Episode 29 | Spotlight on Significant Risk Transfer (SRT) Transactions

CJ Doherty Welcome to the Lending Lowdown. I'm CJ Doherty, Director of Analysis at LSEG LPC. Today, our topic is the first for this podcast. It's about significant risk transfer transactions known as SRT. SRT has proven to be a beneficial risk management tool for banks to share credit risk with third-party investors including the likes of private credit funds and other private investors. So we will delve into this market and hear about market dynamics and opportunities. And in order to do this, I'm delighted to be joined by Frank Benhamou from Cheyne Capital, who's based in London. Frank, thanks very much for joining me. Frank Benhamou Hi, thanks for having me. CJ Doherty Frank, please tell us a bit about yourself, your focus and also a bit of background on Cheyne Capital to set the stage. Frank Benhamou Absolutely. So Cheyne Capital is an alternative credit asset manager of 13 billion AUM that has a global presence and its headquartered in London. I am myself based in London and there I am a portfolio manager in risk transfer, so I effectively invest in these transactions as well as meet investor and develop the investment strategy. We have a dedicated fund, a dedicated team to that strategy. Before joining Cheyne to do that, I was working for many years at Barclays, where I was a Managing Director, Head of Funding and Capital Solutions, and in particular I was co-heading the whole SRT platform of Barclays that I helped to set up from the ground up. So it's fair to say that I have the benefit of having been on both sides of the equation in term of SRT, which is very helpful to my current position at Cheyne right now. CJ Doherty So firstly, can you explain SRT and give an overview of the history of the instrument and the type of growth you've seen? Frank Benhamou Yes, of course. So first of all, I like sometimes when I'm asked this question to start with naming convention because we see a lot in the press and everywhere CRT, SRT, TRS, RST. A lot of different names for exactly the same thing. So ultimately, SRT stands for significant risk transfer, that comes from the regulation associated to the product. All of the other terms, whether it's credit or sharing, credit risk transaction and so on, are the same. So I I think that is always helpful to not getting confused and assuming there are different type of product. So what is an SRT? Fundamentally, it's a way for a bank to hedge a portfolio of assets and transfer some of the risk to investor in a securitization format. To give a very simple example, let's assume that the bank has a 1 billion portfolio of corporate loan and the bank will sell the first zero to 100 million tranche to an investor like Cheyne Capital and because it is going to sell such a tranche which capture most of the risk of the portfolio, then the bank will be able to make a case to its regulator to say that he has significantly transferred the risk of the portfolio and assert it deserve to have a very high relief of capital on that portfolio. So that's a very dynamic industry that has been growing now 20-30% year-on-year because it's actually fulfilling a number of benefits for the bank. I think it is fair to say, in terms of history, that this transaction existed for a long time, but pre-global financial crisis or pre, I would say 2007, 2008, the transaction were quite different. They were probably much simpler and doing different things economically. Since the global financial crisis, regulators across the globe wanted to install a number of rules around how to do this transaction and come up with almost like a rulebook of what is allowed and not allowed. And in Europe, as well as in the UK for example, each transaction is individually approved by the regulator. So it is an asset class that is quite scrutinized. But has been working quite well and has been growing across the globe quite steadily now. CJ Doherty Great. And so next, can you elaborate on what is the role of SRT in the economy when it comes to supporting bank lending and capital positions? And also are there any market misconceptions out there? Frank Benhamou Yes, so what is the benefit really is, it comes down to post-global financial crisis and, until now, banks are being more and more constrained from a capital point of view. Regulators every few years kind of like comes with a new set of rules that that impose like higher capital consumption of the lending, and so the bank have done two things really from there is to reduce the type of lending they do to focus on their core customer and we say the main asset classes and that's why you had effectively the massive development of private credit. But the banks also started to use tool like SRT to optimize the capital efficiency and the credit limit efficiency of their lending. So SRT really is a way for a bank to make the lending more efficient from a capital point of view and to free risk limit. And because of that, it means that the bank are able to continue to serve their customers, continue to effectively provide the landing that they need to that otherwise we need to probably reduce. So it has a real positive impact on the economy. It also has the benefit, from the regulator standpoint and from the general economy standpoint, of removing the risk from the banking sector to the private credit sector, like to Cheyne and other of our peers. There are sometimes some misconceptions about the asset class, so sometimes some external participants assume there is some sort of financial alchemy where the risk is not really transferred or it is just some sort of capital arbitrage. Think this is fundamentally wrong. It's possible that it certainly has happened, pre-global financial crisis that some trades were like that, but since then it has not really happened. There are a lot of claims on this transaction where the bank is actually claiming for payment for certain default on the portfolio of loans they have hedged and they are always being paid as far as I'm aware, there's never really kind of like contention or issue with it. The documentation is very well structured now, such that the transaction do exactly what they're supposed to do, and I think that is actually very healthy. We even as investors, we look for this transaction to work properly because we think that's what contribute to the growth and the health of the market. CJ Doherty For banks, then, can you expand on the benefits for them? And how can SRT help them remain competitive in the face of regulatory pressures on lending? Frank Benhamou I've touched upon some benefit of SRT for banks. So the first one being no doubt capital reduction, which also lead to an increase in the return on tangible equity of the bank. Some of the banks do this trade to also free credit limit, but this transaction have also benefit. They feed into the bank regulatory stress test. They also provide accounting implement mitigation. They also, of course, provide real credit edge, and the bank get actually paid real cash. For default and there is an element as well of funding being provided to the bank. So there is actually quite a number of benefits which explain why this transaction actually more and more interesting for banks to do and to explain how the growth has happened. That has helped them to remain competitive and continue to sell to their customer. And what we're seeing now is there is also a general expansion across jurisdiction. So it used to be a market that was predominantly European. And when I say Europe, I include the UK as well. But in recent years, Canada came being very active. We're starting to see East Europe being active. We're starting to see the US banks and some of the regional banks starting to do these transactions as well. So that shows us that the banks are desperately looking for ways to make their portfolio more efficient. And that's where SRT kicks in. CJ Doherty Great. And now let's pivot a little bit. How has the opportunity for SRT evolved as the market matures? And how are LPs adapting to this strategy? Frank Benhamou Yeah. So you know, when I started in the industry, we used to say that SRT was a niche market. It's not a niche anymore. It's actually a very mature market and what that mean is we've seen banks doing more and more of this trade. We've seen banks that were not doing this trade doing this trade and so we've seen a general material increase of the number of transactions, but also the type of transactions, meaning that SRT can be applied to corporate loans, but as well as SME loans, mortgages, trade finance, subscription line, commercial real estate. And so on. So what we're seeing is an expansion both in terms of count, in terms of jurisdiction, as well as asset classes that it's being used on. So that create effectively a new opportunity for us or I would say more an increased opportunity for us, which is we get to see more transaction as investor and we effectively are able to be even more selective because of the flow of transaction and having a real discussion with banks on how to best structure this transaction. And I think that's what, you know, our LP are looking for, which is which is the ability for GP to be quite selective in the strategy. But at the same time recognizing that SRT, while offering decent return as a relatively high stability of cash flow and predictability of cash flow. And I think that combination is quite important for LP, particularly when you think about that LP are on a general trend right now to increase allocation to private credit in general and on which SRT falls into. And to try to diversify a little bit more from like a pure kind of like equity/private equity strategy. So I think there is definitely that trend that is also helpful in the context of the SRT asset class. CJ Doherty OK. And now I'd like to dig a little bit deeper on the investor side and ask you what makes a trade compelling for investors? Frank Benhamou So the first thing that we look for when investing in SRT is we want to make sure that the transaction that is being presented to us is a fair representation of the lending universe of the bank. It is not a subset that the bank may not like. It's actually something that is very consistent with the overall lending portfolio of the bank because what we are looking for and I think most issuers are looking for is to build a long-term partnership where we feel we are on equal footing with the bank in terms of the portfolio risk and where we are building data and knowledge about the bank performance that allow us to be an investor for many years. So I think there is definitely an element, the first element is really that idea of partnership, being transparent and having that fair representation of lending. Then there are a lot of other things for us that matters. The quality of the portfolio, no doubt, the fact that the bank is actually best in class it what it does and it may be in a specific jurisdiction or a specific asset class. That the bank has the best teams in terms of originating and managing the asset, but also for us the structure, the documentation matters a lot. There's a lot of aspects that goes into the structure that sometimes are underestimated and actually that are very relevant. So all of this actually come together to make us decide whether or transaction is actually compelling or not. CJ Doherty And now final question and you touched on this a little bit already, but what are the trends you're seeing in Europe versus the US when it comes to SRT? Frank Benhamou So the trends are a little bit different between the US and Europe because the banks are different and are under a different regulatory regime. So I was mentioning that, but in Europe you have a very clear set of rules around how to apply SRT. And in the US, it was relatively vague until a year or so ago where certain things got clarified, I wouldn't say everything but that actually helped in adding more regulatory certainty to the type of transaction. In addition the US banks are sometimes better capitalized most of the time better capitalized than European banks and as a result their motivation may be a little bit different. So that can be more to free risk limit or to hedge a specific portfolio. While some of the European bank may be a little bit more focused on capital saving. As a result, it triggers different type of transactions, so you tend to see tranche that are secure in the US than in Europe because of regulation, the choice of asset class tend, to focus probably more on investment grade, corporate loan or mortgages or auto loans. So while this asset class that we certainly see in Europe that seems to be a higher focus in the US. And then the big question becomes, now we've reached a stage in the US where most of the G-SIBs, if not all, have done SRT transactions now and they came much later than Europe, but they are now quite active. The next big thing will be with regional banks start to embrace SRT. So think like, I want to say up to 10 or so, regional banks have done SRT to date. And the big question remains, how many more will do knowing that I think there are something like 2000 regional banks in the US. So that give a lot of scope for growth and that will be the next big thing to watch out in the US. CJ Doherty And with that, we will wrap up for today. Frank, that was very informative and no doubt will give our listeners much to digest on SRT. So thanks for sharing your insights. Frank Benhamou Thank you very much for having me. Was a pleasure. CJ Doherty And thank you all for tuning in. I invite you to check out our sister company IFR’s coverage of the SRT market at ifre.com. Also check out LSEG LPC’s private credit market news data and analysis at loanconnector.com. I'm CJ Doherty, subscribe to the Lending Lowdown on your favorite podcast platform.