Following a meeting in March, the Basel Committee on Banking Supervision cited its ongoing work in such areas as “lessons learned” from the 2023 banking turmoil, technology risk and resilience, and “banks’ interconnections with non-bank financial intermediation (NBFI).”
As part of the latter assessment, the committee said it intended “to conduct over the coming year a deep-dive investigation on synthetic risk transfers (SRTs),” which banks use to transfer their credit risk while keeping loans on their books and maintaining the borrower relationships.
SRTs – historically known in Europe as significant risk transfers – have grown in the U.S. in the form of credit-linked notes (CLNs) or credit default swaps (CDS). Two-thirds of the $1.1 trillion in synthetically securitized assets since 2016 were in Europe, transferring primarily corporate loan risk, while U.S. banks have focused on auto and other retail loans, according to the October 2024 Global Financial Stability Report of the International Monetary Fund, another global body that is weighing in.
Banks’ use of the instruments appears to be waning, although some multinational banks have recently completed deals to reduce regulatory capital requirements – one of the main reasons to pursue the transactions.
Source: IMF Global Financial Stability Report (Chapter 1, Figure 1.1.1)
U.S. banks were active in SRT issuance last year. That was partly because high rates prompted them to transfer the risk of relatively low-return consumer loans and free up regulatory capital to invest in higher-return loans. The largest banks also used SRTs to bolster their capital levels because of possible Basel III Endgame requirements. Some multinational banks completed SRTs early this year on certain capital-intensive loans.
“SRTs can be used to transfer banks’ credit risk to NBFI entities, helping banks manage risk and/or reduce regulatory requirements,” the Basel Committee said in its notice. “While SRTs are not a new financial product, their use has grown and transactions structures have evolved in recent years. The investigation will seek to better assess the benefits and risks posed by SRTs.”
The European Central Bank developed, for testing in the first half of this year, “a fast-track process for the supervisory assessment of SRT.” The bank said in February that it hoped to “substantially reduce” from three months the time needed to assess “sufficiently simple securitizations meeting certain requirements. Supervisors will save time leveraging on product standardization and harmonized templates.”
The ECB added that it would maintain close scrutiny of “complex and innovative securitizations . . . Efficiency will not come at the cost of resilience: fast-tracked transactions will be assessed against all applicable provisions of the existing regulatory framework. In this vein, the fast-track SRT process is a good example of how processes can be simplified within the existing regulatory framework.”
The central bank stressed the importance of banks’ “adequately manag[ing] the risks related to their overall securitization activities” and their need “to identify and mitigate risks linked to interconnectedness with securitization investors” – thus getting at NBFI concerns and “substantial hidden risks being retained in the banking system, with lower capital coverage overall.”
In a similar vein, the IMF said that heightened interconnectedness could “create negative feedback loops” during periods of market stress. It pointed to anecdotal evidence that banks are providing leverage for credit funds to buy credit-linked notes issued by other banks.
“From a financial system perspective, such structures retain substantial risk within the banking system but with lower capital coverage,” the IMF said, adding that the magnitude of interconnectedness is difficult to assess due to SRTs’ opaque nature.
The multilateral agency said SRTs could result in bank capital buffers being reduced while overall risk is unchanged.
Marcos Chazan of Alvarez & Marsal
“The IMF’s concern is that SRTs should really transfer risk outside the banking system,” commented Alvarez & Marsal senior director Marcos Chazan.
Bloomberg reported last November that Goldman Sachs, Morgan Stanley and Bank of America were asking investors to disclose their use of additional bank debt to invest in SRTs, and BofA – consistent with other large U.S. lenders – is not allowing investors in its SRTs to take on debt provided by other U.S. banks.
Regarding the quality of assets whose risk is being transferred, the Alternative Credit Council (ACC) stated in response to the IMF that such transfers should be encouraged because they improve a bank’s risk profile and allocate the risk to parties better able to handle it.
“Furthermore, a fundamental feature of SRT transactions is that they are typically fully collateralized with cash or cash-like instruments,” the ACC asserted.
In fall 2023, the Federal Reserve began approving favorable capital treatment for banks executing SRTs via CLNs, at first for the largest banks, with several regional institutions following in the first half of 2024. The rise in SRT offerings appears to have invited the now-global regulatory scrutiny.
Matthew Bisanz of Mayer Brown
Arguing in favor of SRTs, the Bank Policy Institute last September said that private credit funds and asset managers investing in the transactions generally maintain lower leverage than banks and can absorb potential losses. In addition, the high cost of SRTs makes it unlikely they’ll scale sufficiently to pose systemic risk, and banks must receive written approval from the Fed to pursue the deals.
Matthew Bisanz, a partner at Mayer Brown, said several large banks with stellar credit quality and robust capital management and optimization programs have approached the market recently with CLNs completed bilaterally with institutional investors.
“They’re getting favorable terms because of the notes’ high credit quality in a time of uncertainty,” Bisanz said.
In the last half year, Chazan noted, banks including Goldman, Wells Fargo and JPMorgan have transferred loan risk to asset-manager clients to fund their investments between capital calls, when the managers seek equity from limited partners. “That’s a new SRT asset class that’s been quite active recently,” he said.