From selling large and highly complex credit derivative trading portfolios to securitizing derivatives counterparty risk, European banks such as Deutsche Bank and Société Générale are leading a renewed and growing purge of some of the most esoteric and capital-intensive areas of their credit trading businesses. Société Générale is reportedly close to securitizing a portfolio of derivatives counterparty exposure – in effect transferring the portfolio risk to a third party – while Deutsche Bank is in the final stages of selling a €16 billion credit derivative correlation trading book, one of the largest sales of its kind.
Credit Suisse, UBS and Crédit Agricole engineered and executed similar transactions last year, and expectation is growing that more derivative and cash-based deals – regulatory capital relief trades – could emerge this year.
Reg cap
“Reg-cap trades are certainly back on the agenda,” says Jonathan Clayton, managing partner of Venn Partners. “Funding as an issue for banks has dissipated and really the only efficient way banks can generate capital outside of earnings is through RWA relief.”
This purge by banks on both the derivative and cash side is ultimately driven by Basle III, which requires banks to strengthen core capital ratios relative to RWAs, and heavily penalizes them for holding the type of exposures inherent in correlation trading and derivative counterparty risk.
Société Générale’s securitization should enable it to reduce the capital it holds against credit valuation adjustments – the market value of counterparty credit risk – on derivatives exposure by placing the risk with a third-party investor, thereby gaining capital relief. Société Générale declined to comment.
The outright expense of the new CVA capital charges on long-dated derivative portfolios is one clear reason why some banks need to shed this exposure, but there are others.
“There is an additional capital charge on the CDS hedges the banks have with the market, which is again expensive and a very inefficient way of managing the capital being held against that credit risk,” says Clayton.
“Another aspect to this is that we should not forget the recent credit rally, the growing liquidity in the market and, frankly, the market’s greater appetite for risk, which actually allows some of these CVA trades to get done now.”
Such has been the credit rally that returns on reg-cap trades have fallen sharply.
“Certain regulatory capital motivated transactions a year ago were offering returns of at least 15% to 16%. Today, returns are closer to 12% and moving lower, which is a striking compression in returns,” says Walter Gontarek, chief executive of Channel Capital Advisors.
As a result of this tightening, “for the bank, post-tax, the cost of capital is in single digits, and it now makes sense for some to do this,” says Clayton.
On a simpler level, banks are also being forced into this because of the high and often crippling IT costs involved in managing vast and complex credit trading books, especially when costs are not offset by revenue growth in the underlying business. This is particularly true of credit correlation trading, strengthening the argument in some cases to exit the business entirely.
“Capital is clearly the main driver here, but cost reduction is another major factor, and particularly cost reduction in IT because you need incredibly sophisticated systems to manage credit correlation portfolios and large staff to run this business as well,” says a structuring and advisory banker in London.
He adds: “Before the credit crisis there was a lot of new business being printed to support P&L, but since 2007 the synthetic CDO business has effectively died, which means no new profits are being generated to cover costs, creating a capital drag.”
Deutsche Bank has said that it aims to raise its core tier 1 capital ratio to 8.5% – the required threshold under Basle III – from 7.8% by the end of the first quarter of 2013, partly supported by the sale of over €100 billion of RWAs from its non-core operations unit. The €16 billion correlation book forms part of that disposal programme.
A year ago Crédit Agricole reduced its RWAs by €14 billion with the sale of its correlation book to hedge fund BlueMountain Capital Management. BlueMountain is one of a few firms that engage in credit correlation trading and therefore have the sophisticated systems, infrastructure and personnel needed to manage these portfolios.
Supply side
On the supply side, there are probably 10 bank credit correlation books in existence, some of which might be sold, with UBS considered a prime candidate to do so. UBS declined to comment.
“It may make sense for some of the banks that have made a lot of noise about exiting some businesses such as UBS,” says the structuring and advisory banker. “But for the others, it would have to be done at a very good price to make sense.”
For other banks it might be more prudent for them to sit tight, because up to 90% of the credit derivative-based collateralized synthetic obligations that compose these portfolios are expected to amortize in 2014, bringing a natural end to the problem.