10 October 2011

FN analysis: Hedge funds offer risk-sharing bridge

On one side stand the banks, which are trying to reconcile an increased cost of capital with political pressure to lend more to small businesses and help kick-start the economy. On the other side are the pension funds, insurance companies and family offices, which are sitting on large pools of long-term capital but face a dwindling universe of investments that deliver a decent yield.

One way to close the gap is for banks to engage in capital-relief transactions, in which they securitise some of the assets on their balance sheets using credit derivatives and other techniques, offloading a portion of the risk to non-bank investors.

Minding the gap

Many financial regulators are adopting a ratings-based approach to evaluating bank assets, according to Adrian Docherty, head of banking advisory at BNP Paribas. This can often result in risk assessments that are at odds with the banks’ own valuations. For example, the methodologies of rating agencies can include country ceilings: loans originating in a certain country will never get a higher rating than the sovereign, regardless of the quality of the issuer.

Sharing the load

Typically, risk-sharing transactions work by packaging parcels of assets, such as high-grade corporate loans or counterparty risk, and transferring a portion of their risk to a non-bank investor, who agrees to absorb the first or second tranche of losses should the loans go sour or counterparties default. For the banks, this reconciles the high cost of holding these assets with the need to continue lending money to important clients, which is often crucial to winning other parts of their business.

Regulatory headwinds

Last month, following a consultation that was launched in May, the Financial Services Authority issued new guidance that will fundamentally change the way in which UK banks can enter into risk-sharing transactions, by insisting on the involvement of the rating agencies before the banks can get capital relief. Until now, UK banks have been allowed to rely on a calculation called the supervisory formula method to get capital relief by selling off the risk in a loan book.

The old approach stemmed from the part of the Basel II framework that allows banks to model their own risk exposures, subject to regulatory approval, and come up with a figure for their own risk-weighted assets, which determines how much capital they must hold. In the consultation, the FSA said that the supervisory formula method often fails to capture appropriately risk in retained securitisation positions, particularly with regard to systemic risk.

The upshot of this is that – except in exceptional circumstances – a bank will have to get a rating agency involved before it can demonstrate significant risk transfer. Richard Robb, chief executive of Christofferson, Robb and Co (CRC), which has been investing in risk-transfer transactions since 2002, wrote to the FSA in June warning that a cost to the ratings-based approach was its “vulnerability to rating agencies’ erratic behaviour”. He said this approach “attributes an expertise to the rating agencies that they demonstrably do not possess”.

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