'Exotic' deals by banks could boost returns – if regulators don't say no

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This quiet little corner of the financial markets has become a lot noisier lately.

Senior risk transfers, a tool banks use to pool loans, can protect against credit risk. But more importantly, these trades can also reduce risk-weighted assets. SRT transactions have more than doubled globally to 200 billion euros in the two years to 2022, according to data from S&P Global.

Reducing risk-weighted assets is a way for banks to free up capital held against these assets (mostly loans) on their balance sheets. The freed up capital can return to shareholders, or it can be directed toward growth in other businesses. European and UK banks, such as Santander and Barclays, have used SRT in a small way for many years. Now US lenders are starting to act.

This is how these deals typically work: selling the riskiest portion of the loan book to specialist investors – mostly credit funds and asset managers who specialize in this area – reduces the risk weight of the loan book to the lender. This in turn means lower capital reserves required against these loans.

Lower reserves should improve a bank's return on tangible equity, a critical factor in valuing banks. Higher returns should mean improved valuations. Eurozone banks have perennially traded at cheap rates, now on average 20 per cent below their tangible book values, according to Citigroup. Its US counterparts, with higher return on equity, are trading 30 per cent above breakeven.

In Europe, these deals are usually in the low billions of euros. But over time, it can be a real release of capital. However, this will only improve the return sustainably if it is directed towards (profitable) growth, and not driven into more and more share buybacks.

This has just happened in North American banks. In Canada, total transactions jumped to C$87 billion ($64 billion) last year, according to Bloomberg, a nearly nine-fold increase since 2021.

American banks are just beginning to grow in size. The Fed only gave its blessing in September last year. By the end of 2023, JPMorgan had offered $20 billion, a tenth of the previous year's global total, in five separate transactions.

Regulatory bodies' blessing for this activity is certainly conditional. In Europe, each transaction is examined to ensure that banks' exposure to loan losses has been truly reduced, a process that typically requires two to three months. The Bank of England does not have pre-approval, but it could take 18 months to give final approval for the deal. Memories of the financial crisis still linger: a US senator last year urged regulators to scrutinize these “strange transactions”.

The goal of reducing risk-weighted assets is a worthwhile one, especially for undervalued banks. We expect lenders to pile into more deals this year, unless their enthusiasm is a test of regulators' ability or willingness to approve them.