Regulatory Capital Relief Trades as a tool for regulators to prop up stability of the financial system

By: Alexander Gold, Chairman of Bankograph Capital Management Pte Limited           May 2020

Capital relief trades are generally a type of financial engineering that enables banks to offset the risk of borrowers not repaying their loans. To an uninformed, capital-relief trades may look like derivatives that caused the 2008 Financial Crisis, but they are different in both nature and purpose. 

Capital relief trades, or structured capital deals, may be instrumental in current economic environment and getting them into a transparent and compliant structure will be crucial if we are to avoid economic risk distortion.

There are number of methodologies which come under capital relief trades, however all products all have one thing in common: They improve bank’s balance sheet. 

They transfer the risk of a borrower defaulting away from the bank to investors — in a similar way that loans were sold before the financial crisis.

 Banks are only sharing the risk of unexpected losses on a loan portfolio with the investors. The servicing rights remain with originating bank — and the risk transfer allows the bank to reduce the amount of its own capital it must set aside to cover the risk that the borrower defaults. 

This in turn leads to an enhanced ability of a bank, utilising capital relief trades, to raise new capital and grow balance sheet and the bank can re-acquire assets back from the investors.

The incentives for both sellers and buyers of capital relief trades are very compelling. Investors — from hedge funds to insurers — are keen to pick up higher returns in the low or in some jurisdictions, negative interest rates. 

They allow lenders to adjust regulatory capital without unfavourable dilution of shareholder, with valuations near record lows, banks would prefer not to raise fresh equity capital on the stock market. 

The capital relief trades are private, the deal structures are typically covered by non-disclosure agreements between bank and investors and do not affect reputation of the bank in the public eyes as opposed to direct asset sales or public rights issues.

In the meantime, whist the structure of the  these trades is designed to replicate that of Bank’s Additional Tier 1 bonds, they tend to have a higher return because they are based on the cashflows of a basket of Bank owned high yield assets.

It is crucial for regulators to set parameters to these trades and to condition banks to use the capital relief trades as a support instrument for banks to recapitalise and get their capital buffers to the levels required of them, a goal that is being complicated by the current economic environment. The Tri Party engagement of Banks, Investors and regulators will create a “fair play instrument” which will prevent distortions experienced during GFC

Big banks like HSBC and Deutsche Bank have used capital relief trades to shore up their balance sheets, and if done right, capital relief trades should be an integral part of the financial ecosystem extended to smaller banks, especially in the emerging economies where access to local stock market driven equity capital is limited, as this will attract participation of multinational hedge funds and institutional players looking for higher yield. 

But regulators need to ensure participants in these deals are adhering to prudential principals and standards and the arrangers of these deals have adequate measures for ensuring that the aim of such structures is not being diverted into simply a synthetic balance sheet leverage.