SRT set for big expansion as Basel IV deadline approaches
The Significant Risk Transfer (SRT) market is set for growth but faces headwinds, principally in the form of Basel IV, which, while increasing the need to transfer risk, makes SRT a less efficient tool for doing so. Even so, growth seems likely as nascent markets develop, new assets are considered, and global regulators come to recognise the importance of SRT in managing bank capital and risk
The imposition of Basel IV’s output floor is expected to hit European banks that have adopted the Internal Ratings Based (IRB) approach. The banks will be obliged to calculate risk-adjusted assets under both the Standardised approach and IRB approach. The capital they must hold under IRB cannot be less than 72.5% of what it would have been under Standardised approach. This floor will be phased in from 2023, rising 50% to reach 72.5% in 2028.
Because the floor pushes up capital consumption, banks should be more motivated to transfer risk which would theoretically be good for the SRT market. However, the floor will also apply to the senior retained pieces of a securitization, which is currently not the case. As such, the Basel IV’s floor will make SRT a less efficient tool for transferring risk.
Basel IV’s output floor should mean that lower risk portfolios attract higher risk weights, according to Vincent Charles-Gervais, ABS portfolio manager at M&G. He says the retained senior tranche will detach higher up the capital structure, “meaning there’ll be a need for thicker risk transfer tranches”.
This is likely to prove prohibitively expensive and therefore, “to make the economics work banks may opt for a two-tranche SRT structure,” says Charles-Gervais, who adds that this should effectively reduce the overall blended cost.
The problem is that there may not be enough investors to buy the mezzanine risk, which is expected to have a return target of between 300bp-500bp. Charles-Gervais says that capital that yields investment grade returns is “not easy to find” as most investors with these sort of return targets usually require an external rating and a liquid investment.
This potentially means there’ll be insufficient investor interest, which may lead to an increase in the executable price level to a point where the SRT structure is ineffective or “no longer works”, he said.
The very idea of applying an output floor to the retained senior tranche of an SRT trade is considered “excessively punitive,” according to Olivier Renault, portfolio manager and head of the risk sharing strategy at Pemberton Asset Management. “There is therefore some effort being made with regulators to clarify whether this is intended or not.”
If the regulation goes through without adjustment, banks will have to issue more mezzanine debt for which, he agrees, there is a limited investor base. “That then means there is a higher risk the deal economics do not work which ultimately means banks will be more constrained in their ability to lend to the real economy,” said Renault.
This negative view is somewhat underscored by Frank Benhamou, head of funding and capital solutions, CRE and NPL financing at Barclays. In his view, Basel IV’s capital output floor is likely trigger a higher capital consumption for most SRT positions and as a result it will be less efficient depending on the specific bank.
“Thicker tranches are going to be required to be sold to achieve an efficient capital reduction on a given portfolio,” he says, noting that a number of institutions had pointed this out to regulators as an unintended consequence in the hope that a mitigating solution might be found.
On the asset side of the balance sheet, Basel IV may cause risk weights to go up, in particular where asset classes do not have sufficient historical loss given default data. According to Renault, this lack of relevant data makes it difficult for regulators to ascertain the appropriate risk. As such, they “will insist on a more bucketed approach that will effectively push risk weights up”.
Although the introduction of Basel IV has mixed blessings for the SRT market, it should nonetheless be set for growth as new issuers in established and nascent regions turn to the market with a broadening array of asset classes.
In Canada and Japan Basel IV is also an important topic suggesting the output floor will cause selective banks following the IRB approach to consider SRT trades. Bank of Montreal has been involved in the SRT business for years, and it’s likely all other major Canadian peers will follow, with Royal Bank of Canada thought to be among the front runners.
In Japan MUFG Bank has issued SRT deals in the last few last years and some believe the other mega-banks will follow suit with issuers primarily motivated by the desire to transfer risk on their foreign assets.
There are also high hopes for the US market. The fact most US banks have adopted Basel IV’s Standardised approach means they will be unaffected by Basel IV’s output floor which mainly affects those adopting the IRB approach. Even so, US issuers have found the SRT market a useful tool for managing risk. Citi has been active for years but more recently JP Morgan, Goldman Sachs, HSBC and several regional banks have issued SRT deals.
More pointedly, the Collins Amendment to the Dodd Frank Act is likely to signal an increase in risk weighted assets “obliging US banks to issue more SRT,” says Gervais.
Bankers say Australian issuers are also keen to follow Europe into the SRT market, but the region lacks a regulatory framework. This reflects the widespread view that the Australian Prudential Regulatory Authority (APRA) has so far not been convinced about the merits of SRT issuance.
Irrespective of what APRA thinks, the SRT market’s standing has become more assured, particularly over the last two years. “Overall, it feels SRT deals have become more and more accepted by regulators across all jurisdictions,” says one banker who highlights developments in Greece, Poland, and Italy.
In his view, the big, sophisticated European banks have exported their knowledge to second tier banks, helping to broaden the market. As a capital management tool he thought SRT was superior p
roduct to additional tier one issuance because risk exposures are more defined. “SRT is eating the lunch of AT1 a bit,” he says, noting that investors can more readily negotiate their exposures, unlike AT1 which “theoretically fund the worst assets of the bank”.
Benhamou says SRT is likely to be increasingly applied to many asset classes and thought this trend was set to continue. “SME and corporate loans have been the staple asset but increasingly we’re seeing other assets like mortgages, infrastructure loans, commercial real estate loans, auto loans, subscription lines and trade finance loans,” he says.
According to the senior portfolio manager at a leading SRT investment firm based in New York, a very busy fourth quarter is expected. “The stresses caused by Covid gave banks and regulators some confidence about the effectiveness of the SRT market,” she says. “We now see more banks in more geographies beginning to use the tool, while those that are already using SRT are expanding into new assets”.
But according to the same person the uncertain macro-economic backdrop caused by the conflict in Ukraine is likely to impact the way investors select pools leading to more sensitivity around certain sectors, names and levels of disclosure.
Renault agrees, saying that the Ukraine crisis had helped shift bargaining power into investors’ hands. As a result, they have started to factor tougher assumptions which may result in wider spreads and/or tighter criteria. “If banks expect to have more losses that deplete capital there should be a greater need to transfer more risk which will be good for the supply side of this business,” he says.
The impact of the Ukraine crisis is expected to result in SRT deals excluding or decreasing certain risk exposures to affected regions as well as to the industries that are most impacted by inflation, says Benhamou. However, this may not necessarily lead to wider spread levels.
A more detailed pool selection, greater disclosure and thicker tranche sizes “should mitigate the need for higher spreads,” said the US portfolio manager. Her firm’s goal is to focus on stable structures “with a deep insight into the underlying credits in order to create a robust portfolio”.
A robust portfolio is likely, to some extent, to be a sustainable one, but according to the same person, environmental, social and governance regulations are slightly onerous.
“On the one hand it’s very important to protect against green washing but on the other you don’t want to stifle innovation. My concern is that the strict qualification of green assets limits what qualifies as green which risks cutting out a lot of interesting sustainability-linked, impact-oriented structures,” she says, highlighting pioneering ESG deals from the African Development Bank and Santander.