Basle scrutinizes capital relief trades

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Cost of protection under scrutiny as demand for risk transfer grows.

It is not only Europe’s banks that have been taking a closer look at the potential for regulatory capital relief trades as the EBA’s June capital ratio deadline approaches.

The Basle Committee has been taking an interest too – announcing just before Christmas that it will closely scrutinize some recent credit protection trades, particularly where the cost of credit protection is deemed excessive.

This could put a brake on what has been a useful tool for a select few banks, but it is not the killing off of a trade that could have been widely adopted by the region’s cash-strapped lenders.

Regulatory capital relief trades, whereby banks transfer a slice of risk on various portfolios to a third-party investor to gain capital relief, have been the preserve of a small number of banks for some time. While mostly private, a few public deals have now been done – primarily by Standard Chartered – after stricter guidance from the UK’s FSA.

One adviser close to the trades explains that there are around half a dozen banks that issue programmatically but that, unsurprisingly, there are more banks attempting to break in. This could be tough given current appetite for European bank risk and competition for a limited investor base.

These trades look similar to a sale of the first or second loss piece of a balance sheet CLO. A bank sitting on a portfolio of €1 billion triple-B loans might be looking at expected losses of around €40 million to €50 million. Capital relief trades can be written on a range of assets on a bank’s balance sheet – RBS announced a $130 million deal last month that aims to sell a slice of risk from a $2 billion portfolio of counterparty exposures.

These trades differ from CLOs in that there is a formal alignment of interest between the bank and investors – the latter in effect taking exposure to a snapshot of the bank’s balance sheet. For this reason, the investor must have a high degree of comfort over the bank’s viability or be paid a whacking great fee to take on the risk.

This is what the Basle Committee is worried about. Banks might be paying over the odds to buy credit protection on exposures that they know are bad but do not want to take an immediate write-down on. Buying five-year-swap protection enables the impact of these losses to be spread over a longer period. They are particularly focusing on trades where the cost of credit protection could exceed the expected losses on the assets themselves.

Capital relief trades that are shown to be legitimate will likely be unaffected by any Basle diktats, but that doesn’t mean that the market is set for an uptick in activity. These are term investments where investors can be tying their money up for some time – up to 10 years. As such, the 14%-ish return falls somewhere between what they might be able to get in, for example, private equity and more traditional – and tradable – fixed income.

There are a small number of specialist funds operating in the space and there have been a limited number of new fund launches, but given the size of bank capital requirements in Europe, it will remain a drop in the ocean.