By John Hintze
U.S. regional banks facing increased investor and regulatory scrutiny regarding how they manage their balance sheets and capital are eyeing synthetic risk transfers. SRTs have been popular in Europe and enable banks to transfer credit risk to investors while retaining the loans on their books.
Moody’s Investors Service and Standard & Poor’s issued reports in February projecting increased SRT issuance by banks, and other market participants indicate such activity is in the works. Bank of New York Mellon, as a provider of paying-agent and account-bank services on such transactions, has received inquiries regarding potential SRTs from even regional banks, says Tom Ahern, global head of relationship management for BNY Mellon.
“Default and delinquency rates are coming into focus, if from a small base,” Ahern says. “So banks are looking at SRTs as a way to effectively spread the risk and not have to take the loss on the deteriorating value of those assets by selling them to an SPV (special purpose vehicle, used in securitizations) or in the secondary market.”
Regulators and investors have increasingly scrutinized regional banks since the collapses last year of Silicon Valley Bank and other regionals, prompting them to reduce credit risk on their balance sheets, Ahern adds. He notes that more SRTs transferring the credit risk of commercial real estate assets, consumer loans and even syndicated loans could arrive as soon as the third quarter.
Matthew Bisanz, a partner in Mayer Brown’s financial services regulatory practice, says that a few unrated SRTs were completed by banks in 2023 that referenced healthcare commercial real estate assets and warehouse facilities. He points out that uncertainty about the final shape of looming Basel “endgame” rules in the U.S. may have caused banks that will be impacted by the rules—those with $100 billion or more in assets—to pause or slow issuing SRTs. But that does not affect smaller banks.
“We expect to see smaller banks issuing SRTs over the course of the year,” Bisanz says. “There are plenty of smaller banks that would benefit but don’t have relationships with the big investment banks, so it would be in investors’ interests to diversify their bank contacts.”
In theory, any asset class could be included in a reference portfolio, says Matthew Mitchell, managing director, S&P Global Structured Finance Ratings, and in making that choice banks consider the capital relief achieved and the +cost of that capital compared to the cost of the credit protection.
“Asset classes where the cost of the credit protection is relatively low, but the risk-weighs are high will be the most attractive for banks,” Mitchell says.
In Europe, where stricter bank capital rules started earlier, banks have regularly used SRTs—referred to across the pond as significant risk transfers—to bolster capital ratios. SRTs enable a bank to transfer loan credit risk to investors via a credit agreement that references the assets, which remain on the bank’s balance sheet, but inoculates the bank from the credit risk and provides favorable capital treatment.
Late last year, several large banks in the U.S.—Huntington National Bank, Morgan Stanley, Santander Bank and US Bank—sought and received approval from the Federal Reserve to issue credit-linked notes directly that referenced their auto loans. Truist Bank received a similar approval letter in mid-March, and in early May so did Ally Bank, the smallest bank so far, with $186 billion in assets, to receive approval.
The approvals were necessary because the banks held the proceeds from the CLN sale, the risk mitigant enabling favorable capital treatment. That approach differs from the approach used by previous CLNs involving SPVs, in which the cash collateral is owned by the SPV and the bank has only a security interest in the cash. The Fed’s approval letter for Truist describes the bank using a credit derivative to transfer a portion of the credit risk of the underlying auto loans to investors and retaining the proceeds of the CLN sale, which it will return to investors at maturity minus any credit losses stemming from the referenced loan pool.
The banks have yet to issue CLNs directly. However, Huntington pursued a more traditional SRT in December when it transferred the cashflow and credit risk of auto loans to Bayview Asset Management via a credit default swap. Later in April, Bayview issued a $346 million CLN that referenced $2.8 billion in Huntington auto loans.
U.S. banks have issued SRTs in the past, if not as regularly as in Europe. Over the last year, as the Basel endgame proposal unfolded, J.P. Morgan has engaged in several SRTs on a bilateral basis with individual investors, according to Bloomberg, and it’s considering upwards of $2 billion in SRTs later this year, at least in part referencing corporate debt. The bank also issued CLNs through SPVs in 2021 that referenced its residential mortgage and auto loans. In 2022, Santander and U.S. Bank issued CLNs referencing auto loans.
“Banks may execute SRTs for a variety of purposes, with a key motivation being capital relief,” said Mitchell at S & P. “But they may also use them as a strategic risk management tool to actively manage loan portfolios, address sectoral and single-name [loan] concentrations, and create capacity for further lending.”
SRTs can also help banks deploy their capital more efficiently as rates remain persistently high.
“High rates are not going way, so one way to increase capacity [to originate higher-return loans] without having to sell current loans and recognize market-to-market losses is though transactions like SRTs,” Bisanz said.
Huntington, for example, transferred the credit risks of auto loans with an average percentage rate of 5.5 percent, compared to the more than 6.5 percent interest rate auto loans now pay.
“It’s a combination of de-risking and efficient use of capital that motivates banks to issue SRTs,” Ahern said. “And that motivation vary from bank to bank.”
While SRTs appear to be an effective tool to manage balance sheets, they do present some risks to banks. Bisanz says regulators may change their views on the effectiveness of the transactions from a risk-capital standpoint, although that’s unlikely given the transactions are already account for in existing capital rules. A bigger risk is the bank pricing the credit risk too low, so the protection it is buying from investors does not cover all the losses that accrue.
“If a bank estimates the loss rate on a credit card portfolio at 6 percent and it ends up being 12 percent, it will take losses above the level of protection and will not be sufficiently compensated,” Bisanz says.
Moody’s says in its report that many U.S. banks have limited ability to grow capital organically given modest loan growth and declining net interest margins that are unlikely to improve this year, making SRTs more attractive for banks. However, the rating agency adds, CLNs only transfer the credit risks of the referenced assets but not a bank’s other credit risks, interest-rate risk, or legal or operational risk, whereas as equity protects against all types of losses and is permanent.
The ratings agency also notes that the cost of CLN obligations to the bank is much higher than the cost of issuing bank debt, which has lower credit risk.
CLNs also create additional bank-level risks and can complicate a bank’s overall risk management, according to Moody’s, adding that while modest use of CLNs can be useful as a risk-management tool, heavy use can signal bank credit weakness.
John Hintze frequently writes for the ABA Banking Journal.
