Barclays, Deutsche Bank are back into credit derivatives. Stay calm

This is one big reason why capital-relief trades are more popular in Europe than the US: Equity for banks is more expensive, so the cost of good insurance is more likely to be cheaper. Like Barclays, Deutsche Bank AG has talked a little about buying loss cover in the past, and it shouldn’t be too surprising that these two find insurance costs worth paying.

Both banks have low stock valuations, which means high implied costs of equity. Barclays’ implied cost is currently about 18 percent and Deutsche Bank’s about 16.5 percent. For comparison, JPMorgan Chase & Co’s is about 9 percent, so insurance cover would have to be cheap to beat that.

Risk-transfer trades like Barclays’ involve selling the risk of losses on a portfolio of loans to an investor that is typically a credit specialist or hedge fund. The investor wants the nice yields available from credit cards or other loans without having to do the nitty gritty of managing customers.

These deals are mostly private and bilateral, so they aren’t easy to track. Barclays and Deutsche Bank are unusual in talking about them publicly at all. The market is quite concentrated with just 27 banks doing any deals in Europe and the top four accounting for 60 percent of all European volume outstanding, according to the European Systemic Risk Board.

The whole idea of anything synthetic, private, complicated and involving derivatives of credit risk still has a bad name from the crisis of 2008. There’s nothing wrong with the principle of insurance – it’s been with us for thousands of years, most likely. The problems come if it doesn’t cover the risks you hoped, or the insurer turns out unable to pay your claim.

Lightly regulated hedge funds and private capital firms are less reliable than big banks or insurers as counterparties, so the solution is to get them to put up the money to cover all potential losses in a trade at the start. These days most risk transfers are fully funded in this way, according to Richard Barnes, credit analyst S&P Global Ratings.

Banks typically sell credit-linked notes, or take the cash upfront as collateral. To the investor that looks the same as buying a bond. Only supranational institutions or very highly rated insurers don’t need to hand over cash, Barnes says. That sounds fine, although the major caveat here is that American International Group Inc was a very highly rated insurer that sold a lot of unfunded credit-loss protection before 2008 – and that didn’t turn out very well at all.

The problem of not getting the cover you expect is a trickier issue, but should be manageable so long as the pool of loans to be covered is clearly identified and the order and size of losses are also clear.

Removing the potential cost of losses makes a pool of loans less risky. What that means practically for banks is they can record a lower number for their risk-weighted assets, which is the balance sheet measure used to set their capital requirements.

Banks aren’t alone in pushing this concept. When JPMorgan bought First Republic Bank out of bankruptcy last year, it got credit-loss insurance from the Federal Deposit Insurance Corp. The FDIC and JPMorgan weren’t worried that all these loans were bad; the point was to cut the capital requirements of the First Republic assets to make them more attractive. UBS Group AG got a similar policy from Swiss authorities when it rescued Credit Suisse Group AG.

These trades are sound in my view, so long as they aren’t over-exploited. If banks can offload credit risks relatively cheaply, perhaps because there’s excessive demand from private managers looking for less liquid assets, that can very easily encourage the banks to lend too much too quickly and often to borrowers who can’t really afford it. That’s the other lesson from 2008 that everyone should bear in mind.

Paul J. Davies is a Bloomberg Opinion columnist. Views do not represent the stand of this publication.

Credit: Bloomberg