By Yikai Wang
A synthetic risk transfer, sometimes also referred to as credit risk transfer or significant risk transfer in Europe, is a type of financial transaction in which banks maintain ownership of a credit exposure while transferring a portion of the credit risk to third parties in the form of a credit protection agreement.
The SRT market has been growing since 2010. According to Pemberton Asset Management, the number of SRT deals rose from 13 in 2010 to 115 in 2023. Global issuance of SRTs is expected to reach $30 billion by the end of 2024, according to Chorus Capital, a London-based alternative asset manager. Compared to Europe, U.S. banks’ adoption of SRTs is still nascent. U.S. banks currently only account for about 25 percent of global issuance volume.
The growth of SRT issuance is motivated by the capital rules under the Dodd-Frank Act, as SRTs help banks to optimize their capital by reducing risk-weighted assets. In a SRT transaction, the protection buyer (bank/note issuer) typically receives the initial issuance proceeds and has the financial obligation to make principal and interest payments on the notes, net of any protection payments they are owed under the credit protection agreement. Proceeds from the SRTs are deposited in a segregated collateral account and may be held in cash or invested in highly rated securities. This collateral acts as a financial buffer, ensuring the investor’s funds are protected even if the note issuer defaults.
Figure 1: Synthetic risk transfer example with assumption of tier 1 capital requirement of 10.5 percent.
SRTs are also designed to mitigate counterparty credit risk. For example, the major SRT structure, credit linked notes, requires dollar-for-dollar participation on both sides of the trade, which avoids the potential for amplification of risk through speculative trading.
The detailed SRT structure is illustrated in Figure 1 for a stylized bank. In the example, the SRT leads to a drop in Tier 1 capital from $10.5 million to $3.8 million. In exchange, the bank pays a premium for transferring credit risk out of its balance sheet. Through such a transaction, a significant portion of risk (from the mezzanine tranche in this example) can potentially be transferred outside of the regulated banking system. Private credit funds, pension funds, hedge funds and insurers are the typical SRT investors.
It is understandable that regulators are worried when a new and complex financial product emerges. Especially when it is sometimes opaque. However, it needs to be kept in mind this financial innovation also reflects regulatory intent and banks today take risks in a more selective manner. Therefore, it is still too early to worry about systemic risk from SRTs.
Also, the Federal Reserve has closely monitored the development of this new financial product, especially investors’ use of leverage, and examines each SRT transaction individually for approval. Going forward, the U.S. SRT market will likely continue expanding as banks seek capital relief. However, enhanced oversight and potential adjustments to capital requirements could impact the attractiveness and structure of SRT transactions.
Yikai Wang is VP for banking and economic research at American Bankers Association.
