Basel statement on risk transfer could halt legitimate trades, bankers warn

Banks are worried a regulatory decision to fire a shot across the bows of the risk transfer market last week will freeze activity, preventing legitimate trades from happening. The December 16 statement from the Basel Committee on Banking Supervision highlighted its concerns about deals with a high cost of protection – arguing, in effect, that under-pressure banks are so desperate to achieve the capital relief on offer in these trades that they are willing to pay more than the expected loss they are transferring away. A source close to the committee describes it as a "warning shot", but adds there is a strong possibility it could be followed by a capital charge of its own.

The near-term effect could be a temporary halt in attempts to transfer risk, warns one bank's London-based head of structuring. "It's going to have a chilling effect on deals in the pipeline, particularly at this time of year. Any deals that are in the works right now that brush too close to this could be restructured or cancelled," he says.

The Basel statement warns both supervisors and banks to carefully scrutinise the cost of protection embedded in securitisation and credit derivatives transactions, as well as other structural features that could indicate a possible arbitrage of capital rules. The statement points to instances of "high-cost credit protection", in which the apparent costs of obtaining protection outweigh the benefits of the deal.

"In some instances, the premiums or fees and other direct or indirect costs paid for certain credit protection, combined with other terms and conditions, call into question the degree of credit risk mitigation or credit risk transfer of the transaction," it says.

In particular, the statement urges supervisors to study the present value of protection premiums and other costs associated with the transaction, and compare this with the portfolio's expected loss. According to the Basel Committee, supervisors should look more carefully at deals that include protection premiums exceeding the amount of exposure that is being transferred, as well as features such as upfront premiums and rebates, in which the protection seller agrees to refund a portion of the premium depending on the performance of the underlying assets. These are "an indication of excessive premium and, consequently, regulatory arbitrage", according to the statement.

To some extent, it’s not new and the FSA is saying similar things. But if the logic is taken to extremes, it could cause problems

But risk managers say focusing on the present value of future premiums – particularly in an environment when risk aversion is high – will make most trades look expensive. "It would be problematic if the price of protection we pay needs to be the same as the expected loss on the tranche. The price of protection in the credit market would far exceed the expected loss," says one New York-based credit portfolio manager.

Market participants are also puzzled by the timing of the statement. In recent years, many of the market's bad practices have been quashed by increasing regulatory scrutiny, they claim. The New York-based credit portfolio manager says many of the structural features mentioned in the statement are not common, and adds that it has become much harder to get deals approved.

"I didn't think this was an ongoing practice. All the counterparties we deal with have a much higher level of scrutiny than in the past. We have to gain approval from reputational risk committees and a number of other committees to ensure we don't fall foul of regulatory requirements," he says.

The UK's Financial Services Authority (FSA) is among the regulators that have strengthened their supervision of credit risk transfer deals in recent years. The FSA recently reviewed its approach to the granting of capital relief, issuing final guidance in September. Previously, banks securitising a portion of their portfolio were able to use internal models to calculate regulatory capital on the retained senior tranche using what's known as a supervisory formula method. To receive the same capital benefit under the FSA's new rules, banks would first need to obtain an AAA rating from an external rating agency – which would represent an extra cost for market participants.

In that context, the Basel statement has not come as a surprise, market participants say – but they warn that equating high protection costs with arbitrage could make life difficult. "To some extent, it's not new and the FSA is saying similar things. But if the logic is taken to extremes, it could cause problems," notes Allan Yarish, London-based portfolio manager at Channel Capital Advisors.

This article first appeared on Risk.net