Banks’ capital steroid use warrants extra scrutiny

LONDON, March 2 (Reuters Breakingviews) - In athletics, performance-enhancing drugs aren’t necessarily banned per se. It’s sometimes a question of how often a substance is used, and in what dose. A similar principle applies to “risk transfer” deals, through which Western banks have flattered their equity ratios by shifting losses on 750 billion euros ($885 billion) of loans. It’s a broadly safe piece of financial engineering. Yet the sector’s rapid growth and changing nature mean it’s time regulators and shareholders pushed for better disclosure.

Appropriately for such a polarising product, no one seems to agree on what to call these transactions. Leading practitioners, like Barclays (BARC.L), opens new tab and Banco Santander (SAN.MC), opens new tab, favour the label “significant risk transfer”, or SRT. The Basel Committee on Banking Supervision, which just released, opens new tab a chunky study, notes that the first letter can also stand for “synthetic”.

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Yet the basic concept is simple enough. A bank takes a portfolio of loans and transfers a portion of the default risk, through derivative contracts, to one or more third parties — typically hedge funds or private-capital managers. Investors as diverse as Blackstone, opens new tab(BX.N), opens new tab, French insurer Axa (AXAF.PA), opens new tab, London-based Cheyne Capital, opens new tab and Chorus Capital, opens new tab, Hong Kong-based PAG, opens new tab, and hedgie D.E. Shaw, opens new tab are involved. The synthetic structure means the loans stay on the balance sheet of the bank, which also retains some exposure and keeps a relationship with the end borrower. SRT investors promise to cover a portion of the losses and in return receive a premium, which in the European market right now is between 8% and 10% in annualised terms.

It all works because of regulatory capital requirements. For some assets, like corporate credit lines, supervisors ask banks to fund exposures with a relatively high level of equity relative to historic loss rates. By shifting the exposure, banks can free up some equity, meaning they can afford to compensate SRT investors through juicy premiums. An SRT could allow a bank to halve the common equity Tier 1 (CET1) capital required for a corporate loan portfolio, according to the Basel report. Brussels policymakers broadly like, opens new tab the idea of freeing up bank capital, which creates room for more defence and green lending.

Some, including the IMF, have expressed, opens new tab concerns. One problem is that the SRT market may not be a reliable source of capital. The investor base looks highly concentrated, raising the risk it might disappear in a crisis, or if a handful of major players suffered big losses. Moody’s Ratings wrote, opens new tab last May that just 10 investors held about 76% of outstanding SRT exposure, based on a survey. The risk is that hedge funds flee or find something better to do with their money, leaving banks high and dry with expiring SRTs that they cannot easily or cheaply refinance. The good news, however, is that banks wouldn’t be left with a sudden capital hole if the SRT market vanished. That’s because the derivative contracts generally match the term of underlying exposures, and the credit protection would only disappear once the relevant loans matured.

The second worry relates to the links between SRTs and the rest of the banking system, since banks also lend to the hedge funds and credit specialists that buy the deals. In theory, a bank could offload risk through an SRT, but subsequently offer leverage to the same investor that bought the SRT. If losses on the portfolio then exceeded the amount of capital that the investor put down, the bank could end up on the hook after all. The danger, however, is mitigated by the fact that only 21% of surveyed banks, in Moody’s sample, made loans to investors with SRTs as collateral. And the risk transfer market is not that big: the covered assets still only account for roughly 1% of total assets.

Still, that number is growing briskly, and could conceivably double. Moody’s, in its ratings methodology, opens new tab, suggests that banks should avoid using SRTs to boost their capital ratios by more than a percentage point. Since the average CET1 boost from risk transfers in Europe is about half that level, it stands to reason that SRTs could be twice their current size on aggregate. Only a few lenders - Austria’s Raiffeisen Bank International (RBIV.VI), opens new tab, BAWAG (BAWG.VI), opens new tab, Barclays and Greece’s Alpha Bank (ACBr.AT), opens new tab - were close to the 1 percentage point mark in 2024, the Basel report shows, though some bankers have questioned those numbers.

Rapid growth makes it valid to worry about what comes next. Barclays, for example, has an SRT programme that is roughly equivalent in size to 46% of its corporate loans. The true percentage may be slightly lower, because the programme also includes off-balance-sheet exposures. But if the bank was unable to issue new SRTs, it would need to find another way to keep its loan book the same size - or else let it shrink, depressing shareholder returns. If the market shut down completely, it follows that the wider sector’s profits could simultaneously take a hit.

And though banks generally avoid lending to their own SRT buyers, the fact that the system as a whole is still exposed raises the risk that losses ultimately come full circle in a crisis. The risks could also be exacerbated by financial innovation. One new but rising trend is the so-called unfunded SRT, which one banker estimated could eventually account for half the overall market. It’s distinct from the classic version because the investor offering credit protection puts zero cash upfront to cover future losses, leaving the bank exposed if the counterparty fails. This kind of structure may be particularly appealing to European insurers, who are even being encouraged to write SRTs by new capital reforms designed to encourage risk transfer.

At the very least, bank shareholders ought to be able to judge the risks themselves. Very few lenders disclose the all-in CET1 boost from their risk-transfer programmes, let alone the number of counterparties involved. Information on SRT funding relationships seems vital too, to judge the risk of circular financing. The best way to keep banks’ steroid use safe is to get it out in the open.

($1 = 0.8473 euros)

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Editing by Neil Unmack; Production by Streisand Neto

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Liam Proud

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Liam Proud is a Breakingviews Associate Editor, based in London. He focuses on banking, finance, private equity and deals. He joined Breakingviews in 2016 and previously covered technology, media, telecoms and the car industry.

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