Risk takers: Special report on SRTs

Synthetic risk transfers are widely seen as a win-win for banks and private debt funds alike, but does their rising popularity come with potential pitfalls? Jon Yarker reports…

The use of a synthetic risk transfer, or SRT, is a way for banks to meet their ever-increasing regulatory capital requirements. In a cost-effective fashion, banks can reallocate risk weighted asset (RWA) exposure, with a growing base of private debt investors flocking to these transactions. SRTs gives these firms access to high quality, bank-originated assets, meaning these are rapidly emerging as a mutually beneficial arrangement when it comes to risk exposure.

The use of SRTs has flourished in the US private debt market, where firms have sought to replicate what they have seen work well for both parties in Europe.

“US banks have been very focused on capital optimisation as a result of recent regulatory changes over the last few years, which has created opportunities for these banks to join a previously dominated European SRT market,” says Sara McGinty, partner in the alts team at Ares Management. “In part, the rise of SRTs is driven by banks’ desires to optimise RWAs and use their balance sheets more efficiently.”

RWAs reflects the fact SRTs are an innovative response from the industry, where banks are under greater pressure to manage their risk exposures. This has helped the use of SRTs become more commonplace, and Assia Damianova – special counsel in the capital markets group at Cadwalader – says they are now established as a “standard and useful tool” for banks.

“The level of regulatory guidance helps issuing banks along with the process; and the continued development and refinement of the legal documentation to support those trades make execution relatively fast and efficient,” she adds.

This way, SRTs allow banks to meet their regulatory requirements while satiating the appetite of a rapidly growing private debt industry. Standardisation has developed in this field, with banks’ SRTs covered under the EU simple, transparent and standardised (STS) structure. Kanav Kalia, managing director at Oxane Partners, says such maturity and sophistication gives further reassurance to firms engaging with SRTs for the first time.

“The market’s maturity has played a vital role in the rising popularity, with increased standardisation, transparency, and clear regulatory expectations outlined in the EBA’s updated SRT Guidelines 2022, including provisions on synthetic excess spread and risk retention,” explains Kalia. “Additionally, the market demonstrated resilience during periods of stress, including the Covid-19 pandemic, where issuance recovered quickly, thus giving both banks and investors greater comfort in the asset class.”

SRTs are being used for a growing range of risk types, broadening out from vanilla reference pools of corporate and SME loan portfolios. Anthony Breaks, head of global asset-based finance at Schroders, highlights the evolution he is seeing first-hand.

Read more: PAG raises $1.25bn for third SRT fund

“We have seen the spectrum of bank commercial lending books becoming reference pools for SRTs – from trade to SME to specialist to green, infrastructure and commercial real estate exposure – retail assets have been less prevalent historically,” says Breaks. “With changes in capital requirements will come the need for banks to look at SRTs alongside other optimisation tools across their balance sheets.”

One growing area of interest in SRTs is their use in insurance and reinsurance-based credit, according to Oxane’s Kalia.

“These structures, sometimes known as credit insurance SRTs or unfunded synthetic securitisations, involve bilateral or syndicated credit protection provided by insurers or reinsurers, offering banks a capital-efficient and often a more bespoke solution, especially for concentrated or higher-value portfolios,” explains Kalia. “This reflects the convergence of banking and insurance risk management practices and underscores the increasing role of private markets and institutional investors in absorbing bank credit risk.”

The ‘Rs’ in SRTs…

So far, so good but the increasing popularity of SRTs is not without its own risks. An SRT transaction can serve both parties’ needs but some are concerned by the pace of growth in this area. Here, Man Group co-head of risk sharing Matthew Moniot sees two primary risks broadly related to the growing popularity of SRTs.

“First, there’s evidence that banks are becoming more aggressive in their risk appetite – both by expanding credit eligibility to include more marginal cases and by potentially loosening underwriting standards,” says Moniot. “Second, we’re observing a deterioration in documentation quality, particularly among newer programmes and issuers entering the market, which introduces operational and legal risks that require careful monitoring.”

Such concerns are perhaps inevitable with any area of financial services as a particular product or service becomes more popular. Alan Shaffran, senior portfolio manager and partner at Magnetar Capital, says he gets asked if investors are being “gamed” by banks with the use of SRTs. He refutes this assertion but admits it “pays to be paranoid” when engaging with these transactions.

“A private investor should only invest in an SRT transaction where it can independently derive high conviction on the overall investment profile of the deal, meaning across a range of anticipated and unanticipated scenarios,” says Shaffran. “This requires several necessary elements: an appropriate mix of data on and diversity in the underlying portfolio, a well-crafted deal structure that doesn’t give excessive optionality to the bank, such as in replenishment, while aligning the interests of the bank with the investor, the bank to be fully transparent on its underwriting and risk regimes, and infrastructure to model the deal with as much precision as possible.”

Read more: BBB to use SRTs to boost lending to SMEs

This emphasis on due diligence is shared by others. SRTs in Europe may benefit from the STS framework but such transparency is not universal, and where it is unavailable some firms are wary of engaging. McGinty points out the need for deep understanding of the underlying assets to properly inform an overall risk profile. Where visibility is limited, Ares will not participate.

“For example, some SRTs are blind pools with full passive reliance on the banks’ underwriting,” says McGinty. “We remain cautious about the black box commoditised nature of some of the corporate SRTs, which is why Ares focuses on higher quality fully disclosed asset pools.”

Regulatory scrutiny

Like any product experiencing a rapid surge in popularity, SRTs have attracted the attention of regulators. Specifically, their widespread use in Europe recently prompted the EBA to specifically reference them in a risk assessment report on capital and RWAs. In addition to potentially stacking risk to create a “maturity wall” of sorts, the EBA questioned how much undue risk purchasing parties were taking on: “This could create certain ‘circles of risks’, as in the end a private credit fund’s SRT investment would become an implicit risk for a bank that invests – e.g. through providing repo-based or other funding – in that fund.”

Opinions about these concerns are split in the industry. Marcos Chazan, senior director in Alvarez & Marsal’s financial services industry group, sees “no evidence” of these at present.

“Some SRT investors have been in the sector for more than 15 years,” argues Chazan. “As a result of increased investor demand, spreads have tightened significantly in recent years. This is a reflection of the SRT market becoming more efficient.”

Meanwhile, others like Man Group’s Moniot, see merit in the EBA’s doubts: “We share the EBA’s worries and believe there has been a marked deterioration in the overall capital quality of the SRT buyer universe. This suggests that greater regulatory scrutiny is likely warranted and should be expected going forward.”

Read more: AXA IM raises €2.3bn for significant risk transfer strategy

Regulators are naturally going to scrutinise SRTs given their focus on systemic risk. Banks are using SRTs to help comply with such risk-focused regulations, and policymakers will want to know where these transactions lead. Magnetar’s Shaffran sees this as an obvious element for regulators to look at, but points to some mitigating factors he is confident the EBA is keeping in mind in relation to SRTs. These include the low leverage, mark-to-market structure of such financings and banks’ full recourse to funds they are lending to.

“Moreover, we take comfort that the SRT market has thrived amid many rounds of regulatory change in part due to strong and continuous engagement between regulators and market participants who all want the SRT toolkit to be versatile and prudently utilised,” he adds.

SRTs continue to deliver the dual benefits of easing banks’ risk burdens, while satisfying a growing private debt industry’s demand for attractive and high-yielding products. However, further popularity could attract more scrutiny to ensure they are not being used to flout regulations instead of simply complying with them.