Significant risk transfer securitizations have gathered so much momentum in the US that they are drawing the attention of the Wall Street commentariat. This is not always welcome or even well informed.
SRT deals are securitizations, usually synthetic, in which banks transfer the risk of asset pools to investors, to reduce the economic and/or regulatory capital they have to hold against them.
Ever on the lookout for the next 2008, commentators see banks and investors rushing towards something called ‘synthetic securitization’, and before they can help themselves, they are at their laptops foretelling an imminent disaster.
Surely someone is ripping someone else off? Or maybe the banks and investors are colluding to fool the regulators, they bluster.
But SRT exists for good reason. Most policy makers, including those in the UK, US and European Union, want to boost GDP growth. As banks are capital-constrained, lending will be limited unless they can recycle their capital to support new loans. If lending is limited, then growth can be too.
SRT is the tool that allows banks to recycle capital. If they can pass the risk of their lending on to a private investor, it frees up the capital.
That explains why it is possible to have a deal that works for everyone.
The regulators monitor the capital in the banking system and get to sign off on every transaction. The banks are excellently placed to make loans, but inefficient holders of the risks, because they are so tightly regulated to protect the system.
Non-systemic private investors are a natural home for such risk, if they are adequately compensated.
To engage in an SRT, a bank pays far more than its average cost of funding because the deal is designed to liberate capital, not merely to raise liquidity.
Generally, the cost of an SRT compares favourably with the costs of alternative sources of capital, such as equity.
The investor in an SRT is taking risk on specific assets, so needs to be compensated for that risk — it is not the same as providing senior funding to a bank.
Why not just sell the loans? Well sometimes banks do, like Metro Bank in the UK, which sold £2.5bn of mortgages last week. But whether that meets the bank's needs depends on whether it needs liquidity and how attractive the bid is for the assets, especially the large, low risk senior part of the portfolio.
For a bank considering freeing up capital on a portfolio in the billions, it needs a hefty player to take on the whole book.
Besides, if you borrow from a high street bank, you don’t expect your loan to be sold to a hedge fund, so it can be tricky for banks to sell whole loans out of the banking system. Indeed, Metro sold its mortgage book to NatWest.
Other kinds of loan cannot be sold at all. Banks extend hundreds of revolving credit facilities to companies. Most of the time these sit undrawn, but still eat up capital. Yet the bank will not want to part with them, because they are a core service it provides to their clients, which the clients need, and also which unlock the chance for the bank to earn other business from those companies.
Bearing in mind the reason these loans were granted, they can hardly be sold, but the risk can be.
As critics often fail to recognise, the risks being sold in SRT deals are real — some deals have transferred actual losses.
As the latest iteration of the Basel Capital Accord is brought in, the capital constraints on banks will bind more tightly.
SRT will only get more important to the healthy working of the banking sector. Some observers will need to look more carefully at how it works.