Complex debt trades that started as a way for lenders to reduce their loan exposure are becoming a business opportunity for some of the world’s biggest investment banks. Others are worried they could become another source of systemic risk.

Nomura Holdings Inc. and Credit Suisse Group AG are among the most-active firms earning high fees by providing loans to help hedge funds buy so-called capital-relief bonds from other banks as investor demand for high-yielding securities increases, according to people familiar with the matter, who aren’t authorised to talk about it and asked not to be identified. Those lenders are also facilitating trading, making it easier than ever for investors to buy and sell the instruments.

Global lenders including Banco Santander SA and Lloyds Banking Group Plc have used the bonds to reduce the amount of capital they have to hold to cushion against losses on loans. Growth of the complex securities — which use derivatives to transfer that risk — has raised concerns because of similarities with synthetic collateralised-debt obligations which were blamed for making banks more interconnected and exacerbating the financial crisis.

“I’m pleased banks seem more willing as of late to support capital-relief trades,” said Greg Branch, chief investment officer of SCIO Capital LLP, which buys the deals. “It seems investors can’t get enough of this risk, but they’d be wise to be careful.”

Hedge-Fund Loans

Nomura is one of the biggest lenders to hedge funds investing in the deals in Europe, according to the people familiar with the matter. The bank, together with Credit Suisse and Deutsche Bank AG, loaned about $1.5 billion to investors through 2016 to finance purchases of synthetic securitizations from other banks, one of the people said. Nomura and Credit Suisse also helped funds trade about $700 million of the notes with one another, the person said.

Officials at all three banks declined to comment on their involvement.

The loans allow hedge funds to invest with borrowed money, amplifying potential gains. The lending banks can charge as much as 4.5 percentage points more than the London interbank offered rate in interest, the people said. That compares with an average yield of 1 per cent for investment-grade corporate bonds in Europe, according to the Bloomberg Barclays Euro Aggregate Index.

Critics say the trades move risk without reducing it, making the system more interconnected and reducing transparency. The securities are bespoke and illiquid, meaning banks can be left exposed to another lender’s loans.

Risk Transfer

“While it’s known that structured finance is a tool for transforming and spreading risks in the financial system, it’s equally clear that these risks don’t vanish,” said Vincenzo Bavoso, a lecturer at the University of Manchester, England, who’s written papers on securitisation.

There will be more deals in 2017 than in any year since the crisis, according to bankers at Barclays Plc and Lloyds. The sales also allow investment banks to generate fees from related business including lending, structuring deals and connecting buyers and sellers.

“In a bonus-driven culture, of course some investment banks will proactively market these trades, it makes money for them,” said Moorad Choudhry, a former Royal Bank of Scotland Group Plc executive who worked on capital relief deals. “It isn’t reducing systemic risk, it’s just transferring it from the bank sector to the non-bank finance sector, which in turn is being funded by the bank sector.”

Last year banks sold about $6 billion of notes, protecting as much as $100 billion of debt on their books, according to Himesh Shah, a London-based managing director at Christofferson Robb & Co.

Read more: The return of complex credit products

The securities appeal to banks because they ease the burden of capital rules without having to find buyers that can take on large portfolios. Bank of Ireland completed a transaction in December in which outside investors assumed the credit risk for 185 million euros ($200 million) of potential losses, and the deal had the equivalent capital impact as shedding about 2 billion euros of risk-weighted assets.

Hedge funds, insurers and pension funds typically buy the bonds, which put them first or second in line for losses. Lloyds sold notes in December paying 12 percentage points more than three-month Libor for the first-loss portion of a portfolio of UK business loans.

“I’m glad to have some liquidity in what’s a very illiquid asset class,” said Douglas Charleston, a money manager at TwentyFour Asset Management, which oversees 7.6 billion pounds ($9.7 billion) of assets. “It gives us some comfort that a handful of dealers are now prepared to find the other side of the trade.”

Hedge fund Chenavari likes to buy capital-relief deals in secondary markets, according to money manager Hubert Tissier de Mallerais. There’s value there, with distressed sellers looking to get out, he said.

The number of buyers has about tripled in the past five years, according to Alan Shaffran, a senior money manager at Magnetar Capital in London. As many as 70 investors now buy the notes or are actively exploring the market, said Robert Bradbury at StormHarbour Securities LLP, which structures synthetic deals.

New Sellers

There’s also room for more new issuers to enter the market, which has been dominated in the past few years by Europe’s largest banks, according to bankers including Jeremy Bradley, head of asset risk transfer in the securitised products group at Lloyds in London. Sweden’s Nordea Bank AB priced a debut deal last year, passing on the first losses from an 8.4 billion-euro portfolio of corporate loans to a pension fund, people familiar said at the time.

“Many European banks are moving from a position of intellectual curiosity on these deals, to something much more purposeful,” said Rob Scott, head of securitised products for Europe, the Middle East and Africa at Barclays in London.

— With assistance from Silla Brush