In recent years, synthetic risk transfers (SRTs) have become a significant topic of discussion in the banking sector. Originally developed in Europe in the early 2000s for regulatory capital optimization, these instruments are now essential for banks managing their balance sheets efficiently.
Since 2016, financial institutions have engaged in SRTs involving assets exceeding $1.1 trillion, with annual issuances in the billions. As interest in these contracts has increased, particularly from private credit funds, regulatory bodies and financial experts have intensified their scrutiny of SRTs. The key question is whether this heightened attention is warranted.
What exactly are synthetic risk transfers?
SRTs are a form of synthetic securitization, often described as “on-balance-sheet securitization.” This approach allows banks to mitigate credit risk associated with their loan portfolios through contractual agreements, such as credit derivatives or guarantees, while retaining the loans on their balance sheets.
In Europe, investors typically assume mezzanine loan risk by writing a credit default swap (CDS), whereas in the U.S., they use a credit-linked note (CLN). Public and private credit funds primarily act as protection sellers, attracted by competitive yields, diversified credit exposures, and the flexibility to customize risk via tranches. By transferring part of their loan risk to investors, banks can reduce their regulatory capital requirements, enabling them to allocate capital for new loans more cost-effectively than raising equity.
The structure of SRTs
In these agreements, the originating bank retains the first loss or junior tranche of the risk. The investor, who lacks detailed knowledge about the specific loans in the portfolio and only has access to general information like maturity dates, ratings, and industry classifications, receives a fixed premium or coupon. In the event of defaults, the bank absorbs the initial losses while the investor is liable for losses up to the mezzanine tranche limit.
To maintain a vested interest, banks continue to manage client relationships, loan administration, and interest income. This structure meets regulatory requirements for retaining “skin in the game.” By transferring a portion of their portfolio risk, banks can effectively reduce the capital they need to hold against these loans.
The growth of SRTs in different markets
European banks dominate the SRT market, accounting for approximately 60% to 70% of global transactions. The development of the European market is driven by its bank-centric loan structure and strict interpretations of capital regulations following the global financial crisis (GFC). A robust supervisory framework and a well-established investor base have further supported this growth. Each SRT transaction undergoes rigorous reviews by the European Central Bank and the European Banking Authority, with recent regulatory changes favoring high-quality structures by providing more efficient capital treatment.
In the United States, the Federal Reserve’s updated guidance acknowledged direct CLN structures as eligible for capital relief, prompting banks to quickly engage in the market. Currently, the U.S. accounts for nearly 30% of global SRT activity. In Asia, countries such as Australia and Singapore have begun experimenting with SRT-like structures under different names and with significantly lower volumes.
Regulatory concerns surrounding SRTs
Despite their advantages, SRTs are under considerable regulatory scrutiny. Authorities are particularly concerned about rollover risk, investor concentration, and back-leverage, which can escalate with increased issuance. Rollover risk arises from the typical three to five-year maturity of SRTs, while the underlying loans may remain on the balance sheet for longer. If market conditions deteriorate upon renewal of an SRT, banks may struggle to replace the protection, leading to a spike in risk-weighted assets (RWAs) and potential pressures to reduce leverage.
Investor concentration exacerbates this risk, as a limited number of private credit funds dominate the mezzanine market. This reliance raises concerns about the sustainability of the SRT ecosystem, particularly if these funds decide to withdraw during challenging market conditions. Additionally, regulators are cautious about back-leverage scenarios, requiring banks to demonstrate that a significant portion of the portfolio risk has been transferred and that the transfer remains effective in adverse market conditions.
Since 2016, financial institutions have engaged in SRTs involving assets exceeding $1.1 trillion, with annual issuances in the billions. As interest in these contracts has increased, particularly from private credit funds, regulatory bodies and financial experts have intensified their scrutiny of SRTs. The key question is whether this heightened attention is warranted.0
A strategic tool for banks
Since 2016, financial institutions have engaged in SRTs involving assets exceeding $1.1 trillion, with annual issuances in the billions. As interest in these contracts has increased, particularly from private credit funds, regulatory bodies and financial experts have intensified their scrutiny of SRTs. The key question is whether this heightened attention is warranted.1
Since 2016, financial institutions have engaged in SRTs involving assets exceeding $1.1 trillion, with annual issuances in the billions. As interest in these contracts has increased, particularly from private credit funds, regulatory bodies and financial experts have intensified their scrutiny of SRTs. The key question is whether this heightened attention is warranted.2