Regulatory Pressure

Banks have found themselves under increasing regulatory scrutiny post-financial crisis. The introduction of Basel III regulation in June 2011 (adopted by the EU and the US federal banking regulators) requires more robust capital adequacy and stress testing, such that banks are better able to “absorb shocks arising from financial and economic stress”.

With banks having to meet Basel III capital adequacy requirements by the end of March 2019 (Exhibit 1), and more stringent “Basel IV” refinements likely to follow in the near term, banks remain under significant pressure to reduce their risk weighted assets (Note: Risk weighted assets were introduced under Basel I in 1988, whereby banks’ “asset or off-balance-sheet exposure [are] weighted according to broad categories of relative riskiness.” In practice, riskier assets with higher probability of loss receive higher weights, and banks must post more capital to protect against potential losses), to increase their capital buffers and to further improve their Core Tier 1 capital ratios (Note: The Core Tier 1 capital ratio is the ratio of Tier 1 capital (shareholder equity and retained earnings) to risk weighted assets).The pressure is most pronounced in Europe, where banks are generally less well capitalised and have lower Tier 1 capital as a percentage of assets than their US counterparts.

In having already exited legacy, non-core, capital intensive businesses post-crisis, Capital Release Transactions (CRTs) represent one of the remaining options for banks to improve their capital bases without exiting business they wish to retain, or raising additional capital. In reducing the risk weights attributed to their loan books, banks are able to release capital that they can post against other assets, or with which they may onward lend.

The CRT market is increasingly proving an attractive option for banks, and there have never been as many issuers and as broad a range of deals as there are today.

What is Regulatory Capital Relief?

Regulatory Capital Relief is an investment strategy whereby investors underwrite losses on portfolios of banks’ loans. The Capital Release Transactions that they structure and acquire are synthetic securitisations which transfer the risk of losses on a junior tranche away from the bank, without removing the assets from their balance sheets. By retaining the underlying assets, the banks ensure that their relationships with their debtors are maintained, allowing for continued loan issuance and the possibility of developing other fee generating business.

These transactions may be undertaken on a broad range of asset types, though the bank derives the most benefit by structuring them around portfolios of assets that carry high risk weights, typically Small and Medium Enterprise (SME), residential mortgage, trade finance or infrastructure loans.

In transferring this exposure, the risk weight applied to the bank holding the portfolio is lowered. These risk weights vary from one asset to the next and are intended to adjust notional exposure to reflect the asset’s true risk. Clearly a reduction in the risk weight applied to an asset will reduce the capital that the bank must then post. In doing so, banks’ Core Tier 1 capital ratios are also improved.

Capital Release Investing

There are a number of elements that make CRT investing attractive; however, the core component is the high coupon that the bank pays the investor, relative to the gross income generated by taking first or second loss exposure to the reference portfolio.

With this tranching comes the greater probability of loss relative to taking exposure to the entire stack, however the structures are generally highly resilient and, in some instances, can withstand significant stressing of the historically worst probability of default without incurring losses.

CRT investors also benefit from banks retaining skin in the game, and so banks are incentivised to avoid defaults. Importantly, the coupon on the transaction is independent of the coupons on the underlying portfolio.

Other interesting components of CRTs for investors include gaining exposure to diversified bank credits, a market that is otherwise inaccessible. Indeed, CRT investors can benefit from banks’ underwriting expertise and the better service provision, liquidity and market access that they offer their core clients relative to non-bank investors. Direct lending to SMEs is a core business of many European banks, and so investing in CRTs that reference European SMEs allows access to a relatively closed market in partnership with the leading lenders.

Key Risks

There are a number of risks associated with investing in CRTs.  Below are a few of the more significant risks and how they can be mitigated.

Credit Risk of Underlying Loans – CRTs provide protection on portfolios of loans and as such, performance is sensitive to defaults, recoveries and the broader economic environment.

• Mitigant: This can be mitigated via a manager’s in-depth due diligence of a bank’s credit underwriting process and writing transactions on loan portfolios that only represent the core business of the banks. Alternatively, managers restrict reference portfolios to companies that they are comfortable with, having undertaken detailed fundamental credit analysis.

Counterparty Risk – The risk that the bank defaults and the investor’s funding is non-recoverable.

• Mitigant: The risk is mitigated if the bank provides collateral which the investor may sell should the bank default. Investor capital is also often held in a segregated account and deals can be structured such that funding is moved to a third party should triggers be met (e.g. the bank’s credit rating falls below a pre-determined level). The investment manager may also purchase CDS on the bank should they have concerns. In some jurisdictions (e.g. Italy), CRT funding is pari-passu to customer deposits, adding further protection. Transacting with Global Systemically Important Banks with low default risk also provides comfort.  

Regulatory Risk – The risk that regulators cease to approve deals, and that historical deals cease to provide regulatory benefits.

• Mitigant: This risk cannot be mitigated, and as such investors must be comfortable that regulators are going to continue to approve these transactions, and that should they choose to increase the risk weight floor applied to banks’ retained exposure, that these transactions will continue to make sense. These deals make sense from the perspective of regulators, who are involved throughout the process and approve all transactions.

Legal Risk – The risk that investment managers lack the expertise necessary to properly negotiate and structure deals, or that deals successfully executed sufficiently protect investors from other deal related risks (e.g. protection from bank default).

• Mitigant: These risks are mitigated by investing with managers who have longevity and experience investing in the space, and so who have learnt from past issues.

What to look for in a Regulatory Capital Relief manager

Absolute Return Partners is of the opinion that when investing in the space, managers with a long experience of structuring capital relief transactions should be favoured. Such managers typically have strong expertise in structuring, having executed a number of deals and having learnt from the pitfalls of the past. By virtue of their long tenure in the space, they have developed strong relationships with banks and with key bank personnel, allowing for smoother, quicker and more efficient structuring, as well as an increased probability of sourcing attractive deals, of putting raised capital to work and of completing on deals that have been negotiated.

Similarly, managers dedicated to capital relief transactions should be favoured as they will less likely be distracted by alternative opportunities (e.g. direct lending, portfolio acquisitions) that are packaged into broader bank deleveraging products, or in multi-strategy hedge funds. It is important that the manager is not being opportunistic and is a true specialist. In this regard, managers must be focussed on originating primary market transactions and not relying on a secondary market, which can often be inactive.

In terms of investment strategy, managers focussed on bilateral transactions, and with the assets to match this claim, should be favoured in that they are better able to control the terms of a structure and build in provisions that will protect investors, not having to accept banks terms and allowing an improved risk adjusted return. These managers must be well resourced, from both an AUM perspective and also from human capital perspective, to ensure that they have sufficient capital and expertise to close large, complex deals.

Return Expectations

Regulatory Capital Relief currently offers returns between LIBOR +8-10%, with income post-investment period (often the second year of a 5-7 year vehicle) as the ~8-10% coupons are distributed quarterly. Returns are entirely income and there is no capital gain component.

Conclusion

The strategy currently poses an attractive investment proposition. The opportunity set is strong-banks are under significant pressure to improve capital ratios and to continue to lend. This pressure allows experienced, well-resourced investors to structure transactions with economics in line with a bank’s cost of capital, and well in excess of the coupons generated by the reference portfolio. Risks remain, not least a spike in defaults of the underlying credits, or a bank credit event, and so manager selection is key to ensure that investors are protected against these via structuring expertise.

Mark Moloney

2 September 2019

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