Banks are giving credit risks an ethical spin to sell to ESG investors

For decades, the world’s big banks have been using smart financial whistles to offload credit risk. Now it’s giving some of those products a makeover in hopes of attracting ethically minded investors.

In significant risk transfers (SRTs), also known as credit risk transfers, investors assume a portion of the default risk of a portfolio of loans in exchange for regular interest payments.

This reduces the levels of equity that banks must maintain against these loans, potentially allowing for larger cash payouts to shareholders or for more loans.

Santander, Crédit Agricole and Société Générale are among the banks now issuing SRTs with a sustainability or social impact dimension, such as using additional lending capacity to invest in renewable energy projects.

In this way, they hope to tap the demand of pension funds and other investors for products with an environmental, social and governance (ESG) bent.

However, while ethically credentialed SRTs have become more common, the industry is far from a consensus on which products should count.

“There is no standard. This is very much about working with the banks on what is possible,” said Mascha Canio, head of credit and insurance investments at Dutch investor PGGM, one of the biggest buyers of SRT.

Banks have been using SRTs since the 1990s, but issuances have increased in recent years as they sought new ways to offload risk in the face of tighter capital requirements.

“SRT deals done by banks these days will always have an ESG overlay to the extent possible,” Dennis Heuer, partner at White & Case, told the Financial Times. Claims about sustainability and other ethical credentials in SRT’s deals have gained momentum over the past year, he added.

According to Leanne Banfield, partner in structured finance and derivatives at Linklaters, the trend “tends to be driven more by investors than banks”. Asset managers, pension funds and insurers like the high interest rates that ethical and sustainable SRT products often pay, she said, and the opportunity to consider them for their ESG goals.

SRTs marketed as helping society or the environment come in a variety of flavors.

“We’re looking at SRT as one of the tools we’re incorporating into everything we want to push as part of our ESG trajectory and commitments,” said Florence Coeroli, SocGen’s head of distribution and credit solutions in the UK.

Some banks have excluded assets with exposure to industries such as coal from the underlying loan pool, Banfield said, to classify an SRT as sustainable.

Others said they would use the additional lending capacity made available by an SRT transaction to provide loans with positive environmental or social impact, such as renewable energy projects or affordable housing.

“We have exposure to many of these types of assets, including renewables, affordable housing and other social infrastructure,” said Molly Whitehouse, a founding member of Philadelphia-based alternative asset manager Newmarket Capital.

Newmarket has specialized in ESG-themed SRTs, with renewables making up the bulk of its investments in those products, she said.

A recent deal between BRD, a Romanian subsidiary of SocGen, and the International Finance Corporation, the private finance arm of the World Bank, used an SRT to free up BRD’s lending capacity to finance what IFC called “impact projects related to sustainability”. .

As part of the agreement, IFC provided BRD with a risk guarantee for a portfolio of up to 700 million euros of loans for small businesses and companies. The resulting freed up capacity will be used to lend up to €315 million to climate-related initiatives and women-owned small businesses, IFC said.

Some SRT products marketed as durable have been criticized. “How do you show that the bank wouldn’t have made that (revolving loan) anyway?” Banfield said.

Another option is to sell a product with an underlying portfolio that consists exclusively of sustainable loans. However, Banfield said, most banks “simply don’t have enough of these types of loans to make meaningful portfolios.”

PGGM tailored its investment strategy for each bank, Canio said, adding that “we don’t hold back from a mixed portfolio where some parts are greener than others.”

Other investors have chosen structured SRTs that come with a reduction in the interest rate, or coupon, paid to the investor if the bank meets certain sustainability targets.

How these risk transfers are structured – and whether they qualify as investments with a positive social impact – remains a matter left to the discretion of the bank and the investor.

“For now, sustainable securitization means something different to every investor,” Banfield said, adding. “There is no regulatory framework in place.”

“The market doesn’t really know what sustainable securitization means and needs to figure it out. In a way, this is quite an exciting opportunity.”