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A year ago the IMF warned that the growing “synthetic risk transfer” market could pose a systemic danger. Unsurprisingly, SRT people violently disagreed. The IMF has now taken another look at the phenomenon, and it doesn’t seem entirely convinced.
In case you are fortunate enough to not be au fait with every acronym in finance, SRTs are basically a funky form of securitisation. By buying some first-loss insurance on an underlying “reference pool” of loans from an investor a bank can free up capital for more loans. The insurance seller is typically an actual insurer or an investment fund, which typically gets a nice double-digit return for taking on the risk. Everyone’s a winner etc.
However, there are concerns that the SRTs might perversely end up making the banking system riskier. Here’s the abstract of a paper the Fund has just published, with Alphaville’s emphasis in bold below:
Since 2016, over $1 trillion in assets have been synthetically securitized, with recent expansion driven by U.S. banks alongside established European issuers. SRTs enable banks to transfer credit risk on diverse loan pools to investors, facilitating capital relief and supporting additional lending. The paper reviews market trends, common SRT structures, and regulatory frameworks across major jurisdictions.
We find that SRTs offer benefits such as enhanced risk management and capital efficiency, and that strengthened prudential requirements and a relatively small SRT market have, for now, contained financial stability risks. However, the rapid growth of SRTs and certain transaction complexities can increase vulnerabilities, including higher leverage in the financial system and exposure to rollover risks. The entry of risk-tolerant investors seeking compelling returns may also weaken credit standards or increase leverage.
This broadly matches the conclusion of its previous study (and Alphaville’s own take on the matter, fwiw): SRTs can be a great tool for banks to shed credit exposure and free up capital for more loans, and it doesn’t look too dangerous right now. But like many financial technologies, it can and probably will end up getting misused, and there are already a few worrying signs of froth.
This new IMF report is much more detailed than the treatment SRTs received in the 2024 Global Financial Stability Report, so it’s worth a gander if you’re interested in the subject.
It concedes that the SRT market remains pretty small in the grand scheme of things, that regulators seem to have a pretty firm handle on it — the capital relief they offer has to be formally blessed, after all — and that SRTs can be a valuable tool for banks. This is especially true in Europe, where the traditional securitisation market remains a bit of a mess.
However, the IMF’s three main concerns are worth spelling out in a bit more detail:
First, SRTs can increase the overall leverage of the financial system by transferring credit risk originated by banks to less regulated financial institutions, such as hedge funds, which have more freedom to use leverage. As a result, the operations of a diverse set of financial institutions become more intertwined, raising potential contagion risks and hindering financial system-wide risk assessments. These risks are exacerbated by regulatory arbitrage opportunities across the sectors involved and the private and opaque nature of the transactions, which challenges the evaluation of exposures. Additionally, banks often provide leverage to investors, meaning that part of the credit risk is retained within the banking system.
Second, the number of SRT investors is limited, and the market is very concentrated, exposing banks to rollover risks. Credit funds and asset managers have accounted for close to 60 percent of the global investor pool in recent years, and the top 10 investors hold over 75 percent of banks’ outstanding SRT exposure. In addition, the maturity of SRTs is often much shorter than the maturity of the underlying loan portfolio. If investors suddenly withdraw from the market, banks could face an abrupt increase in capital needs as their risk-weighted assets increase and capital ratios decline. Additionally, banks could face higher funding costs and liquidity pressures if SRTs need to be replaced by higher-cost funding structures during normal or stressful times.
Finally, compelling returns from SRT transactions have attracted more risk-tolerant investors, potentially leading to a deterioration in credit standards or higher leverage to finance certain transactions. In pursuit of higher returns, certain investors could resort to riskier deal structures and higher leverage. Increased competition for deals can erode due diligence and weaken underwriting standards. Overall, this process could make the broad financial system more vulnerable to credit shocks.
Further reading:
— Inside Wall Street’s booming $1tn ‘synthetic risk transfer’ phenomenon (FTAV)
