Banks use
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
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.
Banks and financial institutions face a barrage of lawsuits from consumers alleging they failed to investigate inaccurate information on a credit report. Industry blames the uptick in litigation on social media sites and the proliferation of credit repair companies.
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
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
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.