April 5 (Reuters) - European banks are increasingly turning to bespoke deals with investors such as hedge funds to offload some of the risk on multi-billion euro loan portfolios and improve their financial strength, several sources involved told Reuters.
Banks supervised by the European Central Bank (ECB), the biggest ones in the euro zone, completed a record 174 billion euros ($189 billion) of such deals last year, the regulator told Reuters.
These "significant risk transfer" (SRT) transactions are not new, but because they are usually bilateral and private, data on them is not public and their terms are closely guarded.
By offloading some of the risk on their loans, the banks can significantly reduce how much capital they need to set aside to cover potential losses, according to law firm Clifford Chance.
Unlike a traditional securitisation, in which a bank's assets are moved to a separate entity that then sells securities to investors, SRTs are often "synthetic" and mimic a sale.
A bank can normally transfer risks of losses equivalent to around 7% to 12% of a loan portfolio, two market sources said.
The attraction for the investor is a less volatile return than on many publicly-traded fixed income assets, and depending on the quality of the loan pool, higher rewards in the form of a coupon for the protection they provide to the bank.
"Investor interest has widened," said Jason Marlow, managing director in Barclays' corporate loan portfolio management team.
Marlow said banks that had in the past used SRTs once every three years could now deploy them "once or even multiple times" a year to free up credit lines that may be used for further lending in an increasingly capital-constrained environment.
With synthetic structures, a bank transfers the risk via credit derivatives or guarantees but keeps holding the underlying exposures.
To minimize the risk the bank would face were the investor unable to make good on its part of the trade, cash collateral is posted to cover the potential losses whose risk has been transferred, which market sources say is key for the bank to obtain the capital relief from the regulator.
The ECB, which directly oversees the most significant banks in the euro zone, told Reuters that the bulk of the transactions in 2022 involved loans that are still performing, a change from 2021 when soured loans made up more than a third of such trades.
'KNOCKING ON DOOR'
The first quarter of this year "was particularly busy", said Olivier Renault, managing director at Pemberton Asset Management, which has sold banks protection on loan portfolios.
His firm is talking with lenders on "50-plus" SRT plans and expects a strong pipeline for 2023 "as banks have fewer options to bolster their capital ratios".
The ECB, which has not published data for SRT trades in 2022, typically does not name the banks involved, the number of proposed transactions at any one time nor the likely volume.
The Bank of England does not publish any SRT-related data.
However, some banks do disclose them.
Germany's Oldenburgische Landesbank AG said last week it had entered into its first SRT and boosted its common equity Tier 1 ratio, a key measure of balance sheet strength, by 40 basis points. OLB, backed by Apollo Global Management, previously reported a CET1 ratio of 13.6% for 2022.
And in November, BayernLB placed a 1 billion euro synthetic securitisation that referenced a portfolio comprising corporate loans through which it freed up around half a billion euros in risk-weighted assets for new transactions, its Chief Risk Officer Marcus Kramer said in a press release at the time
While banks were already using such deals before last month's banking sector turmoil, the failure of two U.S. lenders and the rescue of Credit Suisse have added to existing concerns about the impact of an economic slowdown on loan portfolios.
Banks are seeing "disruption in the market and the closer scrutiny of idiosyncratic risk, and to consistently fund and capitalise their businesses going forward, they know they need to take action earlier than may normally be the case," said Robert Bradbury, head of structured credit at Alvarez & Marsal.
Lenders' funding costs are also rising after a hit to Additional Tier 1 (AT1) bondholders from the Swiss-engineered rescue takeover of Credit Suisse by UBS jolted the market.
Filippo Alloatti, head of credit at Federated Hermes, said the unseasonal pick-up in demand for SRTs suggests banks believe recession is "knocking on the door".
Italy's biggest bank, Intesa Sanpaolo (ISP.MI), said that last year it transferred credit risk through a number of deals on loans totalling 15.7 billion euros, with one worth 7.5 billion euros in the fourth quarter among Europe's largest.
In February, BNP Paribas (BNPP.PA) and the International Finance Corporation (IFC) offered some insight into one such deal. The IFC sold BNP a $50 million guarantee on $1 billion of loans to emerging markets, they said, without disclosing terms.
While Europe has been at the forefront for risk transfers, the stock of loans covered by SRTs is small relative to European banks' balance sheets. BNP Paribas alone had assets totalling 2.7 trillion euros at end-2022, Refinitiv Eikon data shows.
The ECB says on its website that banks wishing to strike such deals must request regulatory approval at least three months before their expected closing date.
It also warns that SRTs are monitored closely, as unsuccessful deals could harm the bank involved.