized portfolio, “unloading” is possible only under RAS, while in accordance with IFRS rules, the issuer’s balance sheet is consolidated with the balance of the originator. These restrictions can be overcome by carrying out a multi-originator transaction, which implies the issuance of bonds secured by the asset portfolios of two or more banks, with retention of risky tranches in proportion to the share of each pool participant. The possibility of introducing a new form of risk retention, the so-called vertical cut, is being widely discussed by market participants. It includes the purchase by the originating bank of shares in all tranches of the issue in proportion to the subordination of the transaction. Since when implementing this approach, the originator will not be the only holder of the riskiest position within the issue, it is highly likely that the issuer and originator will not be combined into a group. Securitization instruments can also support the activities of leasing companies that are gradually becoming familiar with SF instruments. The difficulty of securitizing lease payments lies in the obligation to pay VAT by the lessor, which complicates the differentiation of cash flows between the issuer and the originator. Nevertheless, several securitizations of portfolios of leasing contracts have already been completed in the Russian market, although a standard structure for the implementation of such projects has yet to be developed. SF mechanisms as a source of long-term financing are of significant interest to leasing companies, as they are traditionally dependent on bank lending. ACRA believes that the possibility of reducing this dependence through securitization is becoming especially relevant in the new economic realities.

It seems that the role of PF bonds will also grow in the coming years. According to the Agency, the main factors in the growth of the popularity of this tool are as follows:

• Flexibility of options for structuring issues, taking into account the specifics of the implementation of financed projects;

• Possibility of issuing structured bonds, the repayment profile, terms and amount of obligations for which may differ significantly from traditional corporate bonds or the terms of bank loans;

• Reducing dependence on bank lending when it comes to raising funds directly for a project;

• Possibility of refinancing long-term large loans or even shares of syndicated loans, if the initiator of the transaction is a bank.

From the borrower’s point of view, it is a stable source of liquidity and the possibility of reducing funding costs

Since the interest rate on a loan for an end borrower is determined by both the risk characteristics and the cost of raising funds, further development of the securitization and PF bonds market will help reduce funding rates. A high level of transparency in securitization transactions is ensured by regular reporting on each transaction, the preparation of which involves several independent transaction participants, which eliminates the possibility of error and deliberate misrepresentation of information. Practice shows that in order to successfully carry out an SF transaction, many originating banks upgrade their IT systems and optimize business processes associated with the collection and analysis of portfolio data. The costs of these transformations are justified especially if transactions are streamlined, that is, they are implemented regularly, as portfolios of assets accumulate. As a result, information on assets is more accessible and granular, which simplifies banking supervision and enhances the ability of banks to conduct a detailed analysis of the credit risk factors of their portfolios. Such research helps the originator to identify the baskets of borrowers with the best characteristics and adapt the terms for issuing and servicing loans for them.

At the same time, an increase in the number of issuers and issues of bonds secured by one asset class or another leads to the formation of a secondary market for such instruments. Instrument awareness, investors’ deeper expertise and high credit quality push down coupon rates for highly structured securities. This is true for both SF instruments and PF bonds.

Let us consider the SME lending segment as an example. Thanks to the identification of debt risk profile, a selective approach and selective reduction in interest rates on loans, an instrument is being formed to support the most reliable and competitive SMEs. According to ACRA’s research², in Russia, the average interest margin for SME loans with maturities of three to five years ranges from 4.25% to 6.25%. For comparison, in Europe this figure ranges from 2% to 3%. At the same time, the share of the Russian SME securitization market is less than 1% of the total debt of SMEs in Russia, while the share of securitization in the European market reached a maximum value of 16% of the total volume of loans issued, which, in ACRA’s opinion, was directly translated into more accessible and cheaper funding for SMEs. An increased volume of securitized SME loans will help reduce interest margins in Russia, resulting in lower funding costs for SMEs. The growth in the number of new issues of structured securities, in turn, will give banks the opportunity to reduce the pressure on capital and significantly increase the volume of funding for small and micro enterprises.

From the investor’s point of view, it is a reliable investment tool

In the new economic reality, SF and PF instruments, a priori secured by assets, are a reliable area for long-term investments for both private and institutional investors. In ACRA’s opinion, a credit rating is the most objective and independent assessment of the credit quality of such securities. The main features of SF and PF instruments that determine their credit quality are:

• Collateralization with assets segregated from third-party risks, including loan liabilities, liquidity, tangible assets; at the same time, an investor has the right to receive a portion of the cash flow generated by the collateral portfolio, in proportion to investments, as well as the amount of compensation for defaulted assets in the portfolio;

• Subordination of tranches, implying the breakdown of an issue into tranches of different priorities, wh ere the credit quality of each senior tranche is supported by all the junior tranches;

• Internal credit quality protection mechanisms, such as provisions for liquidity gaps, prioritization of cash allocation, mechanisms for loss compensation using excess liquidity, triggers to maintain the credit quality of a collateral portfolio, etc.;

• Transaction structure, and the division of support functions between generally non-associated counterparties.

All of these features contribute to the potentially high credit quality of senior structured bond tranches, which is reflected in their credit ratings. Over the entire history of the securitization market in Russia, SF instruments with a public rating or a guarantee of development institutions have not defaulted. The level of credit risk of senior issues of securities backed by high-quality assets is less affected by macroeconomic changes.

Of course, this does not mean that all issues of securitization instruments will a priori have the maximum rating. The credit rating of SF and PF instruments is the result of a detailed analysis of all aspects of issues: structure, counterparties, and collateral. However, for most securitizations of granular portfolios of assets, there is a theoretical level of subordination at which the senior tranche of bonds backed by these assets can receive the highest rating. The more concentrated the securitized portfolio, the higher the dependence of the final rating on the credit quality of each asset in the portfolio. For example, in the case of issuance of PF bonds to finance a single project, the assessment of the project quality is translated into the credit rating of the bonds.

ACRA’s rating analysis is based on the so-called AAA scenario³, which essentially models an economic shock accompanied by a recession, a drop in production volumes, a decrease in prices for collateral, etc. Therefore, the maximum rating of SF instruments indicates that such bonds are highly likely to survive economic shocks.

Senior classes of highly rated structured bonds can be offered to pension funds as long, low risk and predictable instruments, while mezzanine and junior tranches, as well as lower rated papers, can dilute the strategies of hedge funds and other qualified investors who are able to adequately assess potential risks.

From the government’s point of view, it means new forms of support

SF and PF instruments can be used by governments as part of their programs to support a particular industry. For example, this sort of program (“Quantitative Easing Program”) was implemented in the EU after the financial crisis of 2008–09. The essence of these initiatives is the systematic purchase by government agencies of market-based SF or PF instruments. Various scenarios for the implementation of such support measures are possible. Thus, a simple program involves the participation of the government or its authorized agents, such as development institutions, in market placements of structured securities, subject to a limited number of criteria (for example, the maximum credit rating and a given coupon rate). If necessary, such programs can be implemented through a more complex scenario (with additional restrictions and requirements). For example, to support the SME segment, the government may approve a targeted program for the purchase of bonds backed by claim rights under SME loans. The terms of such a program, in addition to the credit rating and yield, may include additional requirements for loans that constitute collateral, weighted average rates for securitized portfolios, the minimum amount of subordination, and other terms of issues or collateral. At the same time, the intended use of issue proceeds received by the originator may be limited to the formation of new portfolios of SME loans. The scale of such a program will depend on the planned amount of support and the required economic effect.

By buying structured bonds, it is possible to influence precisely the level of interest rates in a particular lending segment. In particular, a large-scale program to buy bonds secured by SME loans at reduced coupon rates will lead to lower lending rates for SMEs in banks participating in such a program, and will affect rates on other types of loans to a lesser extent.

Use of SF and PF instruments in government support has some advantages over direct funding or subsidizing interest rates.

First, the use of market mechanisms contributes to the development of the target segment, as well as the financial market as a whole, which in turn contributes to the growth of the economy. The market becomes more independent, regardless of the participation of the government.

Second, since securitization instruments are highly resilient to cyclical fluctuations in the economy, by investing in senior classes of secured bonds with high credit ratings, the government takes less risk of loss compared to many other types of investment and, eventually, saves budget funds.

Third, these support programs are scalable depending on the economic situation and can be applied not only to SMEs or mortgages, but also to financing projects, including large PPPs, as well as venture funds or start-ups (for example, IT).

Fourth, the high degree of transparency of securitization transactions makes it possible to control the asset quality at any stage of a transaction, while the originating bank, which holds a risky position in the securitized portfolio in the form of junior debt, is interested in the best quality of the collateral portfolio, since it would be the one to suffer initial losses.

In conclusion, ACRA is of the opinion that SF and PF instruments have significant potential that can play a positive role for the Russian financial market and the entire economy and help respond to the current challenges. In our opinion, the reverse is also true — the current economic situation is able to induce a rapid development of the structured finance market, which will be able to compensate for missed opportunities. As a participant in the discussion of the regulatory and legislative framework for securitization and project finance, ACRA hopes for the successful completion of the changes, which should result in the creation of favorable conditions for the full-fledged implementation of the entire positive potential of structured finance instruments.

³ For details, see the Methodology for Assigning Credit Ratings to Structured Finance Instruments and Obligations under the National Scale for the Russian Federation.