Balance Sheet Optimization
Optimizing return on regulatory and economic capital is a key concern for bank portfolio managers. Reducing the capital backing existing holdings can help redeploy the capital to more profitable businesses, shrink the balance sheet, or boost returns.
One obvious way of reducing the capital held is to sell a particular set of assets that are capital-intensive. But these assets tend also to be the ones that yield more and selling them could harm the return on the banks portfolios. CDO technology enables banks to keep most of the returns while significantly reducing regulatory capital.
The idea is to sell the assets to a separate bankruptcy-remote special purpose entity, thereby ridding the balance sheet of these assets and then buying back the equity tranche of the CDO, which has a levered first-loss exposure to the original assets and a correspondingly high yield.
The rationale of the trade is the same as for cash CDO, but it does not involve a true sale of assets. The bank buys protection on the second loss piece of its loan book and retains the first loss. Because assets remain on the balance sheet, a full deduction of capital cannot be achieved but the hedged portion would typically benefit from a reduction of capital from 8 percent to 1.6 percent.
The much lower costs involved in synthetic reduction of risk compared to a true sale partly offset the lower reduction in capital. The added benefit of synthetic balance sheet CDOs is that the risk transfer can occur without the original borrower’s knowledge that the bank has hedged the credit risk. This enables banks to maintain or even increase relationships with borrowers while keeping the bank’s risk exposures to individual borrowers under control.