The Lex Newsletter: Banks’ balance sheet wheeze raises regulatory questions

Dear reader, 

Journalists, like everyone else, are a product of their experiences. My career history involves writing about the credit crunch in London before arriving in New York in July 2008 to cover banking for this very column. As a result, I am destined forever to see echoes of the financial crisis everywhere. Call it professional PTSD.

Some of the Lex column’s writing on the woes of UK (and European) banks has tripped those switches. Banks are struggling to boost returns given the higher capital requirements and regulatory restrictions they are under. Risk-weighted assets (RWAs, against which banks must hold capital) are rising as the post-crisis regulatory overhaul continues to home in on certain more volatile exposures.

From Lex on NatWest’s results last week:

One way to get RWAs down can be through syndication, often via specialist alternative asset funds, known as significant risk transfer trades. NatWest plans more of these, which could help reduce this RWA inflation . . . The Bank of England apparently approves of these so-called capital relief trades. 

From a Lex column last year:

Some [banks] try to reduce their risk-weighted assets. Regulators allow banks to originate loans and then share the credit risk with specialist investors, both alternative asset managers and also insurers. More banks have turned to this method in recent years as higher capital Basel III rules come into force.

This, as far as I’m concerned, should come with a trigger warning. The idea of banks structuring and securitising their way to lower capital requirements, including using off-balance sheet vehicles, sets off all sorts of alarms.

But this is not a new idea. Banks, according to a paper from the European Systemic Risk Board, have been using so-called significant risk transfer (SRT) securitisations to reduce risk-weighted assets since the 1990s. 

Though this market is “not well known”, noted the ESRB, the implementation of Basel III has made such transactions more attractive for banks. This is predominantly a European market. In 2022, said the European Central Bank, more than 30 banks issued 118 securitisations worth more than €170bn, significantly more than in previous years. 

These deals come in multiple flavours. A traditional SRT transfers a pool of assets to a special purpose vehicle, which then issues notes to investors. The synthetic variant keeps assets on a bank’s balance sheet but transfers a portion of the credit risk to third parties such as hedge funds via derivatives or guarantees. 

They aren’t always aimed at alleviating capital burdens. Such transactions could be used for various purposes, including offloading non-performing loans. But the majority of the European market in 2022, by volume, involved synthetic transactions. And, as the ECB said: “Banks often prefer synthetic securitisations to obtain capital relief because they tend to be cheaper and easier to execute.”

It is worth making clear that regulators see these trades as an important risk and capital management tool. The growth in Europe has come partly as a result of clarifications in the regulatory framework. In the UK, where the BoE says six banks have issued securitisations, the regulator has taken a more cautious approach to synthetic deals (the volume of which has doubled in the euro area since 2018). But it issued a discussion paper last year on its approach in this area.

At Lex, we plan to dive into this soon to look at how investors should be thinking about these trades and how banks might benefit.

For me, there are questions about how regulators will manage the development of this market. The banking watchdogs vet, deal by deal, whether there has been a genuine transfer of credit risk from the bank to investors that justifies a reduction in regulatory capital requirements.

As activity rises, this will either constrain volume or could test regulatory oversight of the trades. In the UK, at least, financial regulation has become increasingly politicised in recent years, with watchdogs instructed to consider the UK’s competitive position globally (another echo of the regulatory status quo before the financial crisis). 

Already this year, UK chancellor Jeremy Hunt has called in bank bosses to discuss whether their ailing market valuations are a problem economically. In a speech this month, BoE governor Andrew Bailey said low bank valuations were hard to explain, but he took issue with those arguing that banks have to hold too much capital.

This tug of war between the political priorities of growth and competitiveness and regulators’ concerns around safety and soundness has already played out in insurance regulation. The debate about SRTs specifically has fresh impetus because some changes under the forthcoming Basel 3.1 rules could in effect undo the benefit to risk-weighted assets of these types of deals — something the BoE is considering how to handle. 

More generally, the overall wisdom of ratcheting bank regulation ever tighter with one hand, while finding ways to mitigate the effects of that with the other, merits some thought.

Things to read 

1. The deals above effectively transfer credit risk from the highly regulated world of banking into the hands of other investors. The shifting of assets and activity into the non-bank realm is a broader theme. Lex looked at how the thaw in the leveraged buyout market owes more to securitisation and collateralised loan obligations than it does to a sunnier outlook for bank lending into these deals. Read it here. 

2. Activist hedge funds often buy modest stakes in listed companies and then strong-arm their targets into selling themselves at a premium. Buyers then make the sorts of operational changes the activist wanted and relist the business, earning several multiples on their initial investment. What happens when the two decide to team up, asks Lex.

3. Another enduring preoccupation of mine, thanks to an early career in property journalism, is with warehouses. This year has started with a flurry of share-based takeovers in the logistics and warehousing sector of the London market. This, Lex argues, could be the start of a wave of deals as valuations trough. Read more here.

Things I enjoyed 

This week I have mainly been watching sports documentaries, a genre of television that is absolutely everywhere. 

I’m up to date on Formula 1: Drive to Survive (more about paddock personalities and the influence of wealthy owners than motor racing). I finally watched the David Beckham documentary on Netflix (great TV, particularly if you’re of a certain vintage). The Mark Cavendish one wasn’t as well constructed as some but is hard to beat as a comeback story. 

But one of the best I’ve seen recently (and as you might gather — tennis, golf, rugby — I’ve done the rounds) is The Edge of Everything, a film about Ronnie O’Sullivan on Amazon Prime. It is not very much about snooker and much more about people, the burden of dazzling talent and mental health.

And while I’m here I will recommend one of my favourite films, Free Solo. It’s about rock climbing. But not really.

Meanwhile, this Economist piece was a great read on the tendency in British politics to try to ban things harder — and what it says about the running of the country (nothing good). A sample:

“Britain is in the grip of a bad bout of statutory inflation, in which public demand for tough new laws outstrips the supply of social ills that have not yet been legislated upon. The result is lawmaking that renders the already illegal even more illegal.”

Have a great weekend,

Helen Thomas
Head of Lex