The world’s major banks have been using clever financial tricks to shed credit risk for decades. Now they are giving some of these products a new coat of paint to attract ethically minded investors.
In significant risk transfers (SRTs), also called credit risk transfers, investors assume part of the default risk of a loan portfolio in return for regular interest payments.
This reduces the level of capital that banks must hold for these loans and may allow for higher cash payments to shareholders or the granting of additional loans.
Santander, Crédit Agricole and Société Générale are among the banks that are now issuing SRTs with a sustainability or social impact dimension, for example by using the additional lending capacity to invest in renewable energy projects.
In this way, they hope to address the demand from pension funds and other investors for products with environmental, social and governance (ESG) aspects.
Although ethical SRTs are becoming more widely used, the industry is still far from reaching consensus on which products are eligible.
“There is no standard. We work closely with the banks to find out what is possible,” says Mascha Canio, head of credit and insurance investments at Dutch pension fund PGGM, one of the largest buyers of SRTs.
Banks have been using SRTs since the 1990s, but their issuance has increased in recent years as they have sought new ways to shift risk in the face of tighter capital requirements.
“SRT transactions conducted by banks today will always have some ESG component, wherever possible,” Dennis Heuer, a partner at White & Case, told the Financial Times. Claims about sustainability and other ethical criteria in SRT transactions have increased sharply in the past year, he added.
According to Leanne Banfield, structured finance and derivatives partner at Linklaters, the trend is “driven by investors rather than banks.” Asset managers, pension funds and insurers value the high interest rates that ethical and sustainable SRT products often pay and the opportunity to count them towards their ESG targets, she said.
SRTs, marketed as helping society or the environment, come in many different varieties.
“We see SRT as one of the tools we embed into everything we want to drive as part of our ESG strategy and commitments,” said Florence Coeroli, head of SocGen’s UK sales and credit solutions business.
Some banks have excluded assets with exposure to industries such as coal from the underlying loan pool, Banfield said, in order to classify an SRT as sustainable.
Others have stated that they would use the additional lending capacity released by an SRT transaction to offer loans with positive environmental or social impacts, such as for renewable energy or affordable housing projects.
“We have exposure to many of these asset types, including renewable energy, affordable housing and other social infrastructure,” said Molly Whitehouse, a founding partner of Philadelphia-based alternative asset manager Newmarket Capital.
Newmarket specializes in SRTs with ESG themes, with renewable energy making up the largest share of its investments in these products, she said.
Under a recent agreement between BRD, a Romanian subsidiary of SocGen, and the International Finance Corporation, the private finance arm of the World Bank, an SRT was used to release lending capacity to BRD to finance what the IFC called “high-impact sustainability projects.”
Under the agreement, the IFC provided Germany with a risk guarantee for a portfolio of loans for small businesses and companies of up to 700 million euros. The capacity thus freed up will be used to lend up to 315 million euros to climate-related initiatives and small businesses owned by women, the IFC said.
Some SRT products marketed as sustainable have come under criticism. “How do you prove that the bank would not have done this (a renewable loan) anyway?” asked Banfield.
Another option is to sell a product whose underlying portfolio consists entirely of sustainable loans. However, says Banfield, “most banks simply do not have enough of these types of loans to put together meaningful portfolios.”
PGGM has tailored its investment strategy to each bank, Canio said, adding: “We do not shy away from a mixed portfolio where some parts are more environmentally friendly than others.”
Other investors have opted for structured SRTs, which involve a reduction in the interest rate or coupon paid to the investor if the bank achieves certain sustainability targets.
How these risk transfers are designed and whether they are investments with a positive social impact is left to the bank and the investor.
“Currently, sustainable securitization means something different to every investor,” Banfield said, adding, “There is no regulatory framework.”
“The market doesn’t really know what sustainable securitization means and is still trying to figure that out. In some ways, it’s a pretty exciting opportunity.”