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 (SRTs) are emerging as an additional mainstream approach that banks and investment firms may have the potential to leverage to their mutual benefit.
With a greater influx of private credit investors and managers, so too comes a shift in the market, its traditional players, and its challengers. As an example, traditional banks may now face new competition in corporate lending, and although there are new entrants to the space, their acquisition of banks’ portfolios of mortgages and consumers loans is showcasing other potential dominance in the field.
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.
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:
Investment managers seek out SRTs for several reasons, including:
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.
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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.
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:
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
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.
Rochelle Glazman
Rochelle is responsible for enabling go-to-market and growth strategies across sales, marketing, product, and client engagement. Before taking on this role, Rochelle was a Senior Pre-Sales Consultant, engaging with clients and prospects across the financial services industry. Prior to joining Arcesium, Rochelle spent over five years at BlackRock Aladdin servicing institutional asset managers and leading several implementation projects across North and South America. She graduated from Vanderbilt University with a degree in economics.
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