(Bloomberg) -- As banks increasingly seek to transfer their credit risk to less regulated investors, buyers on the other side of those deals are starting to request an additional feature: sustainability. 

Newmarket Capital, a Philadelphia-based alternative asset manager founded by hedge fund veteran Andrew Hohns, has seen a substantial increase in the number of investors in synthetic risk transfers who now want their SRTs to have some form of environmental or social impact. 

“We’ve really seen the interest in that aspect of our strategy increase quite a lot,” Molly Whitehouse, a founding member of Newmarket who used to work at hedge fund manager Mariner Investment with Hohns, said in an interview. About 40% of invested capital in Newmarket’s flagship SRT fund is now in products with an ESG or impact overlay, she said.

The development coincides with a boom in the wider market for SRTs. Since capital requirements started to rise in the years following the 2008 financial crisis, banks have taken to using SRTs to offload part of their credit risk. Buyers of that risk generally get market-beating returns, while banks get to reduce their capital requirements. The global SRT market is set to grow about 15% this year, according to AXA Investment Managers.

The addition of an ESG layer to SRTs can take many forms. In the most common model, banks exclude certain types of assets from the pool of credit to be transferred, such as loans exposed to the coal industry, tobacco or weapons manufacturers. That way, institutional buyers like pension funds can claim to be making sustainable investments when they hold SRTs.

However, investors are starting to ask for more.

Leanne Banfield, a London-based partner at Linklaters who specializes in SRTs, says there’s now “more of a push to have a fully sustainable transaction” from the investor side. 

That’s typically achieved in three ways, Banfield said. The first is when loans underpinning an SRT are themselves deemed sustainable, for example if they’re allocated to renewable energy. A separate approach requires a bank to invest freed-up capital to issue new ESG-themed loans. The third method is for banks to create so-called transitional portfolios, whereby new ESG loans replace maturing non-ESG loans.

Hohns said earlier this year he’s also looking into a structure that would allow banks to “transfer the credit risk, but at the same time transfer the so-called emissions risk to a third-party investor outside of the banking system, such as ourselves.” Newmarket calls such instruments emissions-weighted risk transfers.

What Are SRTs

Synthetic risk transfers often take the form of a bank selling a securitized product based on an underlying portfolio of loans. SRTs, which are sometimes also referred to as significant risk transfers, allow banks to reduce the risk weights on their assets, resulting in a lower capital requirement. In the case of synthetic risk transfers, banks keep the physical assets on their books and just package and transfer a tranche of the estimated risk. Such products are generally only sold to sophisticated investors such as pension funds, hedge funds or sovereign wealth funds, who stand to get double-digit returns in exchange for the risk they take on.

Banks that add some sort of ESG feature to an SRT can then use the deals to help meet their overall sustainable finance targets, said Florence Coeroli, global head of engineering at Societe Generale SA.

“The way we look at SRTs is completely embedded in the way we look at all the transactions that we do in the global finance team’s approach to ESG,” she said. Coeroli also says she expects the trend to continue, after witnessing “more and more” SRTs with a sustainable impact component in recent years.

The International Association of Credit Portfolio Managers (IACPM) estimates that in 2023, the percentage of sustainability-linked SRTs increased to 11% from 6% the prior year and an average of 3.4% during the previous six years. 

The European Union is considering making structured products subject to the same climate disclosure requirements as other investments. However, IACPM warns that collecting the necessary data would be challenging — maybe even “impossible” — for originators to do in a way that would meet such standards.

Major deals completed by Newmarket include one in 2021, when it partnered with Banco Santander SA in a €1.6 billion ($1.7 billion) transaction covering a portfolio of project finance loans, including for renewable energy development. The transaction includes so-called coupon step-downs. In other words, Santander gets to pay a lower interest rate if it increases the proportion of green loans in the SRT portfolio, or if it boosts its overall financing for renewable energy.

Santander declined to comment on the specifics of the transaction.

Newmarket did a similar $3.4 billion deal in 2019 with SocGen, in which the bank stood to pay a lower coupon if part of its freed-up capital went to “positive impact” projects within four years. 

SocGen declined to comment on whether the target was met, citing the bank’s policy against commenting on individual deals.

Newmarket also declined to comment on individual deals, but Whitehouse says the firm has used “a number of different incentive tools across our transactions,” and for some of them, the bank has hit the target, while for others it hasn’t. 

Whitehouse says freeing up capital can be a “really powerful” way to allow banks to direct more credit to green projects. But there are also skeptics.

Dutch pensions provider PGGM has voiced concern of a potential “disconnect with the ESG-related risk of the securitization itself.” Even if the loan book of the bank providing the SRT becomes greener, “that does not benefit the investor,” PGGM says on its website. Ultimately, there’s a “risk of misleading ESG claims,” it said.

PGGM has limited its own investments in SRTs to so-called blind pools. A controversial construction in their own right, blind pools keep the identity of borrowers behind the securitized loans secret. PGGM says it enters such deals on the condition that certain assets are excluded. It also relies on the bank’s due diligence.

In Europe, using capital-relief products such as risk transfers — whether synthetic or not — has been embraced as a way to help promote policy goals such as affordable housing and the green transition. Deutsche Bank AG recently entered a capital-relief deal with the European Investment Bank allowing it to grant discounts on more than €600 million of green mortgages. 

Still, Banfield at Linklaters warns that a lack of standardization around ESG integration and labeling in the SRT market has the potential to hurt growth. That puts pressure on market participants to ensure the products stand up to scrutiny.

“We need to make sure that a lot of those more traditional institutional investors don’t go off and invest in other sustainable products at the expense of SRT,” she said.

--With assistance from Esteban Duarte.

(Updates paragraphs 19-21 with Newmarket and PGGM comment.)

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