Cash-collateralised notes against an insurer's guarantee on the same tranche: the capital each leaves behind, and the premium discount that makes unfunded cover worth taking.
Funded protection collateralised in cash at the bank releases the full capital on the tranche; an unfunded guarantee leaves the guarantor's risk weight behind, so it only wins if its premium is low enough to pay for that capital. On the fictional Northwall 2026-1, 266m of cover from an insurer weighted at 50 per cent keeps 17.96m of capital, cutting the release from 223.9m to 206.0m. The insurer must quote at least 1.04 points below the fund's 10.50 per cent margin, 9.46 per cent or less, to be the better trade.
Worked in full in Significant Risk Transfer by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
In a funded trade the investor buys credit-linked notes, or posts cash, and the bank holds the money: when a reference loan defaults, the bank pays itself out of the collateral. In an unfunded trade an insurer or another counterparty signs a guarantee or a credit default swap and pays only when a loss occurs. Insurers price unfunded cover tighter because they do not have to fund it, and that is why the comparison comes up. But the capital rules treat the two differently. Cash held by the protection buyer carries no counterparty risk weight. A guarantee replaces the risk weight of the protected tranche with that of the guarantor, under the substitution approach, and the bank holds capital against the guarantor for as long as the cover runs.
| Input | Value |
|---|---|
| Pool RWA before the trade | 3,077.08 |
| Senior retained / SEC-IRBA risk weight | 3,720 at 35.34% |
| Junior protected | 266 |
| Retained junior slice, deducted | 14 |
| Funded margin over the reference rate | 10.50% |
| Unfunded premium quoted by the insurer | 9.00% |
| Insurer's risk weight (illustrative) | 50% |
| CET1 target / cost of equity / tax | 13.50% / 11.5% / 25% |
The funded margin is the cost net of the reference rate the collateral earns, as in the most a bank can pay for SRT protection. A 50 per cent weight is what a single-A corporate counterparty takes under the standardised table; an IRB bank would use its own rating of the insurer.
Step 1: capital before. 3,077.08 × 13.50% = 415.4
Step 2: funded, capital after. Senior 3,720 × 35.34% × 13.50% = 177.5, plus the 14 deducted = 191.5. Released = 415.4 − 191.5 = 223.9
Step 3: unfunded, the counterparty charge. 266 × 50% = 133.0 of RWA, × 13.50% = 17.96. Released = 223.9 − 17.96 = 206.0
Step 4: value created a year. Value = cost of equity × capital released − protection cost × (1 − tax)
Funded: 11.5% × 223.9 − 266 × 10.50% × 75% = 25.75 − 20.95 = 4.80
Unfunded: 11.5% × 206.0 − 266 × 9.00% × 75% = 23.69 − 17.95 = 5.73
Step 5: the break-even premium. Discount needed = cost of equity × guarantor RW × CET1 target / (1 − tax) = 11.5% × 50% × 13.50% / 75% = 1.04 points, so break-even = 10.50% − 1.04 = 9.46%
Excel: =Margin_funded-CoE*RW_guarantor*CET1/(1-Tax)
At 9.00 per cent the insurer saves the bank 3.99m a year before tax, 2.99m after, and its risk weight costs 2.06m a year in cost of equity on 17.96m of capital. Unfunded wins by 0.93m a year, less than a quarter of the headline saving. The ceiling moves too: the most the bank can pay for the funded cover is 12.91 per cent over the reference rate, but only 11.87 per cent for the unfunded cover, because less capital comes back.
| Guarantor risk weight | Capital held | Capital released | Discount needed, points | Break-even premium |
|---|---|---|---|---|
| 0% (e.g. a sovereign or multilateral development bank) | 0.00 | 223.9 | 0.00 | 10.50% |
| 20% | 7.18 | 216.7 | 0.41 | 10.09% |
| 50% | 17.96 | 206.0 | 1.04 | 9.46% |
| 100% | 35.91 | 188.0 | 2.07 | 8.43% |
| 150% | 53.87 | 170.1 | 3.11 | 7.39% |
The discount needed is linear in the guarantor's weight: roughly 0.21 points of premium for every 10 points of risk weight on these inputs. An unrated or weakly rated protection seller has to be very cheap to compete with cash. The CET1 target moves it less: at 10.5 per cent the insurer needs 0.81 points of discount, at 15.0 per cent 1.15 points.
Two further costs do not show in the table. Unfunded cover is exposure to one counterparty for the life of the deal, and a guarantor that is downgraded raises the bank's capital on the spot. And it is correlated with the very losses it covers when the guarantor is itself exposed to the same credit cycle. A rule of thumb that compares premiums only, before capital, will choose unfunded cover more often than the capital supports. STS treatment also narrows the choice: under the rules as they stand, an STS synthetic needs cash or securities collateral, or a zero-weighted guarantor (the European Commission's 2025 reform proposal would admit qualifying insurers), as set out in how much capital STS status saves.
Treasury sees 9.00 per cent against 10.50 per cent and books a 3.99m annual saving. The real gain is 0.93m, because the 17.96m of capital the guarantee leaves behind has a cost. The opposite mistake is to treat all funded trades as free of counterparty risk. If the collateral is held at a third-party bank rather than by Northwall, the exposure moves to that bank: at a 20 per cent risk weight Northwall holds 7.18m of capital, exactly what a 20 per cent guarantor would cost.
All figures are illustrative. Eligibility of an unfunded protection provider, and the treatment of a given insurer, depend on the regulation and the supervisor; the arithmetic above is the comparison to run once both structures qualify.
The book prices Northwall's trade from both the bank's and the fund's side, and the free workbooks for this case compute the release, the ceilings and the bargaining range on your own inputs.
Because the bank swaps a credit exposure to the loans for one to the guarantor. Under the substitution approach the protected tranche takes the guarantor's risk weight. With cash collateral held at the bank there is nothing left to weigh. On Northwall's 266m tranche a 50% weighted insurer leaves 133.0m of RWA, 17.96m of capital at 13.50%.
Enough to pay for the capital its risk weight consumes: discount = cost of equity x guarantor risk weight x CET1 target / (1 - tax). At 11.5%, 50%, 13.50% and 25% that is 1.04 points, so against a 10.50% funded margin the insurer must quote 9.46% or less. A 20% weighted guarantor needs only 0.41 points.
Only if the collateral sits with the protection buyer. Cash posted at a third-party bank leaves an exposure to that bank: at a 20% risk weight Northwall would hold 7.18m of capital against the 266m, the same as an unfunded guarantee from a 20% weighted provider.
This article is one calculation from Significant Risk Transfer. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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