Banks’ growing use of SRT as a balance sheet strategy

European-domiciled banks have historically looked to the securitisation market to optimise their balance sheets. In recent years, the regulatory environment has progressed to drive a wider scope of protection and market penetration. In today’s uncertain global markets, banks are seeking favourable approaches to satisfy capital allocation requirements, based on an assessment of risk retained on their books.

Significant risk transfer (SRT) is a transaction structure prevalent balance-sheet strategy that has been explicitly provided for under the European and UK regulatory framework. Financial markets are likely to see an expansion in SRT activity as Basel IV takes effect in 2023. According to the European Central Bank, SRT volume of securitisation of performing loans is expected to exceed the current record year of 2019, when volume reached €142bn, primarily in response to banks’ need to free up capital.

De-risking loan portfolios

SRT is a portfolio-level risk transfer strategy that offers European banks capital relief on those portfolio portions, typically senior tranches, that the banks then retain unhedged. SRTs, in essence, de-risk loan portfolio exposure by transferring the significant borrower non-payment risk to a third party. Such strategies offer banks recourse to realise access to capital for greater capacity and for risk takers to diversify loan portfolio exposure with quality assets having proved reliable records of performance.

These transactions can be executed on a funded basis via notes purchase or on an unfunded basis through credit insurance. Credit funds dedicated to the SRT market participate on a funded basis, while non-payment credit insurance coverages are underwritten by credit insurance carriers. Banks purchase the hedges to optimise balance sheet concentration to various risk asset classes. Thus, SRTs can offer a competitive advantage for insured banks to grow their book of business and reduce capital allocation requirements.

Alan Ball, director at the Texel Group, a specialist credit insurance broker, stated: “The credit insurance market has been providing cost effective capital relief to the European banking sector for two decades, and over the past five years coverage has incorporated an increasingly wide range of asset classes via different SRT structures as a natural market evolution to meet banks’ diverse needs.”

SRTs can involve such corporate assets as trade finance loans, loans to small and medium-sized enterprises and larger corporates, infrastructure and project finance loans, mortgage loans and other emerging classes, such as capital call facilities.

To qualify for SRT, the regulatory environment has required increasing levels of protection well above the regulatory expected losses during the life of the portfolio. Protection mandated for the bank to gain SRT designation is determined and approved by the respective regulator. “Banks tend to use their own sophisticated models to assess the expected loss exposure of the loan portfolio in extremely stressed scenarios, enabling them to calculate how much protection they should secure over and above expected losses, and to demonstrate to the regulator they have reached the SRT threshold,” said Andy Garston, managing director of London-based specialist broker, Credit Risk Transfer Solutions.

Capital requirements established by regulators vary from region to region. Large banks follow guidance set forth by the European Banking Authority (EBA), as it serves to establish a common set of regulatory rules, offering a consistent approach for structuring SRTs. Banks must undertake comprehensive due diligence to assess anticipated risk of loss exposure on selected loan portfolios prior to submitting documentation to the EBA or other regulator for a determination to achieve SRT.

Analysis for SRT designation

Regulatory-mandated analysis of the individual portfolio demands thorough quantitative assessment, modelling the expected performance of the loans, and a qualitative review, examining in-place bank controls for managing its loan book from origination to repayment. The portfolio undergoes in-depth scrutiny to determine expected loss over the lifetime of the transaction.

Loans achieving SRT share common characteristics according to well-defined eligibility criteria, which categorises those loans to be included under the designation. The resultant calculation informs the thickness of the tranches to be protected by funded and/or insurance protection. The eligibility criteria for portfolio construction generates mezzanine tranche attachments that often model at high non-investment grade or even investment grade levels. Given the current credit climate, bank necessity for SRT insurance protection has matured, particularly for more risk remote second loss/mezzanine tranches.

The portfolio of loans must remain on the bank’s balance sheet for servicing and to retain material net retention regarding portfolio performance. SRT transactions typically have lifecycles of five to eight years, with a designated replenishment period, whereby the bank can allocate new transactions to replace amortisations. Usually, there is a call feature permitting the originating bank to terminate the structure, which mostly occurs after the replenishment period to optimise regulatory capital outputs.

SRT strategies are collectively beneficial to the interests of all parties: the banks, EBA, credit funds and specialty credit insurance companies. With increasing market interest and heightened confidence from the re/insurance sector in SRTs, ongoing opportunities present an appealing diversification strategy over the credit cycle for bank protection.

Daniel L Sussman is president, Crum & Forster (C&F) credit division, and David Wright is head of international credit and political risk, Nexus C&F.

The Bracken column is named after Brendan Bracken, the founding editor of The Banker in 1926 and chairman of the modern-day Financial Times from 1945 to 1958.

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