Should pension schemes consider helping the banks?

Investment

By Alex Janiaud | March 19, 2018

Analysis: Pension schemes have an opportunity to take advantage of banks’ growing capital requirements.

The global financial crisis in the late 2000s led to the introduction of strict capital requirements for banks in an attempt to protect the financial system.

The Basel Committee on Banking Supervision published the first version of Basel III, which lays out these regulatory capital demands, in late 2009.

In a regulatory capital transaction, a scheme acts as an external counterparty and provides risk capital alongside banks for their loan books. In return, the scheme receives a coupon based on the amount it has put at risk.

This is one of the areas where we think the manager due diligence is really important

Barbara Saunders, P-Solve

There are few providers currently offering regulatory capital strategies to schemes, but mastertrust TPT Retirement Solutions has started investing in regulatory capital.

In a January interview, TPT chief investment officer Cliff Speed said: “We’re not replacing the bank. The bank must still have an expression of interest in these loans, but we’re providing some of the capital, and that allows them to have a regulatory capital release.”

These strategies are complex and relatively illiquid. They do, however, potentially offer a high source of return and a new way to diversify a portfolio.

Carry out your due diligence

Identifying an appropriate manager for regulatory capital will pose a challenge to interested schemes.

Barbara Saunders, managing director of consultancy P-Solve’s solutions team, said there are six “credible” providers currently operating in the market. One “large” client has committed to investment in regulatory capital.

“The yields are quite attractive,” Saunders said. “We have a few managers that we like the look of, but if I’m honest, this is one of the areas where we think the manager due diligence is really important.”

Saunders attributed appealing returns to high costs of capital for banks and its lack of widespread adoption among institutional investors.

Regulatory capital is not without its risks, though. The product is fairly illiquid, and the value of potential losses high.

Basel III capital reforms: quality and level of capital

Raising minimum common equity to 4.5 per cent of risk-weighted assets, after deductions
A capital conservation buffer comprising common equity of 2.5 per cent of risk-weighted assets, bringing the total common equity standard to 7 per cent. Constraints on a bank’s discretionary distributions will be imposed when it falls into the buffer range
A countercyclical buffer within a range of 0–2.5 per cent comprising common equity will apply when credit growth is judged to result in an unacceptable build-up of systematic risk
Capital loss absorption at the point of non-viability: Allowing capital instruments to be written off or converted to common shares if the bank is judged to be non-viable. This will reduce moral hazard by increasing the private sector’s contribution to resolving future banking crises

Source: Bank for International Settlements

“You’re exposed to early losses in the loan book,” Saunders said, which means that if any defaults happen, investors are likely to start to lose money.

“Provided that the book of loans is sufficiently diverse, and that there is good underwriting of those loans… the losses should still be manageable and certainly below the premiums that you receive for taking on the risk,” she added.

Trustees can struggle to understand

A trustee board is likely to require an increased level of support when considering regulatory capital. The product is not well known and advisers are still carrying out their research.

Murray Taylor, senior consultant and head of manager research at JLT Employee Benefits, recognises the potential for high returns, suggesting that they could range between 7 and 12 per cent.

He holds concerns over engaging schemes with the product. “It’s not the easiest product to understand, particularly for lay trustees,” he said.

In Taylor’s vision, schemes would make small allocations to regulatory capital, which would form part of their alternative credit exposures. He says that his consultancy will research the product.

“The returns on offer look quite good,” he said. “We’ve got to still understand the risk characteristics behind that and make sure that the reward is sufficient for the risk that you’re taking on.”

Regulatory capital is for larger schemes

Basel III requirements on banks will need to be fully adopted by 2019. Scott Edmunds, investment consultant at Quantum Advisory, thinks that demand for regulatory capital strategies could be sustained by the imminent roll-out of the legislation.

TPT assists banks with risk capital investment

Mastertrust TPT Retirement Solutions is investing in regulatory capital strategies, where the scheme provides risk capital for the loan books of banks. The trust is also making allocations to alternative risk premiums.

Read more

Edmunds identified regulatory capital as a more appropriate investment proposition for larger schemes.

“It does remain a niche area,” he said. “In terms of whether this trend will continue, it is always difficult to call.” However, with the Basel III rules coming in, the trend could continue as banks seek to improve capital adequacy ratios.

“Smaller schemes may struggle to warrant investing directly in these strategies, but might instead utilise unitised private debt funds in order to gain similar exposures,” he added.