The longstanding participants of the lending market in Europe have traditionally been banks. More recently however, this position has been challenged by increasing regulatory pressures (capital, leverage and liquidity requirements). Deleveraging of balance sheets, retrenchment, retention of earnings and raising their regulatory capital base have so far been some ways banks have tried to navigate this.
Retrenchment in particular has given rise to direct lending programmes, private placements and syndicated loans investment opportunities for institutional investors willing to take the right steps to source lending deals, structure them well, accept the credit risk and inject the capital required.
This has spurred the popularity of Capital Solution Transactions (CST), a transaction with a bank that is seeking to improve its regulatory capital ratio while carrying out its usual lending activity. It is a guarantee (amounting to the regulatory capital) for a part of a loan portfolio, selected by an investor in return for a spread, typically in the range of 8-12% above Euribor. The underlying assets (loans) themselves remain with the bank to satisfy Basel rules, and the originating bank continues to service the loans and keep their corporate relationships with the end borrowers.
The CST market in Europe began in early 2000 and has accelerated since 2010-2011 with the advent of Basel III capital rules. Almost 20 banks around the world have issued CSTs and over 40 such transactions were completed across Europe in 2015.
The evidence so far suggests that pension funds, insurance companies and asset managers comprise more than half of the investor base within this market, according to the European Banking Authority. Pension schemes already represent 22% of the investor base of such transactions. Certain large schemes have made sizeable allocations towards this opportunity. For example, the Dutch pension fund PFZW has set itself a target of €2.5bn of total assets in synthetic securitisation by the end of last year, and this figure is expected to reach up to €5bn over time.
While this is undoubtedly a compelling opportunity for institutional investors, as with all investments there are risks that need to be managed. One main risk for investors in the CST trade is the credit risk of the underlying portfolio. Although investors can typically expect to be compensated by a superior risk premium, a robust selection, portfolio construction (diversification) and risk management process are key ingredients for success.
Liquidity is another consideration, since CST portfolios would naturally be less liquid than plain vanilla instruments. To a large extent, the strategy’s investment horizon of five to seven years reflects the liquidity constraints of the underlying transaction. This is something that investors need to be comfortable with.
The ability to source deals correctly – a step before detailed credit analysis – is a further challenge. This is largely dependent on the investor’s relationships with larger banks across Europe. Size, track record and experience all factor into this equation. In 2015, leading players sourced up to €5bn in CST, which represents more than €80bn worth of underlying loan portfolios.
While banks are in need of regulatory capital, investors could take the opportunity to diversify their credit exposure and access a new segment of bank lending activity throughout the real economy, via a diversified portfolio.
In their search for yield, institutional investors who are willing to explore this idea may hold a very valuable asset in the form of regulatory capital – which could command an attractive premium from banks looking to reinvigorate lending activity.
Christophe Fritsch is co-head of Securitised Assets at AXA IM