SRTs are a type of synthetic securitization, often called “balance sheet securitization,” during which a bank offloads a few of the credit risk of a loan portfolio through a contract, typically a credit derivative or guarantee, without selling the loans completely or removing them from the balance sheet.
In Europe, where the market was born, the investor typically acquires mezzanine loan risk by selling (writing) a credit default swap (CDS) and within the United States through a credit-linked note (CLN). The principal protectors are private and non-private credit funds, that are characterised by competitive returns, access to prime quality, diversified credit exposures and the power to regulate risk via tranches. Banks pay for this protection since it allows them to transfer a few of their credit risk to investors, which in turn lowers their regulatory capital requirements and frees up capital for brand spanking new loans at a lower cost than raising equity.
The original bank keeps the primary loss tranche (junior tranche).[2]. The investor, who has no specific knowledge of the loans underlying the pool (only general details akin to maturity, rankings and industry), receives a hard and fast premium or coupon. If there are defaults within the portfolio, the bank assumes the primary loss, while the investor assumes losses as much as the limit of the mezzanine tranche.
The bank retains customer relationships, loan servicing and interest income to remain “in the game,” which is a regulatory requirement. However, since it loses a few of the portfolio risk, the bank is allowed to scale back the capital on the loans.
SRTs are typically designed for capital relief and risk management. In the primary case, the Basel capital requirements are generally viewed as excessively penalizing certain assets. For example, automobile loans require disproportionately high capital despite extremely low default rates. SRTs enable banks to scale back risk-weighted assets (RWA) by 50 to 80% on many transactions. In addition, by transferring risk without shrinking their balance sheets, banks can reduce geographic, borrower or sector concentration risk.
