The Growth of Capital Relief
Introduction
Capital relief transactions (CRT) are providing an effective answer for banks facing an increasing regulatory capital burden. Also known as SRT (for “significant risk transfer”), the product pre-dates the global financial crisis and has seen ca. 20% year-on-year growth over the past decade.
As it starts to knock on the door of mainstream markets, the purpose of this note is to set out CRT’s key features and environment.
Sell-side drivers
Core, lower-risk portfolios
With increasing regularity, banks have successfully transferred large tranches of first loss and mezzanine risk on core loan portfolios spanning multiple sectors and geographies. It’s important to note they like the risk; they just take the view that they are being asked to hold too much regulatory capital against it.
First loss pieces tend to cover the initial 5% to 8% of portfolio losses, although sometimes banks will retain any expected loss position (usually sub-1%). Where used, mezzanine positions range from 5% to 12% of the reference portfolio capital stack and are distributed to insurance companies.
10%+ return on equity
This risk transfer allows banks to achieve double-digit returns on equity, making best use of the capital available to it and avoiding approaching what can be unforgiving public markets.
Client first
Moreover, aided by a synthetic means of risk transfer, banks do not compromise their underlying customer relationships (and the cross-sell that comes with them) or relinquish control over what can be brand-sensitive loan management. In effect, it provides banks with a win-win.
Buy-side drivers
Easy access
For insurance companies and private capital funds, CRT is an effective means of gaining exposure to quality portfolios without the resource impact of loan origination and asset management.
Bank partnership
Faith is placed in the bank’s operations and its dedication to the relevant loan sector, with a great deal of diligence centring around related processes. In return, the bank sees the product as a partnership; investors who understand this perform better in the selection and allocation process.
Relative value
Investors are attracted by the product’s favourable risk / reward metrics when compared with direct loan or traditional securitisation exposures. As confidence in the product grows, it is fair to say that the product’s complexity / illiquidity premium is narrowing somewhat.
Additional leverage
Those seeking enhanced returns may add to the product’s embedded leverage through bolt-on repack or repo structures. Advance rates tend to be 50% or less, and involve a margin call construct. Although relatively small, this leverage market should grow as underlying CRT classes continue to prove their fundamental resilience.
Structures
General themes
Structures vary with financial guarantees being favoured by some banks over credit default swaps which can trigger mark-to-market accounting issues. First loss positions tend to be funded, whereas mezzanine loss positions can be unfunded thanks to an active insurance buy-side market. Single purpose vehicles are also present in many structures to facilitate tradeable investment format and improved counterparty risk management.
Complex documentation
Whatever structure is used, CRT documentation can be highly complex. This is largely unavoidable as banks do not wish to depart from legacy approaches which hold the faith of the regulator.
US structures
Specifically on US structures, they tend to be larger deals with shorter duration and thicker tranches leading to lower coupons and greater use of additional leverage. In addition, the impact of prudential regulation on participating standardised banks has resulted in relatively higher quality portfolios than European counterparts.
Poised for further growth
US appetite and new asset classes
CRT’s positive trajectory is set to continue as the Federal Reserve becomes more comfortable with its use by US regulated banks and as new asset classes are introduced annually across the globe.
Product resilience
CRT can also point to its successful navigation of a crisis. During the pandemic’s first phase, 15%+ market discounts available for certain CRT securities had more to do with distressed sellers dealing with extraneous liquidity issues than product fundamentals.
Investment considerations
Inherent risks
The product is of course not without its risks and buyers should be particularly aware of counterparty and eligible investment risk, loss events and calculation, together with limited or no investor downside control. It is also important to note that this insurance product is “negatively pooled” which can be particularly impactful on less granular portfolios.
Risk analysis
We have a breakdown of approximately 30 investment considerations which are designed to answer the most rigorous buy-side investment committee and which we would be happy to share with you.
Explore more with us
Please contact us to learn more about this product and how you and your team might benefit from its growth.
