Capital Markets Advisors

Turning Change Into Opportunity


Friday, July 10th, 2015

With the impending capital requirements of Basel III in most jurisdictions, banks throughout the world have taken advantage of capital relief trades that allow them to use credit default swaps to alter the risk characteristics of loans on their books. But what impact will this have on the risk profiles of the banks and, perhaps more important, the funds that are selling the CDS protection to them?

In June the Treasury’s Office of Financial Research published a report entitled “More Transparency Needed For Bank Capital Relief Trades.” The report engendered quite a bit of public comment, as well as a response from ISDA. At this point we probably need to look at the whole subject in a bit more detail.

CRTs Explained

So what is a capital relief trade (CRT)? With the impending capital requirements of Basel III in most jurisdictions, banks throughout the world have taken advantage of a provision allowing them to use credit default swaps (CDSs) to alter the risk characteristics of loans on their books. The actual US rule language is:

“A national bank or Federal savings association may recognize the credit risk mitigation benefits of an eligible guarantee or eligible credit derivative by substituting the risk weight associated with the protection provider for the risk weight assigned to an exposure, as provided under this section.” (emphasis added)

OK, but what constitutes an “eligible credit derivative”? As it turns out, it’s really hard to find the definition. I couldn’t. For the moment let’s assume it means a CDS where the reference entity is some portion of the bank’s loan portfolio and the seller’s commitment is firm for the life of the swap. Under those conditions, the bank substitutes the protection seller’s risk weighting for the weighting of the borrower(s).

In terms of who can issue the CDS, the OFR report makes this observation: “Eligible guarantors cannot be a special purpose vehicle or monoline insurer and must have issued investment-grade unsecured debt without credit enhancement.” Over the past several years there has developed an active market for hedge funds and PE funds to sell this protection to banks. As long as the HF or PE has a better risk weighting than the bank’s borrowers, this looks like a win all around.

Looking Under the Covers

Before we evaluate the OFR viewpoint, and some of the commentary that followed, we should understand some aspects of CDSs. If the definition of casualty insurance is “the payment of a premium by one party (the buyer) in exchange for a promise by the seller to reimburse the buyer if a certain event occurs,” then a CDS fits neatly under that definition. Insurance, of course, has a long history, dating back to when gentlemen used quill pens to underwrite policies at Lloyds’ Coffee House in London. Insurance regulation has almost as long a history, and that is what we should look at now.

Although casualty insurance regulation in the US is a state function, and thus somewhat fragmented, there are some common themes, which are evolving along with most other financial regulation. Risk management is one of those areas. According to a document on the KPMG website:

“Supervisors have begun to set new risk management expectations for insurers, such as:

  • Establishing more risk-sensitive capital regimes to better strengthen and link risk management to the capital needs arising;
  • Introducing stress and scenario requirements, including resolution, or strengthening such requirements where these already exist;
  • Expecting remuneration policies for senior Executive personnel that encourage behavior that supports the risk management framework and long-term financial interests of the firm;
  • Requiring a clearly articulated risk appetite statement which is clearly embedded within the insurer’s operations; and
  • Demanding better assessments regarding the suitability and adequacy of the insurer’s risk management framework, including ongoing appraisal of the insurer’s risk culture.”

In general, casualty insurance carriers are restricted in the amount of coverage they can write, based on their reserves, which are closely monitored by their regulators. In addition, casualty insurance premiums are usually based on the premise that losses occur more or less at random. As AIG Financial Products found out during the financial crisis, credit losses are anything but random, which requires a different pricing model. Of course, we are in a different stage of the economic cycle than we were when AIG/FP was selling all those subprime CDSs for 12 basis points of premium. Or are we?

What the OFR report notes, though, is that the new writers of credit loss protection, the HFs and PEs, are essentially unregulated in terms of insurance coverage. No regulator is looking at the relationship between the coverage they are writing and their reserves. In fact, as managers of other people’s money, the concept of insurance reserves may not apply to them. In their normal investment operations, HFs and PEs use leverage, of course, perhaps as much as 10:1. But writing credit insurance for a premium of 150 to 250 basis points equates to a leverage ratio of something like 50:1. And writing casualty insurance is nothing like investing or securities trading.

So while the OFR was looking at the impact of CRTs on banks and their capital calculations, perhaps we should look at the impact on those who write the insurance. There is a big difference between the expertise necessary to trade securities and what is needed to price and manage a book of casualty insurance.

Insurance companies and their shareholders should be well used to the vagaries of the insurance business, where things go along swimmingly for several years until the tsunami comes along. But investment managers and their customers probably have very little experience in this business, and the list of expectations from the KPMG website (above) would probably be news to them. Thus there may be significant repercussions for fund managers and participants if and when the insurance cycle hits them head on. So talking about the impact of CRTs on the banks instead of on the funds may be a case of looking at second while the ball is going to first.

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