* Could cut off capital source for struggling institutions
* Structures with yieldy portfolios still work
* Basel rules aim to shut down crisis-era abuse
By Owen Sanderson
LONDON, March 27 (IFR) - The Basel Committee' is proposing
changes to its capital framework, aiming to ban abusive
crisis-era risk transfer deals, but it could come at the risk of
closing off a capital raising tool for peripheral banks.
Because some peripheral banks want to raise capital up
front, they choose to use synthetic securitisations to hedge
their portfolio risk. Selling legacy assets, rather than hedging
them, would incur an immediate loss - and a hit to capital.
This technique involves banks reducing capital consumed by
specific portfolios, by buying credit protection on the riskiest
part of the portfolio. The strategy can be useful where banks
want to hedge a portfolio risk rather than crystallise losses up
front, or where bank capital requirements make them inefficient
holders of certain risks.
The protection typically covers a mezzanine tranche - the
first loss piece, usually corresponding to expected losses on
the portfolio, remains with the banks. The bank buys protection
on the next piece, but retains the senior portion (which should
be very unlikely to suffer losses).
Banks still have to allocate capital against the remaining
senior tranche, but can risk-weight this at minimum 7%, because
nearly all of the risk should have been hedged.
COSTS UP FRONT
The Basel Committee first flagged concerns on this activity
in December 2011. Now banks will now have to count the cost of
the credit protection through the lifetime of the trade up front
(appropriately discounted for time) - this either means a Common
Equity Tier 1 deduction or a 1250% risk weight, cancelling out
much of the capital benefit of doing the trade.
However, spread income from the underlying portfolio can be
taken into account when calculating the capital deduction - if
the portfolio can effectively pay for its own credit protection,
individual national regulators can choose not to make banks
deduct all of their coupon payments up front.
This change sounds small, but makes a big difference. Where
banks can buy cheap hedges against yieldy portfolios, capital
relief deals can still get done, though if a portfolio does not
throw off enough yield to pay for its hedging, the new rules
block the trade.
"It will be the biggest problem for certain peripheral
institutions," said a London-based head of structuring. "These
have to pay very high coupons to obtain hedging, while the
underlying loan portfolios typically yield little. If these
banks are not able to hedge, they will need to sell,
crystallising losses upfront."
CLOSING THE STABLE DOOR
Some structures, where the total protection premium paid by
the bank is guaranteed to exceed the total size of the
protection it buys, are pure regulatory arbitrage, which
transfer no real credit risk.
Whoever writes the protection bears no risk, but the trade
is worth doing because of capital benefits to the bank.
"There were definitely some deals done during the crisis that
were not real risk transfer, but these largely do not exist
today," said the structuring head.
"The Basel Committee is reacting three years too late, to a
trade that doesn't exist any more. No bank would dare present a
guaranteed coupon to their regulator today."
UniCredit bought protection on some EUR20bn notional from
Barclays in 2008 - but the German regulator decided, just two
years into the five year trade, that this would no longer bring
any capital relief against the portfolios.
The trades superficially transferred risk between the
institutions, but because Barclays expected to get fees for five
years (totalling much more than the protection it was
providing), it did not regard these as risky exposures.
UniCredit claimed capital relief on the basis that Barclays
took over the risk, so the overall result was less capital in
the banking system during autumn 2008.
REAL RISK TRANSFER
More recent trades have been between hedge funds or other
asset management firms and banks, as regulators have cracked
down on possible structures. Banks and structurers typically
involve local regulators at an early stage.
These trades transfer risk out of the banking system
entirely for the life of the trade, to institutions which may be
better able to bear it.
These investors usually pay in funding for the whole
protection amount in advance, depositing it in a segregated cash
account or an SPV. This means the bank buying the protection is
not exposed to the risk of counterparty default.
The capital arbitrage takes place between the capital regime
for banks and others.
If coupons are not guaranteed to be paid, market
participants argue, why deduct from capital up front, using a
risk-free discount rate? In a deal where real risk is
transferred, coupons will not be paid on portions of the deal
where losses have been triggered.
Asset managers may be more efficient holders of risks, and
are typically less systemically significant - so allowing them
to allocate less capital to some exposures makes sense.
Much of regulatory oversight on this sector comes from its
association with instruments involved in the credit crisis.
Technically, these deals are bespoke synthetic CDOs designed to
reduce bank capital charges. They are usually unlisted, unrated,
and transacted privately.
Dutch pension fund PGGM has allocated large sums to this
strategy, investing synthetically in books of corporate loans,
trade finance receivables, project finance and derivative
counterparty exposures. Bank counterparties include Barclays,
Credit Suisse, Citi, Santander, Standard Chartered, RBS, UBS.
The structuring head added that the Basel Committee had
chosen odd worked examples in its paper that do not work - even
when plugged in existing Basel formulae for calculating risk
(Reporting By Owen Sanderson, editing by Alex Chambers and Anil