Bank Capital Relief: Evolving Banking Regulation Creates Investment Opportunity

Bank capital relief transactions enable banks to use the capital markets to shed some of their risk by buying credit protection on a portfolio of loans. The transaction “insures” a portion of the risk associated with the loans, thereby reducing the amount of regulatory capital the banks are required to hold against the loans. This opportunity is driven by regulatory changes in the banking industry, particularly in Europe, where banks have lagged their U.S. counterparts in selling non-core assets and reducing their loan portfolios.

In the typical bank capital relief transaction, the investor agrees to provide protection for the second loss tranche on a pool of loans. The bank usually retains the first loss tranche and the senior risk. The loan pool can include short-term trade finance loans and longer-term corporate loans, usually to small or medium enterprises (SMEs) in Europe.

The bank pays a fixed premium annually in advance for the term of the agreement,typically five years, and the investor posts collateral to a trust account equal to the notional size of the tranche. At the end of the term, the investor receives its collateral back, less any losses on the reference portfolio. The net result for the investor is the premium minus the realized default losses.

Bank capital relief is similar to other forms of bank disintermediation such as securitization or direct lending; however, there are very clear distinctions. The key difference is that in bank capital relief, the loans are not sold by the bank, but instead remain on its balance sheet. The bank typically wants to “own the relationship” with the borrower and usually sells the borrower a range of other services in addition to the loan. This strategy enables institutional investors to obtain exposure to corporate borrowers who typically don’t borrow in the public markets.

The expected returns of bank capital relief strategies are generally higher than those of a direct lending program, and are at the upper end of the range for securitized products such as collateralized loan obligations. The expected volatility of bank capital relief structures is at the lower end of the range for these three types of credit strategies. Interest rate sensitivity is likewise low, since the loans tend to be floating rate.

We think there is a strong case for this strategy for investors that can give up medium-term liquidity, since the term of the transaction is typically five years. The primary risk of the strategy is losses in the reference loan portfolio that are significantly greater than expected. There is also the potential for adverse selection in the choice of the loan portfolio. The fund sponsor must actively manage both of these risks.

We believe bank capital relief strategies can aid diversification within a portfolio and allow investors to access an attractive level of income that has a low correlation with traditional equities and fixed income. An allocation to bank capital relief is especially appealing for investors that do not currently have an allocation to private debt.

As with all actively managed strategies, care must be taken when evaluating and selecting a bank capital relief manager. The strategy remains niche and requires a specialist skill set with considerable experience in implementing and structuring these transactions. Manager selection is therefore critical to successful investing in this area.

Read more here at https://retirement-investment-insights.aon.com/non-profit/bank-capital-relief-idf-paper-10-2018

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