As banks prepare for the capital requirements of Basel IV (implementation expected in January 2023), Significant Risk Transfers (SRTs) are seeing increased attention, and with good reason. These securitized investment products have the potential to help banks manage their risk weighted assets while providing an investment opportunity for investors.
Regulatory capital requirements vary by country and allow banks to sell a certain percentage of portfolio assets that are then converted into securitized products. These transactions have traditionally involved portfolios of performing corporate loans but recently included mortgage and consumer loans. At a time when high capital requirements are squeezing banks’ profitability, banks can potentially offset the expense through SRTs while providing investors with an alternative investment vehicle that offers a rate and return they may not be able to attain elsewhere.
SRTs are not new. Banks, primarily in Europe, have been using them since the late 1990s. Since then, securitization markets have been key in transferring credit risk from a regulated firm’s balance sheet to a firm with a greater appetite for assuming that risk. With credit risk transferred, firms can leverage the released capital and deploy it elsewhere. Regulators have become more comfortable with this approach and have accepted it as legitimate means of risk mitigation, presenting investment opportunities for investors seeking portfolio diversification with product returns uncorrelated to equity markets and providing banks with much needed balance sheet relief.
With Basel IV looming and banks looking to optimize their balance sheets, SRT transactions are anticipated to gain significant traction over the next five years, and not just in Europe. As banks, investors and regulators have become more comfortable with SRTs, jurisdictions outside of Europe, including the U.S., Canada, and Japan, are accounting for an increasing percentage of the market share. This growth is anticipated to continue as new regulations such as the EU’s Simple, Transparent and Standardised (STS) framework come into play, making SRTs more accessible to smaller market players who will become active in the market.
SRTs may be the answer banks are looking for to improve capital efficiency by lending to core clients without diluting existing investments or realizing unnecessary losses. This is an asset class we’ll watch closely as the implementation of Basel IV approaches.