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Last year the IMF dug into the burgeoning “synthetic risk transfer” phenomenon, warning that it “can generate risks to financial stability that need to be assessed and monitored”. Naturally, Alphaville couldn’t resist taking a look at it ourselves.
To recap, SRTs are a technique that banks use to reduce the amount of capital they have to hold in reserve to protect them from loan souring by buying some first-loss insurance from a credit fund, pension plan, or insurer. Here is our Simpsons-based schematic explaining the structure.
Broadly speaking, the risks mentioned in the IMF’s Global Financial Stability Report were that SRTs are incredibly opaque: iffier loans are increasingly being used; structures might not hold up under stress; and banks are increasingly lending to investors to finance SRT deals.
In other words, a financial technology designed to de-risk banks might therefore actually do the opposite. Unsurprisingly, the SRT industry disagreed! 😱
Earlier this week the Alternative Credit Council — an affiliate of the Alternative Investment Management Association trade body — sent an open letter to the IMF, with a somewhat passive-aggressive tone:
We regularly follow the semi-annual GFSR, which always contains interesting data, analysis, and insights into macroeconomic trends and potential vulnerabilities. To our knowledge, this is the first time the GFSR has included a significant discussion of synthetic risk transfers (aka significant risk transfers or “SRTs”). The report correctly notes that since 2016, over $1.1 trillion in bank assets have been synthetically securitized, with two-thirds occurring in Europe. Given that a number of our members are leading practitioners and experts on SRTs, we would like to share some reflections on the six points that the report makes about these transactions. In addition, we would greatly appreciate the opportunity to have a dialogue with you regarding these points and our responses to them
The letter goes through the main arguments raised by the IMF point by point, and—to be fair—some of its rebuttals seem reasonably valid.
For example, while the SRT market may seem murky to nosy financial journalists, bank regulators receive full disclosure, and in many cases have to approve the capital relief that each SRT is designed to give. You can also find some information though banks’ Pillar 3 reports.
Moreover, even when there is leverage it is used pretty carefully, and banks don’t lend to finance their own deals. Here’s the relevant section of the letter, which we’ll quote in full as it is probably the most contentious issue.
In response to the specific objection that “banks are providing leverage for credit funds to buy credit-linked notes,” it would be wrong to assume that credit risk being transferred out of the banking system via an SRT trade is returning with the same risk profile, as would be the case if a bank were to directly acquire another bank’s issuance of CLNs. For one, any leverage is usually provided on a fully secured, fully margined basis with a significant equity buffer. Investors will effectively absorb losses prior to the deterioration of the bank-provided leverage, providing firstloss protection.
As an example, funding banks generally require a 40% haircut with daily margining and a six-month to one-year financing tenor. For a bank to lose money on such a financing transaction, this would require (a) first the credit fund to default and (b) second the market value of the SRT to drop by more than the value of the haircut in just a few days following the default of the credit fund during the financing close-out period. (We note this dynamic reflects a broader macro trend in which banks partner with investors to shift their balance sheets away from unsecured, untranched exposures to safer senior, secured exposures.)
Secondly, any leverage will be subject to the bank’s standard underwriting criteria, which would appropriately account for the correlation risk between the bank-provided financing and the underlying SRT transaction. The financing will also be capitalized as per the usual financing capital rules such that any risk taken will be appropriately factored into the bank’s required capital. Finally, no bank would ever finance an SRT paper it has itself issued.
Fine fine fine. But the issue isn’t really whether the SRT market today is a big danger. Alphaville’s broad conclusion was that it isn’t. The IMF’s report is guarded.
SRTs seem like a pretty handy technique for marrying a bank’s need to manage its balance sheet more efficiently with long-term investors looking for reasonably solid ways to make money. With a bit of optimism, one could even say that this leads to an overall safer financial system.
However, we’ve seen many examples of how even worthwhile financial innovations can devolve into something silly and perhaps even dangerous. After all, the long arc of financial history bends towards fecklessness. Will SRTs follow a similar path? Check in with us again in 10-20 years.
