By Finn Watson
In recent years, the market for synthetic risk transfers (SRTs) – a type of transaction that enables banks to shift credit risk from their balance sheets to outside investors without the transfer of ownership – has experienced significant growth, prompting equal parts industry excitement and regulatory concern.
Since the Global Financial Crisis (GFC) and the subsequent regulatory frameworks such as Basel III/IV and IFRS9, banks have seen an increase in the amount of regulatory capital that must be held as a proportion of lending. This has driven banks to explore new methods for freeing up capital to return to shareholders or redeployment in other growth areas, with synthetic risk transfers emerging as a popular solution.
Between 2016 and 2023, the underlying asset pool size of SRTs has increased from € 55 bn to €207 bn, with much of this growth driven by US bank adoption of the historically European practice.
SRTs are typically structured as follows: the bank identifies a portfolio of assets, primarily corporate, SME, and mortgage loans, and issues a corresponding note that protects against the first 5% – 15% of potential losses. In return for providing this protection, the investor – usually a credit or pension fund – receives a floating-rate coupon, typically set as a fixed margin over the overnight interest rate. Offering coupons often exceeding 10%, SRTs have garnered significant attention from credit funds, pension funds, insurance companies, and asset managers who are drawn to their high yields.
Importantly, the synthetic securitisation of the riskier portions of the loan book allows banks to reduce the portfolio’s risk weight and the corresponding regulatory capital requirement which should enhance the bank’s return on equity and boost its valuation. This is a key reason why SRTs have become well-established and popular in Europe, where banks are often undervalued relative to their tangible book value. Additionally, lessons from the 2023 Silicon Valley Bank debacle have heightened the appeal of SRTs as a method for managing regulatory capital without crystallising mark-to-market losses on assets.
While derivative products offering credit protection, such as Credit Default Swaps (CDSs), which are financial contracts that provide insurance against the default of a borrower or pool of loans, have been available for decades, SRTs offer greater customization and are better suited for achieving regulatory capital relief. In contrast, CDSs are primarily used for trading and hedging purposes.
Compared to the pre-GFC generation of securitisation, SRTs represent a significant improvement in financial sustainability and risk management. The “originate to distribute” (OTD) securitization model, prevalent before the 2008 crisis, was heavily criticised for enabling moral hazard and contributing to the buildup of systemic risk, as banks often offloaded risky assets without retaining any exposure, leading to opaque risk dispersion across the financial system. In contrast, SRTs keep the underlying assets on the bank’s balance sheets, prompting better alignment between counterparties and reducing the potential for unchecked risk transfer. Moreover, regulators now scrutinise these deals more closely, often requiring them to provide cash collateral to cover potential losses. This ensures a more secure system, although the fundamental goal of reducing regulatory capital requirements remains.
Despite these benefits, SRTs have faced criticism regarding their opacity, the growing role of “asset manager lenders,” and concerns about whether SRTs genuinely transfer risk from banks to the non-bank sector.
Although synthetic securitisation offers potential benefits in risk transfer, it can obscure transparency, creating a false sense of security among investors and regulators regarding the actual safety of banks and asset managers.
Much of the criticism has centred on how SRTs and similar practices are contributing to the rise of the “asset manager lender.” By transferring much of the risk and return associated with credit origination to entities not subject to the same capital requirements, it raises the question of why banks are involved in credit creation at all. In this scenario, the asset manager seems to function as the de facto lender. This shift could have implications for financial stability, as the concentration of risk in entities with less regulatory oversight may increase systemic vulnerabilities. Furthermore, it raises concerns about whether current regulatory frameworks are equipped to manage the growing influence of asset managers in the lending space.
Additionally, due to the interconnected nature of the financial system, the use of SRTs may not effectively transfer credit risk from banks to the non-bank sector. The banking sector may end up reabsorbing the credit risk because banks often finance the credit funds involved. This concern is echoed by Rhode Island Senator Jack Reed, who stated, “The use of bank-provided leverage raises serious questions about whether SRTs truly transfer credit risk to outside investors or further concentrate risk among a small number of Wall Street banks.” If the riskier loans in the SRT portfolio default, the banks that provided funding to private credit firms may not be repaid, or might only be repaid in the form of highly illiquid and bespoke assets that these firms specialise in. In such a scenario, the banking sector could realise the risks they believed they had mitigated, potentially causing significant repercussions for the broader financial system and real economy.
This shift in the financial system reflects a broader post-GFC change where regulators are encouraging the transfer of risk to the non-banking sector rather than reducing it. While it is arguably preferable for investors to assume more risk than systemically important banks, regulators must exercise caution in facilitating the accumulation of risk through instruments like SRTs. They should not assume that merely because the risk has been shifted to private credit firms and other non-bank entities, potential failures would be without significant consequences for the performance of the real economy. Further effort should be made to understand how private capital losses would filter down to the economy and regulate accordingly.
While the ingenuity of financial engineers in making risk tradable and transferable is deeply interesting, and the potential of SRTs to reduce systemic banking sector risks through risk transference is commendable, further research and regulatory scrutiny are necessary to ensure these transactions are both robust and effective.
The views expressed in this article are the author’s own, and may not reflect the opinions of The St Andrews Economist.
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