BankThink

Banks' use of credit risk transfer transactions is opaque and risky

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CRTs have changed since the financial crisis. But the eventual credit cycle turn is likely to show again that weaker banks' CRT use merely transformed, but did not eliminate, risk, writes Jill Cetina.
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Banks use credit risk transfer transactions, or CRTs, to compress their risk-weighted assets, or RWA, and thus reduce the denominator of their regulatory capital ratios (as opposed to adding more capital in the numerator) to improve the ratio. But bank regulators do not require reporting in banks' quarterly filings either of such transactions or of their impact on bank capital. U.S. Generally Accepted Accounting Principles, or GAAP, also offers limited visibility into CRTs. More fundamentally, CRTs can transform credit risk into other less obvious risks.

Such transactions aren't new. Prior to the 2008 financial crisis, banks engineered CRTs with credit default swaps, or CDSs. These CRTs went severely amok when AIG and multiple bond insurers couldn't meet their obligations to banks to absorb loss. Credit risk was transformed into counterparty risk and then systemic risk. Reflecting on that fiasco, in 2015 at the Office of Financial Research, we wrote a paper and observed that post-2008 large data gaps remained around CRTs. Specifically, little data is available about banks' use of CRTs and the impact on regulatory capital ratios. Information on CRT counterparties is another data gap. We argued for bank regulatory reporting on both topics.

Fast forward to today, both data gaps remain and some U.S. banks with significant unrealized losses due to interest rate changes are on so-called "RWA diets" to strengthen regulatory capital ratios. One facet of the RWA diet includes a revival in CRTs. In the current credit cycle, these CRTs take the form of credit linked notes, or CLNs, and cash collateralized CDS that better mitigate counterparty risk. In both cases, banks get cash upfront in exchange for making payments to nonbanks that depend on the underlying credit performance of a pool of loans. If the loans default, the bank's payments are reduced, and losses are passed to nonbanks. The AIG risk is gone — so what is the problem? There are three issues.

First, in these CRTs, the bank's cash proceeds may: 1) become general cash of the bank; 2) go to a controlled account at the bank; or 3) be held by a third-party custodian. It is crucial to know what happens with CRT cash because the three structures yield different outcomes. In the first, if the bank uses the CRT cash for other purposes before CRT maturity, such as buybacks or new loans, regulators have effectively permitted it to take out a loan against its capital. If the bank retains the cash and isn't subject to the liquidity coverage ratio, or LCR, its liquidity buffer may appear improved though that cash effectively is bank capital. In the second, again when the bank is not subject to the LCR which requires reporting of encumbered assets, the bank's liquidity could be overstated. In the third, some non-LCR banks report deposits at other banks as part of their liquidity buffers, again liquidity could be overstated. Further, the account legal agreement and the custodian's quick disbursement of funds when losses are realized are key.

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Second, to assess CRTs' impact, it is key to know if a bank is shifting high- or low-credit-risk assets to nonbanks. In 2008, banks shifted high-risk exposures like CDOs to AIG. They paid AIG for unlimited credit protection. AIG was unable to absorb the risk. In 2011 U.S. bank supervisors issued guidance that high-cost CRTs could result in excessive earnings smoothing versus up-front loss recognition. Today the situation is different. Some U.S. midsize banks with an overhang of low-yielding assets and weak profitability are shifting low-risk exposures to nonbanks. CRTs on low-risk loans — prime auto, fund finance and asset-backed securities — help minimize CRT cost and support profitability. However, because these CRTs are cash collateralized, they only absorb a finite amount of credit loss, not unlimited loss. Per one 10-K, "[o]ur credit linked notes do not ensure full protection against credit losses, and as such we could still incur significant credit losses. …" Further, if high quality loans are cherry-picked for CRTs, the bank may retain the credit risk of lower quality loans. In essence, this is a classic adverse selection problem where the CRT provides relief based on a risk-weight for the loan that reflects an average level of credit risk, but transfers low risk due to CRT pricing. Thus, a bank may obtain RWA relief on good loans in excess of the underlying economics and have less capital for other unexpected losses. The 2024 CCAR stress test covers 32 banks, at least 7 of which have CRTs. Clarity on how banks' specific CRT loan pools, structures and amortization impact CCAR would be welcome.

Finally, CRTs may create governance risk. A key data gap is the limited counterparty information available to investors and supervisors when a bank turns to hedge funds, private equity or private credit for CRT. CRTs improve capitalization ratios. At the same time, U.S. banks' lending to nonbanks continues to grow rapidly. It is unclear how to monitor CRTs' compliance with Regulation O, which limits loans to bank insiders. Nonbanks or their portfolio companies could have borrowing relationships with the bank. There are also emerging examples of nonbanks engaged in bilateral CDS with banks for risk transfer and then securitizing the CDS for sale to still other financial institutions. This opacity increases governance and financial stability risks from CRTs.

Given stated policy goals, regulators seem surprisingly sanguine about CRT growth, particularly at midsize banks. CRTs change a bank's capital structure. CRTs can yield double digit returns but are senior to bank equity and unsecured bonds. Also, no CRTs have been bailed in to several European bank failures. Sound policy requires data and analysis of potential costs and benefits of CRTs on banks' ability to raise common equity and interaction with long-term debt requirements, stress tests and least-cost resolutions.

Yes, CRTs have changed since AIG. But the eventual credit cycle turn is likely to show again that weaker banks' CRT use merely transformed but did not eliminate risk.

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