Synthetic Risk Transfer Issue Summary

Recent commentary has raised concerns with growth in banks' use of synthetic risk transfers (SRTs), sometimes also referred to as credit risk transfers (CRTs), to transfer default risk on credit assets to third parties.^[1] Here we explain how SRTs work, why banks are incentivized to use them and the factors that mitigate concerns raised about their use.

What are Synthetic Risk Transfers?

Credit risk is the risk of loss due to a borrower's failure to repay a loan or other credit obligation. Capital regulations require banks to assign a credit "risk weight" to each exposure to reflect that exposure's relative risk of loss.^[2] Any unexpected loss on the asset is intended to be absorbed by that capital. Standardized credit risk weights are a very rough attempt to reflect historical loss distributions for a given asset class, and by definition are not tailored to the loss experience for a particular bank given its underwriting and collection practices. This is particularly true of the proposed Basel III Expanded Risk-Based Approach that introduces new standardized risk weights for credit risk.^[3] (This situation stands in contrast with the Internal Ratings Based approach adopted in Basel, which uses each bank's own models, tailored to its particular experience; the U.S. banking agencies, unlike their UK and EU peers, have proposed to abandon that approach in favor of only standardized risk weights.)

Banks use SRTs to allocate regulatory capital more efficiently by transferring credit risk to outside investors. "Synthetic" simply refers to the fact that, rather than selling the loan portfolio outright, the bank keeps the portfolio on its balance sheet-both to maintain client relationships and avoid incurring losses on an outright sale of a loan asset whose value has declined in a rising rate environment-but pays outside investors to bear some of the credit risk on the portfolio.^[4] Such transfers reflect, and are motivated by, how standardized risk weights under the regulatory capital rules differ markedly from actual historical loss rates for a particular asset class.

This situation would not occur if the U.S. were able to keep a truly risk-based approach, rather than relying on standardized approaches under the Collins Amendment. The capital benefit of SRTs would not be worth their cost and effort if risk weights accurately reflected the true risk.

What Sort of SRTs are Banks Using, and What are the Costs?

Two common ways banks transfer risk are through credit-linked notes (CLNs) and credit default swaps (CDS). With CLNs, banks sell securities to investors for cash. These securities have a unique feature: if a pool of loans incurs more losses than expected, the bank pays back less on the bonds. The reduction in repayment acts like an insurance for the bank. CLNs are safer for banks because they are pre-funded by investors who purchase the notes (that is, the cash is received by the bank at the time the notes are purchased, with the repayment obligation dependent on the performance of the underlying assets), so the bank does not face counterparty risk.

Banks can also use CDS, which is like buying insurance on their loans from an investor. When the investor puts up cash as a guarantee for the CDS, it works very similarly to CLNs. CLNs are often sold to many different investors, while CDS are usually agreements with just one investor, which usually makes CLNs cheaper for banks.

What is Driving Recent Increases in SRT Transactions?

These transactions convert the credit exposure of the bank on the underlying loan portfolio into a securitization exposure for regulatory capital purposes. By reducing the bank's exposure to unexpected losses, they lower the amount of regulatory capital the bank is required to hold against the loan portfolio. In essence, the securitization component of the capital regulations can be used to achieve a more accurate reflection of risk than the standardized credit risk component, so banks have an incentive to use them.

The reduction in capital requirements allows capital to be reallocated to other lending activities while maintaining existing client relationships. It may even enable some banks to continue funding business lines that they would otherwise exit to allocate capital more economically.

Mitigating Concerns

Recent commentary has raised concerns with growth in banks' use of SRTs. Some have compared CLNs to the asset-backed securities that were prevalent leading up to the financial crisis of 2007-2009. Others have noted that some investors in SRTs are leveraged-that is, private credit firms have obtained funding from banks to invest in CLNs (through non-repo financing), or banks have provided loans using CLNs as collateral (through repo financing). These critics argue that, as a result, the credit risk is not truly being moved out of the banking system.

First, although they may seem facially similar in some ways, CLNs are not asset-backed securities.^[5] CLNs are simply unsecured bank debt for which the return of principal is dependent on the performance of the collateral. They represent a general obligation of the bank issuer where the investor has agreed to reduced payments from the issuer in the event that the borrowers on the underlying assets default. In addition, many types of CLNs are also typically structured to mitigate maturity mismatch (i.e., banks typically issue CLNs with maturities that extend beyond the underlying loans so that CLN investors bear the appropriate extent of any losses and recoveries). CLNs are structured to allow firms to mitigate risk on an underlying pool of their assets and re-invest capital into efficient investments.

Second, the primary investor base for SRTs appears to be private credit funds, with some large asset managers increasing investment as well. Notably, these types of private credit providers by their nature maintain far lower leverage than banks as both in total amount and as a percentage of their assets. Therefore, these funds are well positioned to absorb potential losses. These funds also have good incentives to continue to limit the use of leverage, as additional leverage could expose the funds and their investors to demands for additional collateral from their lenders. In some cases, if private credit funds obtain additional funding from banks, this would be inherently limited by these incentives, in addition to the fact that investors using bank leverage would be funded with steep haircuts or other provisions protecting the financial institution providing the leverage. A bank providing such leverage would also be required to risk-weight the credit exposure and hold capital against it.

Third, although use is increasing, risk mitigation options open to banks to transfer credit risk to third parties are costly-whether due to the high rates of return required by CLN investors or the high premiums paid to CDS protection providers, in each case for accepting exposure to default risk-and therefore difficult to scale in manner that would be likely to have any broad systemic effects.

Finally, as discussed above, to use the CLN structure that has become more popular since the release of the Federal Reserve's FAQ in 2023,^[6] a bank must request and receive written approval from the Federal Reserve under a reservation of authority, for the bank's specific transaction structures. These approvals are "facts and circumstances"-based, and only the bank receiving written approval may rely on that approval-put differently, for better or worse, a bank cannot structure its transactions to meet the requirements of an approval issued to another bank without requesting and obtaining its own approval from the Federal Reserve. This clunky process currently limits scalability of these transfer transactions, in addition to the factors described above.

Appendix: Different Types of CLNs and the Fed's Recent FAQ

Under the capital rules, a bank can recognize credit risk mitigation benefits from "synthetic securitizations" provided certain requirements are met.^[7] Structures that utilize special purpose vehicles to issue CLNs, where the risk of a reference portfolio of on-balance sheet exposures are transferred to the SPC using a guarantee or credit derivative typically meet these requirements. These structures-use of an SPV that must be consolidated under GAAP plus the use of a credit derivative or guarantee-raise a host of other regulatory hurdles that make them unattractive or impractical for many banks to use to achieve the desired risk transfer.^[8]

However, when banks directly issue CLNs, it has not been clear whether the Federal Reserve would view the transaction as compliant with the definitional requirements in 12 CFR 217.2 to be considered a synthetic securitization and certain other requirements to recognize the credit risk mitigation of the CLNs.^[9] The Federal Reserve addressed this concern in their September 2023 FAQ, noting:

While the way a directly issued credit-linked-note transaction transfers risk is somewhat different from the capital rule's criteria, it is similar to practices commonly used for mitigating credit risk that the Board recognizes in its capital rule. Through a directly issued credit-linked-note transaction, firms can, in principle, transfer a portion of the credit risk on the referenced assets to the credit-linked-note investors at least as effectively as the synthetic securitizations that qualify under the capital rule. Therefore, the Board, on appropriate facts, is willing to exercise a reservation of authority where the primary issues presented by the transaction are limited to the two common issues of directly issued credit-linked notes described [in a prior FAQ]. A Board-regulated institution may request a reservation of authority under the capital rule for directly issued credit-linked notes in order to assign a different risk-weighted-asset amount to the reference exposures.^[10]

The release of this FAQ helped to clarify a path for banks seeking to issue CLNs directly-to avoid the numerous challenges associated with alternative structures-to request review by the Federal Reserve, which under the FAQ will be "based on the facts and circumstances presented." Banks are not permitted to rely on "written action issued to any other firm as the basis for the capital treatment of any transaction," so each bank must request its own finding.

[1] For example, seehttps://www.reuters.com/breakingviews/banks-hot-new-trade-could-burn-others-once-2024-02-29/.

[2] U.S. GSIBs are currently permitted to use the Advanced Approaches to capital risk weighting, which utilizes bank internal models for credit risk weights; under the Basel III Endgame proposal, these banks would no longer be permitted to use internal models.

[3] As explained in our comment letter on the agencies' Basel III capital proposal, the Expanded Risk-Based Approach lacks sufficient risk sensitivity and would result in excessive and incorrectly calibrated capital requirements for credit risk. The proposed risk weights for credit significantly overstate actual risk and would have adverse consequences for both the cost and availability of credit for consumers and businesses. Our joint comment letter with the ABA is available here: BPI and ABA Comment on Basel Endgame Proposal - Bank Policy Institute.

[4] Securitizations involving the transfer of the assets to a special purpose vehicle (SPV) that then sells notes to investors are now uncommon due to the requirement to consolidate the SPV under GAAP, as the capital rules generally follow GAAP.

[5] Unlike asset-backed securities, CLNs are not collateralized by self-liquidating financial assets (investors in CLNs do not receive the cash flows from the underlying pool of loans and payments do not depend directly on cash flows from those assets).

[6] The release of the Fed FAQ explained in further detail in the Appendix helped to clarify a path for banks seeking to issue CLNs directly-to avoid the numerous challenges associated with alternative structures-to request review by the Federal Reserve. See Federal Reserve Board, Frequently Asked Questions About Regulation Q, A3, available at https://www.federalreserve.gov/supervisionreg/legalinterpretations/reg-q-frequently-asked-questions.htm.

[7] Banks may recognize the credit risk mitigation of the collateral on a reference portfolio under the rules for synthetic securitizations provided that the requirements in section 12 CFR 217.41, .141, as applicable, are met and that the transactions satisfy the definition of "synthetic securitization" (12 CFR 217.2, "synthetic securitization").

[8] Use of this structure and either a guarantee or a credit derivative involves a number of regulatory considerations, including compliance with insurance regulations, swap regulations, the Volcker Rule, among other considerations.

[9] A synthetic securitization must include a guarantee or credit derivative and, in the case of a credit derivative, the derivative must be executed under standard industry credit derivative documentation. Directly issued CLNs frequently reference, but are not executed under, standard industry credit derivative documentation. The operational criteria for the simplified supervisory formula approach (SSFA) require use of a recognized credit risk mitigant, such as collateral; the cash purchase consideration for directly issued CLNs is property owned by the note issuer (the bank), not property in which the note issuer has a collateral interest. Federal Reserve Board, Frequently Asked Questions About Regulation Q, A2, available at https://www.federalreserve.gov/supervisionreg/legalinterpretations/reg-q-frequently-asked-questions.htm.

[10] Federal Reserve Board, Frequently Asked Questions About Regulation Q, A3, available at https://www.federalreserve.gov/supervisionreg/legalinterpretations/reg-q-frequently-asked-questions.htm.

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