In the second of a three-part series on bank risk transfer transactions, Olivier Renault* looks at the current state of the market

The SRT market is predominantly European (representing 86% of transactions since 2010), although US banks are accounting for an increasing percentage since 2019 - with JPMorgan now a regular issuer, one transaction by Goldman Sachs in 2020 and a few regional banks entering the market in 2021. Prior to 2019, only Citi and Bank of Montreal were regular issuers in North America. A few transactions have been executed by Japanese megabanks, but they remain sporadic.

Figures 3 and 4 display the number of transactions by country of originating bank and by underlying asset class over the entire period of 2010 to October 2021 and over the more recent period (2019-October 2021).

In terms of asset class split, large corporates account for nearly half of transactions, with SMEs adding another 20% to the corporate group. Figure 4 shows the growing prevalence of mortgage transactions, which were almost non-existent until 2018 but have accounted for 12% of transactions since 2019. This is driven by increasing interest by insurers in the mortgage asset class, high RW on mortgages under standardised US rules, as well as the need for some banks to free up risk capacity in high-LTV mortgages (Lloyds, in particular).

The specialised lending category is quite stable at 12% and refers to an eclectic bucket of transactions backed by real estate, shipping loans, infrastructure, project finance and renewable energy, as well as an increasing number of trades referencing capital call facilities, driven mostly by risk limit considerations. Trade finance transactions have become quite rare in the past few years, but accounted for around 8% of issuance prior to 2019.  

Transaction structures
Box B provides an overview of the main transaction structures used for SRT transactions. The SPV repack structure (illustrated as Structure 1) remains the most common, whereby one or several investors purchase a CLN from an SPV, which sells protection to the bank on a specified tranche of a reference portfolio. The SPV uses the proceeds of the issuance of the notes as collateral for the protection, either as a cash deposit with the hedging bank or by purchasing and pledging high quality securities.

For bilateral transactions between an investor and a bank, the SPV may not be needed, so that the investor could be the direct protection seller to the bank (Structure 2) - again with cash or securities as collateral if required. Well-rated insurance companies and supranational institutions tend not to pledge collateral, as the bank can rely on the credit quality of the counterparty to justify RWA relief.

Bilateral structures, such as those described above, are simpler than SPV structures and cheaper in terms of legal documentation. But they are totally illiquid (i.e. the protection seller would need to novate the contract to another counterparty, which would require bank consent) and do not allow for external leverage. SPV notes, on the contrary, are usually transferable and repo-able, and are more convenient when there are several investors in the transaction.

Over the past few years, CLNs issued directly by a bank rather than an SPV (Structure 3) have become increasingly more frequent and they are the market standard for US banks. The bank issues a bond to one or several investors, whose principal is written down as and when losses erode the reference tranche.

This structure has the same transferability and repo-ability advantages as SPV-issued CLNs, but does not require a vehicle to be set up. This can have favourable tax consequences - in particular, for transactions with a US nexus - and it avoids sometimes difficult Volcker analysis. The main drawback of the bank CLN structure is that investors are exposed to the credit risk of the bank, while SPV structures or bilateral guarantees usually include provisions for the cash collateral to be moved to another bank if the hedging bank’s credit quality deteriorates significantly.

Most risk transfer transactions (between the bank and the SPV or the investor) used to be structured as CDS until 5-6 years ago, but financial guarantees are now the dominant type, due to attractive accounting benefits (no need to mark to market and potential provision release, which is not possible using a CDS). Bank-issued CLNs do not require a CDS or a financial guarantee to be executed, but can be drafted as cross-referencing a hypothetical CDS/guarantee so that the risk transfer language is very similar to that of other structures.

In the third part of this series on bank risk transfer transactions, to be published next week, we will explore the outlook for the market in 2022 and beyond.

*Olivier is a veteran of the SRT market and one of the leading originators and structurers on the asset class