Significant Risk Transfers: Is There Really an Endgame in Sight?

Key Takeaways:

• We believe there are supporting market tailwinds for the continued use of SRTs.
• The United States has been more tactical to date and Europe more strategic given the structural and regulatory differences informing their different patterns of SRT use.
• Ultimately, we believe the more nascent U.S. SRT market will grow as U.S. banks seek to minimize exposure to certain sectors.
• SRTs present a compelling opportunity for scaled global investors who have the capabilities to see the market holistically across structures and jurisdictions.

The market for significant risk transfer transactions (SRTs) has attracted considerably more attention recently, as many banks increase the use of such transactions to reduce risk-weighted assets (RWAs). As the impact of the proposed Basel III Endgame¹ regulations becomes clearer, we anticipate a heightened focus on using SRTs to reduce RWAs.

SRTs typically take the form of cash or synthetic securitizations, through which (primarily credit) risks on various types of portfolios are transferred to investors. Investors, in turn, acquire exposure to the portfolio through tranches that offer varying levels of risk/reward (junior, mezzanine or senior) with target IRRs ranging from mid-single digits to mid-teens.

The use of SRTs is well established among European banks as a tool to manage and optimize regulatory capital associated with banks’ core lending activities. Banks in the United States have stepped up their use of SRTs as well. In fact, we foresee strong growth in the U.S. market this year on the heels of continued deleveraging and shifts in the credit markets (Exhibit 1). Longer term, we think the U.S. SRT market will evolve to resemble the European market more closely.

EXHIBIT 1: The SRT Market Opportunity

Potential Benefits for SRT Investors

For investors, SRTs offer several attractive attributes, including access to high-quality assets and consistent cash flows. Loans to corporations, ranging from small and medium-sized enterprises to large corporates, remain the dominant asset type included in SRTs. These often comprise blind portfolios with long replenishment periods, so that the underwriting process is more a function of underwriting the originator than the portfolio.

However, non-corporate assets such as residential mortgages, auto loans and leases, and personal loans are increasingly included in SRTs. Unlike corporate portfolios, these transactions tend to be significantly more granular and originated with credit scores attached to the borrowers. Evaluating such transactions requires specialized expertise in asset-based finance (ABF). As global asset-based finance investors, we have been leaning into non-corporate SRTs recently. Of the approximately 150 such deals we’ve seen and five transactions we have participated in since 2016, three were executed in the last 18 months.

Investors can select tranches that fit their desired risk-return profile and benefit from the diversification that comes with the granular nature of the portfolios. Given the extensive information on attributes of loan borrowers and collateral (homes, vehicles, etc.) and detailed performance data, often with payment, delinquency, default and recovery curves data, investors in non-corporate SRTs can create detailed models to create base-case and stress-case models of performance. For example, our team worked with a European institution with a 15-year track record on an SRT referenced to a portfolio of prime auto loans. The team reviewed years of historical data, allowing the opportunity to analyze performance in different vintages over time, including the Global Financial Crisis. We have subsequently executed further transactions with the same institution, underscoring the potential value of longevity in this marketplace.

As investors across synthetic and cash SRTs (Exhibit 2) in a myriad of asset-based sectors, we have seen all kinds of opportunities come to market over the past several years – and not all of them are created equal. We focus on transactions involving diversified asset-based portfolios, particularly where extensive historical performance data are available. And while SRTs can be broadly syndicated, bilaterally negotiated, or something in between, we prefer those where, through bilateral negotiations, we can tailor the terms and structures to optimize the risk/reward profile of our investment. Finally, we favor originators with long track records in sectors that our team has extensive investing experience in (i.e., autos, mortgages, or specialty lending).

EXHIBIT 2: Defining the Two Types of SRTs

The SRT Evolution: Not just a European Bank Phenomenon

Global SRT volumes have been rising steadily. In 2022, the most recent year in which data were available, €20 billion of protected tranches were issued globally, collateralized by €200 billion in loans, up from €3.7 billion in 2016, according to the International Association of Credit Portfolio Managers. Our firsthand experience affirms that activity is growing rapidly.

European banks currently account for the lion’s share of SRT volumes, given SRTs have been in use for several years, and bank regulators in Europe have provided regulatory clarity on the use of SRTs for capital relief. Recently, SRT activity has also been increasing in the United States, which accounts for 19% of global SRT transaction volumes, and Canada. The U.S. Federal Reserve paved a clearer way for the SRT market’s growth with written clarification released in their September 2023 FAQs. The document specified which banks could engage in the transfers, and the Fed staff acknowledged that Direct Credit Linked Notes (CLNs) can be an effective way to transfer credit risk.

While both cash and synthetic SRTs are used in both the U.S. and Europe, the two markets have had differing capital constraints informing their use. We categorize these catalysts in two buckets: tactical and strategic.

In the United States, banks have tactically mobilized SRTs to free up capital and liquidity on the heels of the regional banking crisis in 2023, shedding exposure to long duration fixed rate assets, to manage the risk of deposit flight. These SRTs are typically in the form of cash securitizations.  

In Europe, most European banks are using SRTs strategically to optimize their use of capital in the face of ongoing capital constraints that constrain their ability to provide credit to core customer segments. Contrary to the United States, which has thousands of regional banks, the banking sector in Europe is smaller, more concentrated, and predominantly served by large banks. This makes it worthwhile for banks as well as investors to treat European bank-sponsored SRTs as a sizeable opportunity.

Increased regulation lies behind the growth of the market in both regions. The Basel Committee on Banking Supervision issued a rule in 2017 that standardized the formulas banks should use to calculate RWA, which in turn help determine bank capital ratios. In the wake of the U.S. regional bank failures in March 2023, U.S. regulators proposed even stricter rules, known as Basel III Endgame. These rules are still being debated, but the largest U.S. banks could see RWAs rise by as much as 24% if the original rules are adopted, according to the U.S. Federal Reserve.

U.S. Federal Reserve Chair Jerome Powell has indicated recently that the Endgame proposals may be further revised. Some market participants have surmised that, without these ultra-tight regulations, banks will stop using SRTs. In addition, while the Fed settled some questions about how banks could use SRTs in their September 2023 FAQs, including which banks could engage in the transactions and that the Fed’s staff recognize CLNs can be an effective way to transfer credit risk, a number of questions remain.

We believe banks will continue to seek out ways to de-risk and optimize their balance sheets even if the final capital requirements are “looser” than previously anticipated. Banks have been under continued pressure to reduce capital associated with consumer, mortgage, and commercial and industrial loans, and we do not see that pressure abating. Based on estimated bank exposures as of year-end 2023, even a 1% reduction in exposure to these areas could result in some $7 billion of SRTs through CLN issuance.

We also note that raising equity, another option banks could evaluate to improve capital ratios, is both dilutive and expensive in an elevated-rate environment. SRTs allow banks to obtain regulatory capital relief and improve capital ratios without diluting shareholders.

What’s Next?

SRTs are one component of a continuously evolving market matrix. We think taking both a top-down and bottom-up view of markets is essential both to anticipating the opportunity set and determining the optimal relative value between transactions. We expect SRTs on more asset portfolios and of greater variety across a larger number of banks to become available. We believe this market offers fertile investing opportunities for global asset-based investors with breadth, a specialized skill set, and the scale to position themselves as a go-to partner for banks. 

^1. Also known as Basel 3.1 or Basel IV