As the great philosopher Post Malone states:
Run away, but we’re running in circles
Run away, run away
—Circles (2019)
It seems like a magic trick. A bank issues loans to consumers and businesses, and each of these loans has an expected credit loss. The bank is obligated to set funds aside to cover that expected credit loss, funds that can no longer be used to grow the bank.
What the bank can do is pay investors, such as insurance companies, hedge funds, or private credit funds, to take on some of the credit risk of the loan portfolio against a fixed payment from the bank. That is called a synthetic risk transfer (SRT) because even if the loans are still on the balance sheet of the bank, the bank now has protection against the credit loss and doesn’t have to put aside as much capital.
Free and frolicking, the bank can do even better by lending the investors funds to acquire more credit risk. After all, lending money is the business of the bank, and now it doesn’t have to worry about the credit risk.
By now, your brows should start to furrow.
On the surface, it seems true that no matter how those original loans perform, the credit risk has moved on and cannot hurt the bank anymore. However, the European Banking Authority (EBA), the International Monetary Fund (IMF), the Bank of England (BoE), and the Federal Reserve all say: “Not so fast!”
Regardless of who holds the bag, the credit risk of the loan portfolio remains unchanged, and now there is less capital to cover it and more interconnectedness in the financial system. On closer inspection, it looks more like a circle of risk than a magic trick.
It is a bit like moving your smoke alarm to the neighbor’s, thinking that then your house cannot catch fire. And the neighbor can host as many smoke alarms as he wants. Also, neither you nor your neighbor have to tell anybody about your arrangement before it is too late.
It is easy to see why SRTs are a big and growing business. Back in May, the FT reported that while direct commercial and industrial lending by US banks has stagnated in recent years, indirect lending through investors (also known as non-bank financial institutions (NBFIs)) has skyrocketed.
And according to a June report from EBA, about half of all European banks have availed themselves of SRT, and of those, three-quarters say they will continue to do so. In Europe, the vast majority of the SRTs are also on wholesale loan portfolios.
It is worth noting that commercial real estate loans, especially, have seen a sharp increase in credit losses in recent years.
Regitze Ladekarl, FRM, is FRG’s Director of Company Intelligence. She has 25-plus years of experience where finance meets technology.
This article is part of the FRG Risk Report, published weekly on the FRG blog. To read other entries of the Risk Report, visit frgrisk.com/category/risk-report/.