* 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.
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.”
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.
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 transfer. (Reporting By Owen Sanderson, editing by Alex Chambers and Anil Mayre)