Constrained banks look to synthetic sub line risk transfers

The past two years have been among the most challenging in the history of the subscription credit line lending market.

Many were forced to ease up on issuing capital call facilities to avoid breaching internal limits and to adapt to stricter capital regulations. A spring banking crisis that ravaged three of the US market’s participants was another shock. And post-Great Financial Crisis reforms long in the making have intensified risk capital requirements for fund finance products.

But lenders are increasingly making use of multiple tools to mitigate their exposures – tools that have the benefit of doubling as business lines for the financial institutions offering them.

Among them: credit risk transfer deals, in which banks enter transactions with other banks or alternative asset managers. Such deals can take on various forms, but each version involves recipient entities assuming credit risk in exchange for financial upside.

Credit guaranties also garnered increased interest. In these transactions, insurers agree to take on the repayment risks associated with banks or blinds in exchange for premiums.

Both tools have gained popularity in recent years because broader growth in the sub lines market pushed banks’ exposures to their limits, sources say. And this interest has continued into 2023 as lenders have faced a confluence of headwinds.

“The inbound inquiry has picked up over the last year,” says Steven Tremblay, managing director for structured finance at Assured Guaranty, adding that drivers for this range from rising awareness of the product to the spring banking crisis.

“We’re definitely seeing an increased interest in use in financial guaranty and other insurance products,” adds Leah Edelboim, a partner in Cadwalader’s fund finance practice.

The capital benefits of each choice vary by region, sources note, with banks based in the US generally benefiting more from risk transfers and those in Europe seeing guaranties as more attractive. But regardless of the region, they can be used for managing in-house lending limits.

Risk transfer shape shifts

There are three primary ways to perform credit risk transfers, explains Olivier Renault, portfolio manager at Pemberton Asset Management, who leads its risk-sharing strategy.

In the first approach, the investor writes a credit default swap or provides a guaranty to the lender in exchange for compensation.

“They buy protection from us, they pay a premium to us, and then we give them collateral in the form of a cash deposit to secure the protection so that they’re not running counterparty risk on us,” Renault says.

But these transactions comprise just “a small portion of the market,” he says.

The second approach is similar, but here the bank buys its protection from a special purpose vehicle instead of directly from an investor. The SPV is on the hook for the protection, and it issues credit-linked notes to the investor in exchange for cash collateral.

Under the third – and most popular – option, according to Renault, the bank directly issues a credit-linked note to an investor.

Under all three of these agreement types, investors often agree to compensate banks if the underlying loans incur losses of up to certain percentages, Renault explains. The notes offer floating rates comprised of a base – typically SOFR – plus a margin of 5-7 percent, he says.

Jed Miller, a partner at Cadwalader who specializes in credit risk transfers, says they go by several names, including capital relief trades, significant risk transfers (more common in Europe) and synthetic risk transfer transactions.

Credit risk transfers, or CRTs, have existed for decades, but versions engineered for sub lines have only been around since 2018, Renault says. The portfolio manager, who has been involved in CRTs for 17 years, explains that they are primarily used for commercial and SME loans. Government-sponsored enterprises like Freddie Mac and Fannie Mae, as well as some banks, primarily in Europe, have also used versions of CRTs structured as securitizations to offload the risk of residential mortgages.

Banks can use CRTs to obtain lower risk weightings on their sub lines, Miller says.

The Basel IV boost

Sharing sub line risk is important for US banks for capital purposes – both due to the status quo for the largest banks and because of a proposed regime for a broader number of lenders.

Sources point out that the biggest stateside banks currently must use two approaches for determining risk weightings of their assets for capital purposes: a “standardized” approach that can trigger higher percentages, and an “advanced” approach using in-house modeling.

A 2019 rule outlining this dual-approach requirement states that it applies to Category I banks – those designated as global systemically important banks – and Category II lenders, which are not GSIBs but have assets of at least $700 billion or multi-national business activity of at least $75 billion.

The standardized approach requires that banks asset 100-percent risk weightings to assets such as sub lines and NAV loans, sources explain. In contrast, the advanced approach by itself has given them some wiggle room because internal modeling is used.

The requirement to calculate under two approaches meant the biggest banks had to switch to tighter capital regulations, explains Jeff Johnston, chairman of the Fund Finance Association and co-head of EverBank’s fund finance business.

“They were previously largely just relying on [the advanced methodology], but then had to phase in reporting both and being governed by the worst of the two (which recently has been the standard approach),” he says.

In referring to the “worst” of the approaches, Johnston notes that banks must go with whichever one mandates them to hold more capital.

By contrast, the 2019 rule states that smaller banks only have to use the standardized approach.

Smaller banks are designated either as Category III – they have at least $250 billion or a minimum of $75 billion for certain types of lending and off-balance sheet exposures – or as Category IV, with at least $100 billion in assets.

Moving forward, US-based lenders in all four categories will face stricter capital regulations in general due to a proposed “Basel III Endgame” framework that is sometimes referred to unofficially as Basel IV.

The framework is “particularly punitive for US banks,” Renault says. This impending regulatory shift has caused interest in risk-sharing to pick up among US banks, he notes.

And Renault points out that a tighter regime makes sharing risk more important for these banks than it is for European ones.

In contrast, he notes that European banks have little incentive to use CRT arrangements because they don’t face the hefty capital charges on sub lines that their US peers face. Banks in both regions can still use them to manage their internal lending limits.

US implementation of the proposed regime is handled by the Federal Reserve and the Federal Deposit Insurance Corporation. The regulators accepted public comments until January.

The regime’s implementation timeline varies by jurisdiction. For example, Renault notes that Canada is currently phasing it in, while the European Union has finalized its adoption ahead of a phase-in.

Basel III Endgame isn’t expected to directly affect sub lines, Miller explains.

“In most cases, the risk weight for sub lines is not going to be different,” he says.

Indeed, Basel III Endgame calls for an “expanded risk-based” approach for risk weights but keeps them at 100 percent for sub lines, sources note. The difference between the standardized and expanded approaches is that the latter will entail a more “granular” analysis for risk weights, Miller says.

But the proposed regime entails a series of requirements spanning operational to market risk, with the overall impact being restrictive to banks – thereby putting indirect pressure on their debt portfolios more broadly.

“We do think that banks are generally going to be more capital constrained,” he says.

Miller expects they will think more carefully about their general lending activities, rather than causing them to be less receptive of sub lines as an asset class.

“Banks are going to have to be more thoughtful about how they optimize capital,” he says.

Miller anticipates that the new capital regime will be further incentivized to use CRTs in response. But he also expects that the direct capital treatment of sub lines under Basel III Endgame will be neutral versus the status quo.

The expanded risk-based approach would apply to all four categories of banks. Large banks will drop the advanced approach and use the expanded risk-based one for their dual calculations along with the standardized approach.

US banks would have to assign 100-percent risk weights to their wholesale lending exposures, Renault notes. This category spans sub lines, NAV loans and “corporate loans of any riskiness.”

Risk transfers involving credit-linked notes have the Federal Reserve’s blessing for capital relief, per a series of FAQ responses that it released in September. The Fed stated that direct exchanges of notes require approval from its board of governors, while transfers involving SPVs do not.

This guidance marks the latest sign of the central bank’s growing receptiveness to risk transfers.

There was a dearth of approvals of these from the powerful regional New York Federal Reserve, from late 2021 until Q2 of 2023 due to a regulatory pause, Renault says.

“They did a review of the market to make sure the transactions were done according to the rules, so they put the market on pause in the meantime,” he explains. “This review took a long time but was satisfactory, so they provided some additional guidance and allowed banks to resume issuance.”

The New York Fed’s approval authority covers big US-based banks, along with foreign-based ones with significant activities in the US. But Renault adds that authority over non-US banks for CRT depends on the situation.

“A non-US bank doesn’t need US regulatory approval to do a transaction on its US book if they are only looking for capital relief at the consolidated group level,” he notes. “But if they need capital relief at their US entity’s level, then they have to comply with US regulatory rules.”

Guaranteed to lift a load

With a credit guaranty, a sub line lender limits its exposure by partnering with an insurance company.

Under this arrangement, an insurer steps in to take on repayment risk for sub lines to protect the lender in exchange for compensation, explains Tremblay.

“What we are guaranteeing is the payments of principal and interest due under those subscription loans that the lender has made to the fund or the borrower,” he says. “To the extent that the borrower is unable to repay those loans, Assured would ultimately step in and make those payments to the lender so that the lender essentially is paid out in full.”

Assured is compensated for extending guaranties via premiums that are effectively deducted from the sub lines’ margins, Tremblay says.

Guaranties can be used for either regulatory capital or limit relief, but US lenders can’t get the favorable treatment for the former, compared to CRTs.

“A US bank may not get capital relief, but they may not necessarily be seeking capital relief either,” Tremblay says. “They may be seeking simply to manage their internal sector limits or sponsor limits or ticket size limits – whatever those may be that are the touch point for that particular lender.”

Lenders in Europe and Asia can still tap into guaranties to bolster their capital positions, sources explain. And Assured offers its product to both US and non-US lenders to meet their varying interests.

And unlike US-based banks, foreign-domiciled ones can still use insurance to get favorable capital treatment in their home countries for sub lines extended by their US subsidiaries, says Cadwalader’s Edelboim.

“We are seeing these products being used in the US fund finance market by lenders that are established in Europe and Asia,” she notes.