In the final instalment of a three-part series on bank risk transfer transactions, Olivier Renault* explores the outlook for the market in 2022 and beyond

We have seen in part one of this series how far the SRT sector has developed in the past 10 years from a niche market with 10-12 transactions issued a year to a much larger and more diversified market. Barring a material downturn in the credit cycle, the SRT market should continue to enjoy strong growth in the next few years.

Supply could easily double in a five- to seven-year horizon on the back of several key drivers. These drivers include:

1. Greater adoption by banks: As more and more banks acquire the technology, supply should mechanically increase. The first transaction for a bank takes a year to execute and requires significant time and cash investment to complete, as it involves multiple teams at the bank (portfolio management, risk, legal, IT, accounting, capital, etc), as well as its regulator.

Once this sunk cost is spent, the bank is incentivised to continue issuing and to roll out the technology across asset classes and jurisdictions. As shown in Figure 2 (see part one), around 55 banks have executed SRT transactions with private investors and many more have done bilateral guarantees with the EIF, which require much of the same upfront work. This will provide a strong basis for growth as a greater pool of banks applies SRT to a variety of portfolios.

2. STS: As shown in Box A (see part one), the STS framework is a game-changer for standardised banks and many of them will realise that SRT can now be executed in a cost-efficient manner. It is already very clear that this trend started as soon as the STS rules were published in EU law and supply from standardised banks will increase significantly in the coming years (mainly in Southern and Central Europe). The full extent of the impact of the STS classification on supply should be visible in the next 2-3 years.

3. Geographical diversification: We are just at the beginning of the roll-out of SRT hedges in the US, with most of the large US banks still not active but looking at their peers in the context of the binding Collins floor⁵. The top five US banks hold US$2trn in wholesale loans. If they were to securitise 10% of this, it would create an additional circa US$25bn of tranches versus a current stock of circa US$35bn. An increase in supply in Canada, Japan and new jurisdictions (emerging markets) is also likely, based on many conversations investors and arrangers have had with potential issuers.

4. More than RWA relief: While most transactions are driven by the desire to free up RWAs, a number of SRT transactions are executed for other reasons, either as the main driver for the transaction or as a significant motivation.

New accounting rules (IFRS 9 provisioning and CECL in the US) can allow banks to release provisions, either at the inception of the hedge or if/when loans deteriorate in the reference portfolio. This provides banks with a P&L offset to losses arising from increasing provisioning and has been a key motivation for a few recent transactions referencing deteriorated (Stage 2) credits.

Tranche hedges were often ignored by risk departments, as it can be hard to allocate the benefit of a partial hedge to specific credits (if the bank hedges a 0%-10% tranche, should the risk team grant full credit limit on the portfolio, 90% limit release or 100% on the 10% riskiest names?). But increased recognition of their efficiency and the need to better align economic and regulatory capital have pushed risk departments to increasingly accept credit limit relief for tranche hedges, which provides further impetus for issuance.

As these additional benefits are better understood and recognised, the attractiveness of SRT transactions for banks will grow and consequently so will the number of transactions.

Basel 4 has often been touted as a potential catalyst for growth in the market, but the group of measures encompassing Basel 4 can have mixed impact on the efficiency of the SRT market. On the positive side, risk weights of many asset classes are likely to go up - in particular, for assets with low default rates, for which banks may no longer be able to use their own LGD estimates. This is positive for SRT, as banks would free up more RWAs for the same cost, so the cost of freeing up capital would be even cheaper than it is currently.

However, the overall risk weight floor could be more problematic (see Box C). Banks will be required to calculate their capital requirements under both the standardised and the IRB approaches, with the IRB requirements being floored at a certain percentage of standardised capital.

Because the formula to calculate risk weights on senior tranches of standardised portfolios (SEC-SA) is so much more punitive than that for IRB portfolios (SEC-IRBA), an efficient transaction under the IRB approach may bring little or no benefit once the standardised floor is applied. It is still a point of negotiation between the industry and local rule-makers (e.g. the EU) as to how precisely the Basel 4 floor will be applied to SRT transactions. But the initial proposal could be a significant hindrance to issuance - in particular, for non-STS transactions where the gap between SEC-SA and SEC-IRBA is greatest.

Conclusion
The SRT market is now a mature market, with banks, investors and regulators comfortable about its resilience and usefulness. The product is part of the capital toolkit of many banks as AT1 bonds or other well established capital instruments. This market still has considerable room for expansion, as only 50-60 banks have yet adopted the technology globally, and market and regulatory tailwinds should push many more to follow suit while existing issuers continue to apply SRT hedges to more asset classes and in a greater number of jurisdictions.
 

Notes

1. See SCI article on Collins Floor, published on 22 March 2020

*Olivier is md and head of risk sharing strategy at Pemberton Asset Management