Banks’ ‘exotic’ deals could boost returns — if regulators do not balk

A quiet little corner of the financial markets has become noisier of late.

Significant risk transfers, a tool used by banks to syndicate loans, can hedge credit risk. But more importantly, these deals can also reduce risk-weighted assets. SRT transactions have picked up, more than doubling globally to €200bn in the two years to 2022, according to data from S&P Global.

Cutting RWAs is a way for banks to free up capital held against these assets (mostly loans) on their balance sheets. Liberated capital can go back to shareholders, or be put towards growth in other businesses. European and UK banks, such as Santander and Barclays, have used SRTs in a small way for many years. Now US lenders are getting in on the action.

This is how these deals typically work: a sale of the riskiest part of loan books to specialist investors — mostly credit funds and asset managers with a speciality in this area — reduces the lender’s loan book risk weighting. That in turn means less capital buffers required against these loans.

Lower buffers should improve a bank’s return on tangible equity, a crucial determinant for bank valuations. Higher returns should mean improved valuations. Eurozone banks perennially trade cheaply, now an average of 20 per cent below their tangible book values, according to Citi. Their US peers, with higher return on equity, trade 30 per cent above parity.

In Europe, these trades are usually in the low single billions of euros. But over time they could amount to a meaningful release of capital. That, however, will only improve return sustainably if put towards (profitable) growth, not shovelled into more and more share buybacks.

North American banks have only just happened upon this wheeze. In Canada total transactions jumped to C$87bn ($64bn) last year, according to Bloomberg, up nearly nine times since 2021.

US banks are just getting going, and in size. The Federal Reserve only gave its blessing in September last year. By the end of 2023, JPMorgan had offered out $20bn, a tenth of the previous year’s global total, in five separate transactions.

Regulators’ blessing of this activity remains decidedly conditional. In Europe each transaction is vetted to check that banks’ exposure to loan losses is genuinely reduced, a process usually requiring two to three months. The Bank of England does not preapprove but can take 18 months to give the trade a final nod. Memories of the financial crisis linger: one US senator last year urged regulators to scrutinise these “exotic transactions”.

The aim of reducing RWAs is a worthwhile one, particularly for undervalued banks. Expect lenders to pile in with more deals this year, unless, that is, their enthusiasm tests the capacity or willingness of regulators to approve them.