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Regulatory capital relief, capital relief transactions, capital release transactions and significant risk transfers. You’ve probably heard of one of these, but they are all fairly synonymous. Significant Risk Transfers (SRTs), which is what I’ll be referring to it as, are alternative, private credit instruments/structures designed to allow investors to benefit from bank deleveraging, whilst allowing banks to rebalance their balance sheet to meet regulatory requirements.

Banks were already under increasing regulatory pressure to reduce the risk on their balance sheets, and Basel IV, which was implemented at the start of the year and is expected to be fully adopted by 2025, will only speed things up. All this was prior to the banking troubles earlier in the year. While things look to have settled down in the sector, there will no doubt be longer-term consequences. One likely issue is that regulations will get tighter, and banks will have to strengthen their balance sheets further.

This expected increase in supply will unlikely be matched by an increase in demand. There have not been too many players in the SRT space historically and this is unlikely to increase given the barriers to entry. Something’s got to give with this supply and demand imbalance, and I expect this will be through more attractive pricing for investors.

How to reduce a risky balance sheet?

There are a few ways that banks can do this, but most are not optimal. Banks would ideally want to raise tier 1 capital, which includes increasing retained earnings (through reducing dividends) and/or raising equity. However, both options are unpopular for shareholders, while the latter being both dilutive and expensive. Alternatively, banks can also raise tier 2 capital, which includes issuing debt and contingent convertible bonds – which turn into equity at predetermined bank capital levels (though the recent Credit Suisse AT1 issue won’t help). These options are less expensive, but banks typically have limited buckets for these types of alternative financing methods as there is a minimum capital ratio reserve requirement which needs to be provided by tier 1 capital.

SRTs are an attractive alternative solution. They allow external investors to obtain economic exposure to a proportion of a bank’s loan book, thus underwriting the losses (not too dissimilar from CLO structures) for yields in the region of 8-10% (or higher given the current default outlook). The bank will see a reduction in the risk weighting of its loan book from a regulatory perspective, but unlike a CLO, will retain these assets on their balance sheet from an accounting perspective. Banks will structure these SRTs around SMEs, mid-cap loans, trade finance, residential mortgages or infrastructure loans because they carry higher risk weights.

The opportunity driver

The regulatory pressures that banks face will drive this opportunity. Basel III, which increased the minimum capital adequacy ratio requirement from 8.0% to 10.5% by 2019, led to many banks seeking SRTs. Basel IV won’t see an increase in the mandated capital adequacy ratio, but it will constrain the use of the internal model approaches used by many banks to calculate their capital requirements (amongst other regulations). A more standardised approach will likely mean banks ratios won’t look as strong. This should provide ample opportunities in the SRT space, and at attractive rates, as banks will likely be forced to reduce their risk weighted assets, increase capital buffers and further improve their core tier 1 ratios.

Key Risks

The key risk with SRTs is the default of the underlying loans, particularly given we are potentially entering into a recessionary environment. Having said this, investors are able to demand greater yields from banks for SRTs to compensate for the increased default expectations. It is also favourable that historically, SMEs and mid-cap (which account for a large amount of SRTs) company default cycles are usually more idiosyncratic relative to large corporates, which tend to be more cyclical. Also, best-in-class fund managers will add further reassurance through structuring and stress testing SRTs at 3-5x financial crisis default rates to ensure they are well protected from significant credit losses.

The fact that an SRT investor doesn’t retain any economic exposure to the bank, but only the underlying borrower, means they are protected in the event of a bank default. However, underlying due diligence of a bank’s lending standards and its loan book is essential to manage default risk. Best-in-class SRT managers will have strong relationships with the banks and be in a position to identify the weaker banks (i.e. those that might put the riskiest assets in the reference portfolio or retain less of the equity piece) or have the influence to be able to get banks to exclude certain assets/sectors/industries within their SRT reference portfolios.

Final thoughts

Overall, SRTs represent an attractive way of taking advantage of the ongoing bank disintermediation trend that has driven many private credit opportunities since the global financial crisis. SRTs should also be considered a suitable component of a broader private debt strategy, which can provide diversification relative to traditional, primary originated corporate direct lending strategies, with potentially attractive risk-adjusted returns.

This will be driven by the supply and demand imbalance, which should be supportive for better terms and pricing on SRTs. A stricter regulatory landscape should drive supply, as SRTs are the most efficient option for a bank to reduce their risk and improve their balance sheets. The barriers to entry to the SRT space, however, are quite high due to the expertise and banking relationships required to run a successful strategy. This means that this asset class is unlikely to follow direct lending, an area that has become very crowded and attracted many asset managers. This will keep competition at bay and sustain modest returns in this space relative to direct lending, where crowding in the market has affected pricing and diminished returns.

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