Risk Sharing Transactions as an Investment – Part 4

In Parts 1, 2 and 3 of this four-part series, we introduced the Risk Sharing Transactions (RSTs) banks utilise to optimise Tier 1 Capital (CET1) ratios and the regulatory framework underpinning their development. We then went on to explain the economic rationale for the banks that issue RSTs.

In this fourth and final part, we’ll set out some key considerations for investors. Before doing so, let’s summarise a few key points from Parts 1–3: 

• "“RST,” also called “SRT” (Significant Risk Transfer) and “CRT” (Capital Release/Relief Transaction), refers to a strategy whereby a bank increases its CET1 ratio by reducing risk-weighted assets (RWAs);
   
• Estimated global issuance of RSTs has risen from $3.8 billion in 2014 to more than $20 billion in 2023;
   
• The reference assets for RSTs comprise diversified portfolios of hundreds, or even thousands, of loans to companies—from micro-caps and SMEs all the way up to global investment-grade corporates—and consumers, spread across industries and, sometimes, countries, in each case arising from core lending activities of the issuing bank;
   
• RSTs transfer a portion of the credit risk of these loans, typically the first 7%–10% of losses, sometimes above a first portion of loss retained by the issuing bank, to investors, with any losses in excess of this portion remaining with the bank;
   
• The transfer of credit risk using RSTs is usually synthetic, meaning the assets remain on the balance sheet of the issuing bank, which continues to service the loans and maintains relationships with its own customers;
   
• The efficacy of RSTs does not rely on complex structuring; banks or investors merely apply the risk-weighting regime set by the Bank for International Settlements (BIS) and the minimum capital requirements of the Basel III framework;
   
• Although a July 2023 joint proposal by US banking and financial authorities to implement so-called “Basel III Endgame” standards, with additional, more stringent requirements, into bank capital rules led to a rash of US RST issuance, the return of the Trump Administration may herald further change in the regulatory environment, making future volumes harder to predict;
   
• For banks utilising RSTs to release regulatory capital, the benefits of increased activity, shareholder dividends and a higher CET1 ratio potentially lowering funding costs accrue regardless of the performance of the underlying loan portfolio; if anything, banks appreciate that improved RST performance leads to
  lower coupons on subsequent RSTs." 

With regular cash distributions (typically quarterly), relatively short duration and uncorrelated, low-volatility, equity-like returns (Euribor plus high single- to low double- digit margins, depending on the underlying portfolio and deal structure), RSTs provide access to asset classes—such as SMEs and midcap loans—that are otherwise inaccessible and that direct investors and asset allocators alike have increasingly come to see as an important component of a diversified, balanced portfolio.

As with any strategy oZering sophisticated investors the potential for enhanced risk- adjusted returns, there are certain features to seek out and various pitfalls to avoid. The following are just a few of the key considerations:

1. Due Diligence and Valuation

The key inputs for the valuation of RSTs generally include (i) scheduled amortization of the reference portfolio, (ii) probability of default (PD) and loss-given-default (LGD) of the underlying credits1, and (iii) discount rates (forward swap rates plus discount margin).

Projected future cashflows can then be discounted back for valuation purposes, subject to deal-specific cashflow waterfalls based on features such as portfolio replenishment, tranche amortization and treatment of loss provisions.

Given that many of these inputs are provided by the issuing bank, the importance of thorough due diligence of both the underlying reference portfolio and the bank itself should not be underestimated. RSTs typically take many months to negotiate, and committing to a new transaction can, and often will, require years of remote and in- person engagement to fully understand the bank’s underwriting, servicing and workout processes. Successful RST investment requires a partnership between bank and investor, rather than one benefitting to the other’s detriment. Which brings us to the next key consideration…

2. Bank Motivation

Not all RSTs are created equal, and the investor should factor the motivation behind, and consequences of, RST issuance for the bank into any decision. As illustrated in Part 3 of this series, RST issuance releases regulatory capital as a consequence of the transfer, or sharing, of credit risk, but an investment-worthy RST will be motivated primarily, if not exclusively, by regulatory capital savings and not by risk transfer.
 

3. Syndicated or Bilateral

The market for RSTs can be broadly divided into two categories: syndicated and bilateral.
Syndicated transactions are typically widely placed, by either the issuing bank or a third-party adviser, to multiple investors committed to smaller ticket sizes. Syndicated transactions tend to oZer more advantages to the issuing bank than the investor, with a lower coupon, limited negotiation around documentation and more bargaining strength for the bank in selecting reference assets and structure. That said, syndication cannot always command an adequate market—for example, during periods of significant market disruption—and discloses the bank’s sensitive proprietary data to more market participants, including its competitors.

Syndicated deals also trade in secondary markets, meaning old deals may end up competing with new ones.
Bilateral transactions will usually have no more than three investors, with one of these typically taking the lead structuring and investment role. Bilateral deals oZer significant advantages to investors, with the more highly experienced able to negotiate bespoke portfolios and documentation to better suit their, and their underlying investors’, needs. Although bilateral deals may be somewhat less focused on pricing concerns than their syndicated counterparts, banks can still generate price competition between several potential investors before allowing a limited number through to binding oZers. Banks sometimes prefer bilateral deals, particularly for larger and more complex reference portfolios, because of the reliability of execution, greater cooperation post trade (for example, if post-execution restructuring becomes necessary) and more confidential nature of these deals.

4. Investment Grade/Large Corporates vs SMEs/Midcaps

A comprehensive exploration of the reasons for favouring SMEs/Midcaps over Investment Grade/Large Corporates, or vice versa, is beyond the scope of this article. At ChristoZerson Robb, we naturally have a view, but suZice to say, there are several factors weighing for or against one or the other, including the cyclicality of SME/Midcap versus Large Corporate/IG default and recovery rates, as well as the underlying motivation (see above) and economic purpose of the deal. We may return to this theme in a future article, but in the meantime, investors are well advised to investigate and understand an RST manager’s philosophy for favouring, or disfavouring, each when considering this investment strategy.

5. US vs Europe

The RST market is somewhat unusual among the more innovative investment strategies and financial tools in that Europe has led where the US has more recently sought to follow. The reasons are clear: Europe’s capital markets are underdeveloped compared to those of the US. The asset-backed securitisation market in Europe is around one- tenth that of the US, while the Eurozone’s nonfinancial corporate debt market is less than a quarter that of the US. European SMEs and midcap corporates are largely financed by loans that sit on the balance sheet of large, domestic banks. In consequence, Europe has the world’s largest banking system. France and the Netherlands, to take just two examples, record banking assets as a percentage of GDP of 427% and 314%, respectively, versus just over 100% for the US.2, 3

With European bank balance sheets carrying a burden far heavier than those of their US counterparts and funding to SMEs and midcaps constrained, European banking regulators have developed and promoted RSTs.
At the same time, European equity markets are a fraction the size of those of the US. To take the same two examples, France and the Netherlands have an investable stock market size as a percentage of GDP of 64% and 83%, respectively, versus over 190% for the US. Investors are therefore underallocated to Europe. RSTs provide stable, diversified access to an asset class that is otherwise inaccessible while shifting long- term risk to sophisticated long-term investors.

6. Leverage

The number of acronyms used for this strategy has increased over time, as has the universe of participating banks and investors, but RSTs have been around for a while now, even if they haven’t attracted much mainstream attention until relatively recently (largely driven by Basel III Endgame application—see Part 3). A great deal of press attention lately has focused on the extent to which risk is truly placed outside of the banking system, as intended by the BIS rules and Basel Framework.4

The concern is driven by some investors seeking to squeeze out additional yield through the use of recourse, or margin, lending obtained from other banks. If the RST performs as planned, then the issuing bank obtains its capital release, the lending bank receives its return and the investor receives its enhanced yield. However, if the transaction underperforms, perhaps in a general market downturn, exacerbated by poor underwriting and inadequate due diligence, the lending bank steps in to sell the transaction into an already distressed market and the credit risk belonging to one bank has been shifted to another. There is talk of regulators stepping in to address this ‘circularity of risk’, but in the meantime, the solution is clear: avoid recourse leverage!

Conclusion

The late Charlie Munger of Berkshire Hathaway was reported as saying, “We have three baskets for investing: yes, no, and too tough to understand.”

Amidst increasing attention from the financial press and with some estimates for full- year 2024 global RST issuance now exceeding $30 billion, this corner of private credit, just a few years ago considered out of reach for all but the largest institutional investors, may be too important for family oZices to ignore altogether. Mere encouragement of the reader away, in either direction, from the “too tough to understand” camp will be celebrated as ‘mission accomplished’ for this series of four articles on Demystifying Bank Risk Sharing Transactions.
 

1 See Part 1 for further details on PD, LGD and EL.

2 Christo9erson Robb & Company research based on 2022 figures from OECD, Eurostat and the World Bank.

3 Banking assets defined as non-consolidated financial assets of deposit-taking corporations, excluding the Central Bank.

4 See https://www.bloomberg.com/news/articles/2024-06-27/one-of-the-hottest-trades-on-wall-street- an-etymological-study?sref=kGkORAYH&embedded-checkout=true