Growing numbers of banks are issuing credit risk transfer securitizations to manage regulatory capital requirements. Generally known as significant or synthetic risk transfers (SRTs), these transactions enable banks to reassign future credit losses in reference loan portfolios to third-party investors.

European banks dominate SRT issuance but volumes are growing in other markets. U.S. banks are becoming more active after the Federal Reserve (Fed) clarified the capital treatment of certain SRT structures. Higher prospective capital charges on loans under the Basel III reforms increase the incentive to issue, although there is uncertainty over the ultimate treatment of SRTs under these standards.

S&P Global Ratings sees well-designed SRTs as an effective tool for banks to manage their capital and risk profiles. Accordingly, we recognize these transactions as credit risk mitigants in the calculation of our risk-adjusted capital (RAC) ratio, which is our primary solvency metric for banks. Capital relief is a key motivation for SRTs and there tends to be a flurry of issuance ahead of financial year-ends to support regulatory ratios. However, issuers increasingly use SRTs as a strategic risk management tool to actively manage loan portfolios, address sectoral and single-name concentrations, and create capacity for further lending.

SRTs are one of the ways in which credit risk has moved to the nonbank financial sector as bank regulators toughened capital requirements following the global financial crisis (GFC). Some pre-GFC SRTs proved ineffective when economies came under stress, but we think current transaction structures and regulatory requirements reflect lessons learned and result in genuine risk transfer. Nonbanks are typically less levered and run lower asset-liability mismatches than bank peers, but are also less tightly regulated and can be less transparent. We see certain risks associated with the flow of credit to nonbanks but do not view SRTs specifically as a material contagion risk (see “Private Markets: How Long Can The Golden Age Of Private Credit Last?,” Dec. 4, 2023).

The Basics Of SRTs

SRTs can use a variety of transaction structures. The common denominator is the sale of one or more junior tranches such that most unexpected losses on the reference loan portfolio fall to third-party investors rather than the originating bank (see chart 1).

Chart 1

Since the purpose of bank capital is to cover unexpected losses (with balance sheet provisions covering expected losses), SRTs can lower lenders' regulatory capital needs if the transactions satisfy regulators' quantitative and qualitative criteria. Banks often retain the senior tranche in each transaction and sometimes a first-loss piece covering expected losses. SRTs are generally economic for the issuer and accretive to its shareholder returns when the cost of the regulatory capital saving (the credit protection premiums paid to investors and other transaction expenses) is below its cost of capital.

The most common SRT transactions are funded synthetic securitizations, which can be issued directly by the originating bank or indirectly through a special purpose vehicle. In these structures, the reference loan portfolio remains on the bank's balance sheet and the associated credit risk is transferred to investors through credit-linked notes (CLNs), financial guarantees, or credit default swaps. To mitigate counterparty risk to the investors that provide the credit protection, originating banks often receive funds upfront by selling CLNs or taking collateral.

Motivations For Banks To Issue SRTs

SRTs enable banks to manage their regulatory and economic capital needs relative to external requirements and internal targets. They complement other measures that achieve the same goal such as issuing equity and hybrid capital, retaining earnings, syndicating loans, and hedging risk exposures.

Banks have several options to deploy the capital saving generated by SRTs. They may choose to strengthen their reported regulatory capital ratios or return capital to shareholders. Alternatively, they could use the headroom to originate more loans, mitigate regulatory methodology changes, or maintain a presence in a business segment that would otherwise generate sub-optimal returns.

Alongside the capital benefit, SRTs enable banks to rebalance their loan portfolios and manage sectoral and single-name concentrations. There is limited public information on specific credit losses that banks have avoided due to SRTs. A rare anecdotal example was the 2021 disclosure by Deutsche Bank's CEO during a German Parliamentary hearing that the bank had a €80 million gross exposure-at-default to Wirecard and risk mitigation lowered its retained loss to €18 million. This case illustrates that SRT coverage can reduce the amount of credit loss provisions that banks need to build when a borrower's creditworthiness comes under pressure or macroeconomic assumptions deteriorate.

Unlike traditional cash securitizations, funding considerations are not a primary motivation for synthetic SRTs. Issuers generally structure SRTs as synthetics rather than cash securitizations because they offer greater flexibility and are cheaper to originate and administer. Lenders retain their customer relationships while managing the profile of their loan portfolios.

Nonbank Credit Funds Lead The SRT Investor Base

The SRT investor base is led by hedge funds and private credit funds, but larger asset managers are also active and there is growing participation from insurers and pension funds (see chart 2).

Chart 2

SRTs provide investors with attractive premium income and exposure to a diverse range of borrowers and asset classes that may not be accessible in other markets. As problem loans arise, investors benefit from the expertise and resources in banks' work-out units. Fundamentally, however, credit is credit and SRT investors are on the hook for losses in the reference pool in excess of the relevant attachment points.

How We Reflect SRTs In Our Bank Ratings

We think the current generation of SRTs results in genuine risk transfer from issuers' balance sheets and we therefore reflect them in our bank rating analysis. It is not possible to isolate the rating impact of SRTs but the relatively small numbers of issuers and transactions mean that it is minor.

SRTs originated in the 1990s and we generally saw pre-GFC transactions as regulatory capital arbitrages more than genuine risk transfers. Although the effectiveness of current SRT structures has not yet been severely tested, we think tightened regulatory requirements help to redress the balance. Among other rules, banks are typically prohibited from funding investors' participation in the transactions or compensating investors for realized credit losses.

Under our financial institutions rating methodology, the capital and earnings assessment is the factor for which SRTs are most relevant (see "Financial Institutions Rating Methodology," published on Dec. 9, 2021). This assessment takes account of regulatory capital ratios but focuses on our projected RAC ratio relative to stated thresholds. Depending on the transaction structures, we recognize risk mitigation through SRTs in our RAC ratio calculation by reducing exposure amounts and risk-weighting retained tranches (see "Risk-Adjusted Capital Framework Methodology," published on July 21, 2017). The source data for the calculation mostly come from either regulatory disclosures such as Pillar 3 reports and U.S. FR Y-9C statements or input templates completed by rated banks.

SRT market pricing and capacity would likely deteriorate in a credit downturn as investors lower their risk appetite. This could constrain credit availability if banks are stuck with loans for which they intended to buy protection but cannot do so economically. In practice, SRTs are one of many measures in banks' capital management toolkits and we do not currently see an overdependence on these transactions.

Steady Growth In Issuance Activity

SRT volumes have steadily increased over several years, with activity led by European banks and supplemented more recently by Canadian and U.S. peers (see chart 3). Issuers in these jurisdictions had clarity on the regulatory treatment of these transactions and, for some European banks, a need to reduce capital-intensive assets to underpin capital ratios.

Chart 3

We see a growing number of banks issuing SRTs and expect this trend to continue, but issuance remains dominated by larger names. For example, the European Systemic Risk Board disclosed that four institutions account for 60% of the total notional volume of SRT securitizations issued by banks regulated under the single supervisory mechanism. Some banks have provided insights on the scale of their SRT coverage, including the following two examples:

• Barclays disclosed that it held synthetic protection on about 36% of its £50 billion funded on-balance-sheet corporate loan exposure as at year-end 2023.
• Deutsche Bank reported that it held synthetic credit protection through collateralized loan obligations and credit default swaps on €39 billion of exposures to about 2,000 wholesale borrowers as at year-end 2022.

Loans to large and midsize corporates are the traditional focus of SRTs due to their capital intensity and impact on banks' sectoral and single-name risk concentrations. However, we see growing activity in retail and other wholesale business lines, including areas such as project finance that face higher capital charges under the final Basel III standards (see chart 4). For example, Barclays recently indicated that it will explore selective SRT transactions in its U.S. credit card business to mitigate an increase in risk-weighted assets from the upcoming migration of this portfolio to the internal rating-based (IRB) approach. SRTs tend to exclude assets with modest capital charges due to a low probability of default and/or low loss given default. Reference portfolios are usually relatively diversified to spread investors' risks and reduce the chance that a handful of defaults consumes the full amount of the purchased credit protection.

Chart 4

U.S. Regulatory Clarification Provides Further Impetus

U.S. banks have been sporadic SRT issuers but are becoming more active after the Fed clarified in September 2023 the regulatory capital relief available to issuers of certain CLNs. To date, the Fed has published letters to Huntington Bancshares Inc., Morgan Stanley, Santander Holdings USA Inc., and U.S. Bancorp granting requests for directly issued CLNs and follow-up transactions that are substantially similar. The Fed capped the aggregate amount of each issuer's reference portfolios at the lower of $20 billion and 100% of the issuer's total capital. The U.S. bank CLNs issued to date have focused on the transfer of risk in auto loan portfolios.

Residual Uncertainty Over The Ultimate Impact Of Basel III

Implementation of the final Basel III standards is fast approaching and will significantly influence the SRT market's medium-term prospects. The key question is whether increased capital requirements on loans will outweigh increased capital requirements on securitization positions. The introduction of the Basel III output floor could weaken the economic case for SRTs by requiring issuers to sell thicker tranches to investors, which raises transaction costs. This concern is particularly relevant to issuers that calculate regulatory capital requirements according to the standardized approach.

A key variable in the future regulatory capital treatment of SRTs is the non-neutrality adjustment known as the p-factor. This results in a higher aggregate capital charge on securitization tranches than on the underlying loan portfolio, reflecting agency and model risks. The ultimate p-factor calibration is currently unclear in the key jurisdictions of the EU, U.S., and U.K.:

• The EU initially proposed conservative p-factors, but subsequent negotiations produced a compromise lasting until 2032 that benefits banks that calculate regulatory capital according to the IRB approach. This compromise does not solve all issues related to the introduction of the output floor, and EU authorities left the door open to further concessions. By year-end 2026, EU regulators will review whether the Basel III output floor will excessively reduce the risk-sensitivity and economic viability of SRTs and therefore whether p-factors should be lowered under both the standardized and IRB approaches.
• The initial U.S. Basel III endgame proposal similarly included large p-factor increases that would materially increase the cost of SRTs. This was a focus of market participants' responses and we await the final rules to see whether U.S. regulators will follow their EU peers in reaching a compromise.
• In the U.K., the bank regulator consulted on various options relating to the final implementation of Basel III, including alternative p-factor treatments and potentially a more widespread recalibration of regulatory capital charges on securitization exposures. The final rules are expected later this year.

Related Criteria

• Financial Institutions Rating Methodology, Dec. 9, 2021
• Risk-Adjusted Capital Framework Methodology, July 21, 2017

Related Research

• Private Markets: How Long Can The Golden Age Of Private Credit Last?, Dec. 4, 2023