Beware Banks Dipping Into This Murky Trade

(Bloomberg Opinion) -- A type of financial engineering that proved to be toxic during the financial crisis is slowly making a comeback as banks try to offset the risk of their borrowers not repaying their loans..Capital relief trades, or synthetic deals, are making a comeback – and Europe is about to refine the rules of the game. Getting those right will be crucial if we are to avoid a repeat of history..The products all have one thing in common: they provide a cosmetic improvement to a lender’s balance sheet. They shunt the risk of a borrower defaulting away from the lender to other players in the financial system – in much the same way that loans were securitized, or sliced up and sold, before the financial crisis..But these aren’t true disposals. Banks are, in effect, only taking out insurance against the risk of future losses by using derivatives. The actual loan remains on the books of the original bank – and the insurance allows the lender to reduce the amount of its own capital it has to set aside to cover the risk that the borrower defaults..The incentives for both buyers and sellers of credit protection are becoming more compelling than ever. On one hand, European banks are still struggling to get their capital buffers to the levels required of them, a goal that is being complicated by the ongoing squeeze negative interest rates are putting on profits..On the other hand, yield-hungry investors – from hedge funds to insurers – are only too keen to pick up some juicy returns in the era of, wait for it, negative interest rates..The deals aren’t cheap. They tend to yield more than Additional Tier 1 bonds, which can be converted into shares if a bank’s capital ratio falls below a certain level..But they do allow lenders to release a fair amount of equity without attracting public scrutiny. That’s just as well: With their valuations near record lows, banks would prefer not to raise fresh funds on the stock market..What is far from clear is the extent to which synthetic transactions actually transfer risk given their complexity. In deals that aren’t funded, or collateralized, the buyer of the protection (the lender) remains exposed to the risk that the counterparty may not be able to make good on the pledge to cover credit losses..Add to the mix a lack of transparency about where the risk is moving to in the financial system – the sellers of the protection tend to be more loosely regulated – and it will come as no surprise that watchdogs in the U.K. and the U.S. discourage these trades..Because most of the deals tend to be private, bilateral agreements between banks and investors, data on the breadth and depth of the market is sketchy. Anecdotally, those active in this pocket of structured finance say that there has been a steady pick-up in business over recent years. The market may have seen as much as 25 billion euros ($28 billion) of protection being sold, insuring portfolios of as much as 350 billion euros, according to data compiled by Structured Credit Investor..Banks that have used risk-transfer trades include big lenders like HSBC Holdings Plc, Deutsche Bank AG and Banco Santander SA. But new European Union rules that came into effect this year are also attracting smaller firms to the market: Banca Popolare di Bari SCpA, an Italian lender whose capital is below minimum requirements, struck a deal with a hedge fund in July to provide capital relief on a 3 billion-euro portfolio of loans. The deal improved its common equity Tier 1 ratio by 100 basis points..The new rules allow banks using standardized risk models, as opposed to their own internal risk models, to gain capital relief from synthetic deals. And more regulatory changes are on the way..The European Banking Authority is preparing a consultation this month that could pave the way for synthetic deals to be granted the “simple, transparent and standardized” label that securitizations enjoy. This EU-wide seal of approval is designed to attract more investors willing to fund these deals. The EBA may also decide to apply that label to derivatives that are fully-funded with high quality collateral. That requirement cuts the risk that individual investors are stretching themselves beyond their means and many not be deliver on their commitments. The EBA may also push for more transparency, requiring parties to report trades to ESMA, the European securities watchdog..This is all a step in the right direction – but expect some pushback from big finance. Over the last year, insurers in particular have been getting into the market, and they don’t like the idea of posting collateral, much like they don’t when underwriting other risks. .No doubt, if done right, synthetic securitizations should be part of the financial industry’s instruments. But regulators will need to ensure participants are exercising due prudence. More stringent rules on funding and transparency would go a long way to ensuring that..To contact the editor responsible for this story: Edward Evans at eevans3@bloomberg.net.This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners..Elisa Martinuzzi is a Bloomberg Opinion columnist covering finance. She is a former managing editor for European finance at Bloomberg News..©2019 Bloomberg L.P.

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Beware Banks Dipping Into This Murky Trade

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