A Growing Appetite for Synthetic Risk Transfers

As U.S. banks continue to grapple with high interest rates that are hovering at a 23-year high and related balance-sheet management issues, they seek new ways to transfer their credit risk while keeping loans on their books – and while also maintaining their borrower relationships.

At the same time, as credit markets change and evolve, the relationship between bank and nonbank lending institutions continues to change too. The disintermediation of banks and simultaneous growth of private credit managers that lend to noninvestment grade, small- and medium-sized firms is well known, and partnerships between large financial institutions and asset managers on direct lending initiatives has grown as well.

Synthetic risk transfers have emerged as a growth opportunity

Synthetic risk transfers (SRTs) have emerged as an additional mainstream approach that banks and investment firms can leverage to operate in a mutually beneficial way.

The rise of private credit investors and managers signifies a transformation in the financial landscape, with these firms are increasingly challenging traditional banks in areas like corporate lending. While they may not have the same name recognition as large banks, their growing influence is evident as they acquire banks’ portfolios of mortgages and consumer loans.

Synthetic risk transfers allow banks to retain more operational normality in the face of increasingly stringent regulatory controls, and investment managers can benefit from a product that offers attractive and risk-adjusted returns that are backed by high-quality collateral.

Benefits are significant for banks and investors

Synthetic risk transfers help banks manage the challenges of tough banking rules and the effects of higher interest rates. An SRT essentially transfers a portion of the risk to another party in exchange for a fee:

• •Risk offloading. Synthetic risk transfers allow banks to offload some of the risks associated with their loan portfolios to investors, thus reducing the amount of capital they need to keep in reserve.
• •Investor returns. Investors in synthetic risk transfers can earn high returns – often around 15% – for accepting the potential risk of loan defaults.
• •Regulatory response. Financial tools like SRTs can help banks navigate tighter regulatory requirements by legally minimizing the capital charges they face under rules like those of Basel III, set to take full effect in 2025.

Investment managers seek out SRTs for several reasons, including:

• •They produce a steady income of cash flows from payoffs of the underlying loans
• •They appeal to pension funds and other institutions with regular distribution requirements, mostly maturing between 3 and 7 years after issuance
• •They offer larger investors the possibility of negotiating the characteristics of the underlying assets, thus allowing them to design the SRT to suit the risk profile of their funds

Understanding what an SRT accomplishes

Synthetic risk transfer is one type of financial strategy or arrangement that allows banks to transfer or mitigate specific risks without directly engaging in traditional insurance transactions. The strategy operates similarly to an insurance policy, where banks pay interest instead of premiums, effectively lowering potential loss exposure and reducing the required capital against loans. The adoption of SRTs is not new, dating back about two decades, but their usage in the U.S. diminished after the 2008-09 financial crisis.

In an SRT, a bank typically issues a note linked to a pool of loans that also includes a credit derivative. Investors are attracted to the yields (which can exceed 10%), and the issuer gains protection against losses in the pool of loans. The SRT effectively transfers the bank’s credit risk, allowing it to cut the amount of regulatory capital it must hold against the assets.

• •While European banks have been the biggest users of SRTs in previous years, the largest increase in SRT volumes will likely come from Wall Street banks ahead of Basel III Endgame rules. The scale of SRT usage will depend on how stringent U.S. supervisors decide the requirements should be.
• • U.S. regulations have been more conservative. Around 2020, the Federal Reserve declined requests for capital relief from U.S. banks that wanted to use a type of SRT commonly used in Europe.
• • More recently, the Federal Reserve has said that it will allow banks to engage in SRTs where certain criteria are met, and with limits, and on a case-by-case basis. When the rules of the Basel Endgame are finally known, they may penalize holding securitized credit. But bank watchdogs have remained silent on the matter to date, leaving oversight to state-level authorities.

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SRTs can free up a bank’s balance sheet for more profitable investments

In a synthetic risk transfer, a bank earmarks a pool of loans on its balance sheet and buys credit default protection on the first 5% to 15% of the losses of that pool, often by selling a credit-linked note with an embedded derivative; so if losses materialize, the holders of the SRTs absorb the hit. This gives banks a hedge on potential credit losses on that group of loans, reducing the amount of regulatory capital they need to set aside, and freeing up their balance sheets for more profitable investments. If some of the loans fail, the investors who bought the notes will cover the losses up to a certain percentage. For taking on the risk, investors are promised a nice return, sometimes around 15%.

Banks use synthetic risk transfers to pass on the risk of loan losses through a derivative or credit-linked note, often to private creditors and hedge funds who are enticed by the high yields on offer.

SRTs offer relief from regulatory changes and generating returns

By creating SRT transactions, banks can hold less money in reserve to cover potential loan losses, which is something regulators require. The strategy has become particularly important because the Federal Reserve, which oversees banks, has been stricter regarding how much money banks need to keep on hand.

The overarching goal is to allow banks to protect themselves from some of the risks associated with the loans they enter. Essentially, by using SRTs, banks are pooling loans and selling off a portion to decrease the risks on their balance sheets. If the loans end up defaulting or taking losses, the buyer of the SRT absorbs the loss rather than the bank.

The return for investors in SRTs is determined by the risk they’re taking on. The higher the risk of loan defaults in the bank’s portfolio, the higher the potential return demanded by investors. This compensates investors for the possibility of losing their investment.

The specific return rate is set through negotiations between the bank and the investors, reflecting:

• •The risk profile of the loan portfolio
• •Prevailing market interests
• •Investor appetite for such instruments

Be aware of potential risk associated with Basel backlash

Federal Reserve Chair Powell announced in March of this year that the U.S. plans to change its proposed Basel III Endgame rules, potentially remaking them. It’s impossible to know now if, when the dust settles, banks may have less incentive to use SRTs to manage their capital requirements. The viewpoints are a bit contradictory, but according to the IACPM, the International Association of Credit Portfolio Managers, “SRTs allow banks to safely mitigate risk and reduce their capital requirements, while investors participate in credit risk sharing.”¹

While SRTs remain under scrutiny as they may encourage banks to engage in greater risk-taking, the SRT market is taking encouragement from guidance released by the Federal Reserve in September 2023 on what types of transactions can be eligible for capital relief. Specifically, the regulator said passing on the risk of loans to a special purpose vehicle, which would then sell credit-linked notes to investors, can count as synthetic securitization. Banks can also issue credit-linked notes directly but will have to ask for the Fed’s “reservation of authority” first.²

A compelling opportunity requires a sophisticated technology infrastructure

Synthetic risk transfers may be a compelling opportunity for private credit investors and managers, with the potential to generate attractive, risk-adjusted returns that can offer income, diversification, and exposure to assets banks generally hold more tightly. Yet, firms may find it difficult to put this opportunity into action without a data and operational foundation to support this growing asset class.

With SRTs and the broader private credit market, firms can face enormous complexity as each investment strategy can bring its own ecosystem and data management requirements. However, a modern technology platform can be the key tool in a firm’s arsenal to operationalize on this evolving asset class. Those armed with a unified thread of data and intelligent investment lifecycle management technology will have the ability to bring together disparate data and streamline complex workflows presented by private credit.  

Sources:

1. Building a Robust Chain of Synthetic Risk Transfers in the U.S., International Association of Credit Portfolio Managers

2. Frequently Asked Questions About Regulation Q, Board of Governors of the Federal Reserve System, September 28, 2023.