WASHINGTON — Sen. Jack Reed, D-R.I., asked banking regulators to evaluate risks that come with "synthetic risk transfer" transactions, which he says some banks are using to bypass proposals to raise bank
In his letter to the Federal Reserve, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency, Reed said that these these "complex arrangements are a potentially lucrative way for banks to arbitrage the capital rules by selling debt instruments or derivatives to unregulated nonbanks who assume the risk that a consumer or corporate borrower will default on a loan."
In the majority of risk transfers, investors take on the risk of credit-linked notes or credit derivatives issued by banks in exchange for collecting interest on them. This is meant to lower the potential loss exposure for the banks, and reduce the amount of capital they're required to hold against their loans. The practice, which Reed said has been growing, is being scrutinized by lawmakers because of its resemblance to credit-default swaps, which exacerbated a simmering financial panic in 2008 after investment bank Lehman Brothers failed.
Reed said that the practice moves risk outside of the banking system into private markets, where it may not be managed or measured.
"Private market investors who assume credit risk from banks include private equity funds, hedge funds, private credit funds, and other big nonbank financial institutions," Reed said. "They are not subject to consolidated regulation and supervision, do not need to meet risk management requirements, and do not need to make public disclosures. While synthetic risk transfers are purportedly designed to diversify and disperse credit risk among many players in the financial markets," Reed's letter continued, "these transactions may in fact have the opposite effect by concentrating risk among a small number of very large shadow banks."
The transfers could also make it easier for banks to take on even more risk, Reed argued.
"These transactions may free up additional capacity for banks to make more loans," Reed said. "But when risks of defaults and losses are shifted onto others, banks have fewer incentives to make prudent loans and to monitor how those loans perform. Instead of making additional loans, banks could take advantage of lower capital requirements through buying back shares or paying dividends to shareholders. But that may leave banks less able to absorb losses in a crisis."
Fed Vice Chairman for Supervision Michael Barr, at a recent oversight
"We have very strong visibility into the bank side of the transaction — that is, how the bank engages with third parties with respect to these risks. We'll be monitoring those risks," Barr said. "We have, of course, much less visibility into hedge funds and private equity funds. That is a long-standing issue in supervision."
Acting Comptroller of the Currency Michael Hsu said at the same hearing that the synthetic risk transfers "require heightened attention, especially when risk transfer is thought of as risk elimination, which it is not."
"However, when done appropriately in a safe and sound manner with controls, it can help to be part of an effective risk management program, but that does require a careful look," he said.
