As banks are forced to offload more risk, SRTs build an increasingly long list of advantages

Duncan Sankey

Portfolio director and head of credit research

Cheyne Capital

Banks are incentivised to develop relationships with investors

Banks — even global systemically important banks — need additional capital. Problem CRE exposures, increased reserve requirements for expected credit losses under IFRS9/CECL, the entrance of government bond portfolio losses into Accumulated Other Comprehensive Income, attempts under Basel 3.1 to improve the reliability of capital ratios and compensate for the idiosyncrasies of internal models by imposing an output floor for risk-weighted assets, along with the scope for more exacting stress tests, all point toward mounting needs for new funds. We have seen unrealised losses at US banks go from nothing to over USD 500bn in the space of 18 months and some estimates foresee capital needs over the next five years of the same magnitude.

The trouble is, raising equity has limited appeal at the best of times and would be anathema to bank shareholders in an environment in which US bank valuations are languishing at flat to book and those of their European peers are lower still. AT1 is also unpalatable due to its cost and its non-contribution to CET1 capital. Moreover, non-financial corporates have never been more flush with cash and will likely be lavishing it on their shareholders like sailors on shore leave, while the ability of banks to engage in buybacks and special dividends will remain constrained while capital is tight.

Unsurprisingly, rather than raise capital, banks are instead turning to hedging programmes to transfer the risks associated with lending activities to third parties, thereby gaining regulatory capital relief. If a bank can persuade a third-party investor to write bespoke protection on the first-loss piece of a portfolio of loans, the bank can retain the lion’s share of its exposure, but with a much reduced regulatory capital requirement. Such ‘significant risk transfer’ (SRT) structures have been around for a while — long enough to gain regulatory blessings and to demonstrate mutual benefit and alignment of interest for both parties to the transaction.

There has been much development since SRTs were first struck in the early-mid noughties. Asset pools now vary enormously from high-net worth lending through SMEs, project finance, real estate, mortgage warehouses and leveraged loans, all the way up to portfolios of investment-grade and crossover loans from largely public and often publicly rated borrowers.

Supply/demand dynamics for the latter are such that the managers of large corporate loan deals do not enjoy the level of influence they once did. They are no longer typically able to cherry-pick assets for inclusion in a deal and determine which assets may be used for replenishment when a loan matures or is prepaid. However, a manager with credit research capabilities should still be able to analyse the names in the deal, request more information where necessary and price the deal appropriately to reflect the risk. It should also be able to evaluate the bank’s own research, underwriting and workout processes.

The fact that banks must retain a portion of deals and remain responsible for workouts should mitigate concerns that SRTs will be used to palm off potential problem loans. Moreover, the liberal capital relief conferred on banks by SRTs encourages repeat transactions and the development of relationships with managers; banks are therefore incentivised not to leave managers and investors with a bad taste in their mouths.

Avoiding whole bank exposure

An investor in a large corporate SRT arguably ends up with a more compelling offering than it would if it invested in the bank’s own debt, especially its subordinated liabilities. Rather than take exposure to the entirety of the bank, the manager isolates for the investor a vetted slice of mainly investment grade-equivalent, funded and unfunded obligations (including revolvers), some with covenants and/or security, which should confer better recovery in a default scenario. If the manager has done its work, concentration risk need not be a concern, with maximum single-entity exposures often in the very low single-digit per cent range. For this, the investor will typically receive a floating-rate yield superior to that offered by the bank’s subordinated debt and more in line with the weaker end of junk (albeit including a liquidity premium). Moreover, none of the SRTs of those financial institutions that have in some way failed, have yet been ‘bailed in’ by regulators.

Lack of capital at banks is presenting an opportunity for credit investors to gain exposure to some of the banks’ best corporate assets at a highly seductive yield. Additionally, there is potential for significant market expansion as US banks become involved in what has so far been a mainly European niche. SRTs are worth a closer look.

Shifting risk to third parties

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