Rise in synthetic risk transfers could pose issues
Banks across Europe and the US are unloading risk as they look for ways to deal with higher interest rates and new regulations.
The synthetic risk transfer (SRT) market has gained traction is recent years, with banks seeking to free up capital in an attempt to comply with Basel III and Basel IV regulations.
And although many expect the market to continue to grow, there are risks involved due to the complexity of the instruments.
Manisha Baid, associate director of lending services at Acuity Knowledge Services, said SRTs offer banks a way to manage risk and improve capital efficiency, and therefore he expects the market to continue to expand in the near future.
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According to the IACPM Synthetic Securitization Market Volume Survey data, the underlying pool of loans in SRTs was nearing €200bn (£169.1bn) by the end of 2022.
“With the current uncertainty, banks are cautious about holding loans and SRTs function as a hedge transferring some of the risk to investors who are comfortable with it,” said Baid. “Regulators reduce the quantum of equity banks must hold against the loan portfolio when banks offload credit risk from the riskiest part of the loan portfolio.”
BlackRock recently highlighted SRTs as a growing opportunity for investors within private debt as they will also be boosted by fresh issuances from US banks, with recent regulatory guidance set to make it more attractive.
For institutional investors, SRTs can offer attractive returns, often exceeding 10-15 per cent compared to traditional investments, Baid added.
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But with any new investment comes concerns.
“SRTs are complex instruments and valuing the underlying pool is a complex process,” said Baid. “There is a risk of mispricing from underestimation of the credit risk of the underlying pool of loan, which could result in investors being inadequately compensated. Also, the illiquid nature of SRTs makes it difficult to exit the investment before maturity.”
She also said if banks become less diligent as they offload risk, there could be a build-up of riskier loans in the system and higher defaults in case of an economic downturn.
“There is also a debate about whether this is really a transfer of risk,” she added. “A sizable portion of investment comes from private credit investors, who in turn have credit financing lines from the banks, essentially bringing the risk back to the banks. Though there are concentration limits, it may still contribute to the overall systemic risk.”
But currently, the SRT pool is not large enough to impact financial markets overall. With restrictions on total transfer volumes, banks prefer SRTs with upfront cash collateralisation and investors are conducting robust stress testing, according to Baid.
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Jonathan Sloan, in the portfolio valuation group at investment bank Houlihan Lokey, said he is currently seeing issuances through SPVs with asset classes including auto, student and corporate loans, as well as corporate revolver collateral.
There are increased inquiries from Asia, he added, and there is a lot of activity with issuances by European banks.
In the US, funds that are seeking to be protection sellers are continually looking for investment opportunities, he noted.
“While we expect the SRT market in the US to be an avenue banks explore for both capital relief and risk mitigation purposes, the expectation of significant growth of SRTs from large US banks was dampened by the Fed’s thoughts on modifying Basel III endgame rules,” Sloan told Alternative Credit Investor.
