The Resilience of Risk Sharing Transactions to Stressed Credit Environment

In Pemberton’s most recently published article, Pemberton’s Risk Sharing Team, Olivier Renault and Anna Neri introduce how bank risk sharing transactions have become an increasingly popular tool for banks to hedge their loan portfolios and release capital, while aiming to illustrate the strong resilience of risk sharing transactions to credit stresses.

The article further addresses:

• Bank Risk Sharing transactions (“SRT” transactions) are hedging tools designed to provide capital relief to banks on their core lending portfolios.
• Using long time series of Standard & Poor’s default data, we test how the returns of ‘typical’ SRT transactions would have fared during historical credit shocks (global financial crisis, telecoms bubble, second oil shock) and through hypothetical stress scenarios.
• Despite their junior position in the capital structure, we show that SRT transactions can be very resilient to prolonged periods of credit stress, including repeated occurrences of 3-standard deviation events.
• The explanation for such resilience lies in the Basel rules for capital relief which force banks to hedge a very thick and diluted portion of risk. The high coupons paid on the tranches are sufficient to cover principal losses even in high-stress scenarios.
• Our findings are consistent whether we use a simple constant-loss model or a more sophisticated Monte Carlo simulation approach factoring in ratings transitions.

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