5 min read 7 Sep 22
Bank capital relief trades, also known as significant risk transfer (SRT) transactions, have consistently exhibited these traits over the last fifteen years and can play an important role in diversifying long term investors’ growth assets away from increasingly congested equity markets.
An SRT transaction is first or second-loss (mezzanine) protection purchased by a bank on a diversified pool of core lending assets, for example loans to large corporations as well as SMEs.
Over the years, this type of transaction has become more common. Since the global financial crisis, banks have faced tighter and more onerous regulatory capital requirements, imposed by accounting standards and regulations such as IFRS 9 and Basel III, which have effectively impeded banks’ capacity to lend and boost their revenues, as bank lending creates risk-weighted assets with an associated capital requirement. Therefore, SRT transactions have largely come about as a way for banks to improve their regulatory capital position by means of reducing the risk weighting of the loan assets from a regulatory perspective, without having to de-recognise assets on the balance sheet. In other words, synthetic securitisation like SRT provides an effective way for banks to engage in risk-sharing transactions with non-bank investors without needing to raise equity or sell assets.
For long-term institutional investors, SRT represents an opportunity to gain access to opportunities which have the following characteristics:
SRTs have the potential to earn relatively high and sustainable income-driven returns through typically high single/ low double-digit coupons attached to the securities. The following chart illustrates the dispersion of observed coupon rates for various SRT transactions between 2010 and 2021.
By selling first/second-loss credit protection via SRTs, investors can gain exposure to diversified pools of performing corporate and consumer loans that represent the core lending activity of top-tier retail banks. This type of opportunity is predominantly private in nature and usually investment is via an investment vehicle managed by an asset manager.
Due to their private nature, medium-term oriented investor base and exposure to relatively stable, performing bank loan assets, SRTs have tended to exhibit lower return volatility than other publicly-traded fixed income assets. Their return, largely in the form of carried coupon, is mostly impacted by actual losses on the underlying loan portfolio, rather than down to market risk. Furthermore, as SRT transactions are classified as asset-backed securities (ABS), banks must comply with the same risk retention regulations and commit to retaining a vertical 5% portion in every transaction. This results in an alignment of interest between the bank and the non-bank investor. Banks also need to receive preapproval (or non-objection) from regulators to undertake each transaction.
A substantial amount of analysis, due diligence and negotiation goes into every SRT deal. In particular, a high level of scrutiny is applied to the characteristics of the loans which form part of the reference portfolio and investors need access to the granular data to make their own assessment of risk and return. Investors can request specific exclusions on the basis of credit quality, sectoral preferences and ESG concerns, for example. The ability to set these parameters upfront can help to ensure that the default rates in SRT reference portfolios are typically lower than overall bank balance sheets.
The origins of the SRT market date back to the 1990s, however, the market as recognised today has only existed since the introduction of Basel II in late 2007. This regulation placed the onus on banks to protect junior tranches of their loan books in order to receive significant capital relief. Basel III, born out of the Global Financial Crisis, introduced even stricter capital requirements on banks in the 2010s, leading to a rapid growth in SRT issuance. Whilst Europe has been at the forefront of issuance, US banks are beginning to access this market, and with Basel IV looming, more banks are likely to be incentivised to issue SRT.
The SRT market continues to develop as banks’ need for capital relief grows, and with this so does the depth of the opportunity set for patient investors seeking a less volatile and correlated alternative to equity markets.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.