Picture the scene: it's the first quarter of 2016 and, in the Czech Republic, the local subsidiary of Raiffeisenbank is trying to finance a €200 million pile of covered bonds it issued a year earlier and retained. In France, meanwhile, a retail bank is trying to raise the return on the buffer it holds to satisfy the liquidity coverage ratio (LCR).
They don't know it yet, but they are a match made in heaven, and the matchmaker will be Societe Generale Corporate & Investment Banking (SG CIB).
The deals that brought the two sides of the trade together – a repo with Raiffeisenbank Czech Republic, and a collateral exchange with the retail bank – were individually unremarkable. But in combination, the deal is a perfect example of the modern approach to risk solutions: both sides win, and the dealer takes minimal exposure.
"Sometimes it is not obvious how all people could win," says Antoine Broquereau, global head of financial engineering at SG CIB. "Here it is a bit more subtle, and the LCR transaction is a good way to optimise the transaction and make it work for everyone."
The value provided by the middleman is essentially a deep understanding of regulations, solid risk management and the ability to distribute risk – not the willingness to warehouse risk and charge a fat margin for it.
We took some risk on our balance sheet for a limited period, because we were quite keen to conclude the deal with Raiffeisen in an efficient manner – but we were conscious that balance sheet and liquidity are limited resources, and we were confident we could recycle
Antoine Broquereau, SG CIB
The story starts with the Czech mortgage-backed covered bonds, issued in 2014, roughly half of which were sold in the primary market, while the rest were retained by Raiffeisenbank. Towards the end of 2015, the bank started looking for ways to raise financing using the rest of the covered bonds. The spread on the secondary market had widened, so the price wasn't particularly appealing.
"The pricing would have been 30-40 basis points higher than we achieved with Societe Generale," says Jan Pudil, member of the managing board for treasury and investment banking at Raiffeisenbank Czech Republic.
The bonds were eligible for the European Central Bank's (ECB) longer-term refinancing operations, but Raiffeisenbank Czech Republic did not have access as they are not in the eurozone. Raiffeisenbank Czech Republic would have to seek ECB refinancing through their parent company, Raiffeisen Zentralbank, based in Austria. That left some form of private financing, with SG CIB one of two European banks that looked at the collateral in some detail.
The first step was to assess the underlying credit risk. Here, SG CIB had an inside line, thanks to Komerční banka, the Czech banking group it acquired in 2001. The mortgages were all prime, and SG CIB's Czech colleagues were able to give more detailed insight into the risk characteristics of the market.
The next step was to work out whether the loans could be recycled. If not, the bonds would sit on SG CIB's balance sheet, consuming liquidity on their balance sheet, and Raiffeisenbank would essentially be paying for SG CIB to raise funds on its behalf. After a careful look at the bonds, SG CIB was convinced it could find a new home for them – and secure its financing for Raiffeisenbank.
"The target was definitely to recycle it. Without recycling, the price would have been closer to our unsecured funding rates. And knowing we could recycle, we benefited from the fact we could do it in a secured manner," says Broquereau.
The pricing would have been 30–40 basis points higher than we achieved with Societe Generale
Jan Pudil, Raiffeisenbank
The full €200 million of bonds went to SG CIB in a three-year repo transacted on July 1 last year. A haircut applied, meaning SG CIB provided €170 million in cash, with the balance of the covered bond portfolio retained by the dealer as collateral. This would have left Raiffeisenbank with counterparty exposure to SG CIB, so a tri-party pledge structure was employed – allowing either party direct access to the haircut amount in the event of the other's default.
SG CIB then needed to move the rest of the bonds along. In the end, the debt was sitting on the French bank's balance sheet for less than a month.
"We took some risk on our balance sheet for a limited period, because we were quite keen to conclude the deal with Raiffeisen in an efficient manner – but we were conscious that balance sheet and liquidity are limited resources, and we were confident we could recycle," says Broquereau.
This is where the LCR came in. The ratio requires a bank to hold enough high-quality liquid assets (HQLA) to cover its net cash outflows during a 30-day period of stress – with regulators defining the HQLA universe and separating it into buckets according to how liquid it is. The most liquid bucket – cash, central bank reserves and certain government bonds – can be used to meet the LCR with no limits; others are subject to a haircut and can only used as a portion of the total buffer.
Covered bonds fall into one of the latter categories of HQLA – 2A – enabling them to be used with a 15% haircut as long as they make up no more than 40% of the total buffer.
Crucially, other holders than Raiffeisenbank would also have the ability to refinance them with the ECB – and the Czech mortgage-backed bonds offered a 10–20 basis points higher yield than many other LCR-eligible assets. That made them a good fit for the French retail bank, which sent French inflation-linked bonds to SG CIB in return.
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