In recent years, Global RADAR has chronicled the global trend of “de-risking” with respect to the banking sector. This practice has historically centered on FI’s – generally based in well-developed countries – restricting and/or terminating the accounts of clients deemed as high-risk or vulnerable to money laundering and terrorist financing activity, rather than choosing to manage their respective financial crimes risks. With today’s tense geopolitical climate and growing regulatory compliance burdens placed on domestic and international financial institutions (FI’s), the practice has grown substantially both domestically and at the international level. While a positive for banks in the sense that they can avoid potentially crippling financial penalties and sanctions by simply severing ties with entire categories of customer, de-risking undermines many international AML policy objectives by driving financial activity out of the regulated financial system and into other clandestine channels, while also preventing low- and middle-income segments of the population from accessing the financial system legitimately, further hampering the global economy.² With the U.S. Department of the Treasury officially moving to combat de-risking activity earlier this year and encouraging their international counterparts to adopt similar strategies, banks have now been forced to get even more creative in their efforts to avoid repercussion.

While rising interest rates and more restrictive regulations have financial institutions searching far and wide for alternatives to mitigate risk, an old trend has re-emerged across the United States over recent months that has seen major U.S. financial institutions such as JPMorgan Chase, Morgan Stanley, U.S. Bank and others selling complex debt instruments to hedge funds and private equity firms as a way to reduce regulatory capital charges on the loans they make. Coined “Synthetic Risk Transfers” (SRT), this innovative strategy for effectively transferring credit risk – a process that for many firms has held back their respective growth – may become the new norm across the United States. In line with the banking crisis seen just a few months ago, regulators have continued to raise capital requirements for firms small and large, with higher interest rates also impinging on the value of the investment portfolios maintained by many firms. As such, the main play with these practices is to allow a bank to reduce its exposure to potential losses and subsequently allow for the capital charges being levied by their regulator to be lowered.

There are two types of methods to transfer risk via securitization transactions. In the traditional method, the bank utilizes cash transactions to sell assets. The bank benefits by releasing capital via capital reduction, while also increasing its liquidity. Traditional transactions can also be used to remove under-performing loans from banks’ balance sheets. “Synthetic” transactions are the alternative method. With a synthetic securitization transaction, the bank keeps the underlying loans on their balance sheet, while the credit risk is transferred through derivatives or guarantees. The banks will essentially pay interest instead of their premiums, and by lowering their exposure to possible losses, the transfers reduce the amount of capital that banks are required to hold against their loans. Under most circumstances, investors (i.e. the aforementioned hedge funds and private equity firms) will pay cash for credit-linked notes or derivatives issued by the banks, amounting to ~1/10^th of the loan portfolio that the bank is attempting to de-risk.³ Investors can cash in via the collection of high-volume interest on a loan, but do so in exchange for taking on responsibility for potential losses if the loan ultimately defaults. While the moves can be expensive for banks, they are generally viewed as a no-brainer when compared to paying full capital charges on their underlying assets.

Synthetic risk transfers have been popular across the European Union for the better part of the last two decades, due in large part to more favorable legislation in place across the pond. In the United States however, restrictive regulations against the use of synthetic securitizations transactions all but eliminated them as an option for banks for years. That changed recently when the U.S. Federal Reserve clarified their capital rules, allowing for more of the risk loan portfolios to be transferred to investors. In late September, the Fed clarified rules around capital treatment of a type of structured debt which involves the sale of credit-linked notes that carry the risk of losses on U.S. bank loan portfolios to investors. While the reigns have been maintained by the Fed, they have been loosened slightly, as the regulator is now reviewing requests to approve this type of risk transfer on a case-by-case basis.³ Since this point however, the floodgates have effectively opened as a growing number of financial firms have begun to capitalize on these transactions, issuing record numbers as a means of easing their daunting regulatory requirements.

“There has certainly been growing interest in these transactions as banks seek regulatory capital relief,” said Missy Dolski, global head of capital markets at alternative investment firm Varde Partners, an active investor in such products. “This guidance makes it more clear what structures would need affirmative approval for capital relief and what is required to comply,” she added.¹

All told, these developments have culminated in a booming business strategy for private-credit fund managers, with some like Blackstone’s hedge-fund unit and D.E. Shaw recently doubling-down on risk-transfer trades. It now appears that private-credit investment managers are beginning to rival the banks themselves, with many going as far as to take on traditional banking services like corporate lending. Many of these firms are also buying up banks’ portfolios of mortgages and consumer loans.

Financial institutions should pay close attention to regulations on this subject in the months to come, as more capital rules are anticipated ahead of the new year. U.S. bank regulators announced a proposal this summer to further implement Basel III requirements that could increase capital charges by about 20% and penalize businesses that bring in big fees, including banks’ wealth-management and trading arms. The “Basel III endgame”, as it is known, refers to a sweeping proposal of stricter bank capital requirements in an effort ensure the stability of the banks and prevent another financial crisis. The proposed compliance date is July 1, 2025, meaning that financial service providers have less than two years to interpret the new rule, address new data and technology needs, and adjust their business models in accordance with these guidelines.

Citations

1. Ramakrishnan, Shankar. “Fed Shines Light on Path to US Bank Capital Relief Trades.” Reuters, Thomson Reuters, 2 Oct. 2023. 
2. Treasury Department Announces 2023 De-Risking Strategy, The United States Treasury Department, 25 Apr. 2023. 
3. Wirz, Matt. “Big Banks Cook up New Way to Unload Risk.” Mint, 7 Nov. 2023.