The growth of credit risk transfers in the US

What are credit risk transfers?

In the ever-evolving financial landscape, credit risk transfers (CRTs) are emerging as a powerful tool for US banks to manage and optimize their balance sheets. With global bank issuance of CRTs surpassing $16.6 billion in the first nine months of 2024, and projections indicating a rise to $30 billion by year-end, it's clear that CRTs are becoming a critical component of modern banking strategies.

CRTs allow banks to transfer credit risk to third parties while maintaining their lending relationships. This innovative approach helps banks reduce credit risk, lower regulatory capital requirements, and potentially increase return on equity. Unlike traditional risk transfer methods, CRTs enable banks to keep loans on their balance sheets, using them as references while transferring associated credit risks to investors through instruments like credit linked notes (CLNs).

Credit risk transfer transaction tranches

In a credit risk transfer transaction, a reference loan pool is divided into different tranches:

1. Senior Tranche: Retained by the bank, this tranche is furthest from expected losses due to its significant subordination cushion. It represents the largest percentage of the capital structure and is not typically expected to experience defaults.
2. Mezzanine Tranche: Sold to investors, this middle tranche covers unexpected losses. Investors receive payments based on the loan pool's performance.
3. First Loss Tranche: Represents expected losses of the portfolio, calculated by the bank based on historical loan performance, default expectations, collateral-specific recoveries, and recovery lag. The bank may choose to retain this tranche depending on the transaction's cost and capital benefits.

This structure allows the bank to manage risk while providing investment opportunities to external parties.

US regulatory rules for credit risk transfers

The US regulatory landscape for credit risk transfers remains uncertain due to the lack of official guidelines. However, this may evolve as the Federal Reserve provides more guidance with the growing market. Banks should proceed cautiously as regulatory approval is required for capital relief from CRTs, which can increase a bank's leverage ratio. Federal Reserve Governor Michelle Bowman emphasized the need for capital rules to recognize bona fide risk transfers achieving the same economic outcomes as permitted risk transfers under proposed rules.

Investor considerations in credit risk transfers

Investors, such as credit fund managers, seek a detailed understanding of the bank's operations to ensure CRTs are priced according to the underlying loan risks. Since CRTs are bespoke deals, investors need insights into the loan pool details, including the asset class and replenishment criteria, effectively underwriting the bank’s underwriting capabilities.

Investors and banks benefit from standardized risk weights across the banking system, which do not reflect individual bank portfolio risks. For instance, a bank with a high-quality auto loan portfolio must maintain the same risk weights as a bank with lower-quality loans. This allows banks with high-quality portfolios to offload lower-risk loans to investors interested in owning the credit risk. Consequently, banks with high-quality, low-yielding assets can benefit significantly from CRTs by recycling capital and earning new origination fees.

What growth looks like moving forward

The CRT market in the United States is in its early growth stage. Banks should evaluate how CRTs can enhance their capital optimization strategy and determine the optimal timing and method for market entry. CRTs also illustrate how banks are adapting to the rise of third-party investors, such as private credit funds. This synergy allows banks to act as intermediaries for funds seeking to deploy capital, similar to the growing trend of origination partnerships between the banking and private credit industries. A well-executed CRT strategy can reduce credit risk and increase return on equity.

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