Global regulators are increasingly focused on the rapid growth of synthetic risk transfers (SRTs) – a technique used by banks to offload credit risk – warning that the practice could introduce new vulnerabilities into the financial system. While currently representing a moderate portion of overall bank assets, the use of SRTs has more than tripled since 2016, prompting concerns about over-reliance on external investors and potential “round-tripping” of risk.
The Basel Committee on Banking Supervision, in a report released on Tuesday, , detailed the growing trend. Banks in the US, Canada, the UK, and the Eurozone have utilized SRTs to offload risk on approximately €750 billion of loan portfolios, equivalent to roughly 1.1% of their total assets.
SRTs, often described as “on-balance-sheet securitization,” allow banks to transfer a portion of their loan portfolio’s credit risk to external investors – typically credit funds – without fully removing the loans from their balance sheets. What we have is usually achieved through credit derivatives, like credit default swaps (CDS) or credit-linked notes (CLNs). Banks pay investors to assume this risk, which in turn reduces their regulatory capital requirements and frees up capital for new lending.
The report highlights that the increased reliance on SRTs could leave banks more vulnerable to market fluctuations and dependent on the health of non-bank financial institutions. Investors, attracted by competitive yields and the ability to tailor risk through tranches, are increasingly private credit funds.
A particular concern raised by regulators is the potential for “round-tripping,” where investors borrow from other banks to fund SRT transactions, effectively shifting risk around the system without necessarily reducing overall exposure. The report notes that investors can enhance returns by leveraging their investments, creating a layered risk structure.
“SRT financing transactions can lead to the investor having both the leverage from the tranche structures and the financial leverage offered by the funding providers,” the Basel Committee stated.
Regulators in the UK have already begun to address these concerns. Last year, the UK’s financial authorities wrote to major lenders, warning that banks heavily reliant on leveraged SRT transactions would face increased scrutiny.
The Basel Committee’s report identified Barclays as the most intensive user of SRTs for transferring corporate loan risk among EU, UK, and Swiss banks. The UK bank has reportedly offloaded risk on approximately 45% of its corporate loan book through these transactions. Barclays operates a long-established SRT program, known as Colonnade, primarily focused on its UK and US corporate loan portfolios. The bank has previously stated that these transactions are fully funded, meaning investors provide upfront collateral to cover potential losses.
Austria’s Raiffeisen Bank International was identified as the largest user of SRTs for reducing overall capital requirements. The bank has used SRTs to reduce its common equity tier 1 capital requirement – a key measure of financial strength – by more than 1 percentage point.
The committee emphasized the need for increased cooperation and coordination between supervisors to address the growing interconnectedness between banks and non-banks created by SRTs. They suggest that supervisory tools, such as limits on the proportion of lending covered by SRTs or on the capital relief achieved through their use, could help mitigate potential risks.
Despite the concerns, the Basel Committee noted that SRTs “appear to be more prudently structured and managed, both by banks and investors” compared to the securitization vehicles used prior to the 2008 financial crisis. Those earlier structures, often involving mortgages and leveraged loans, were widely blamed for exacerbating the crisis.
The increasing popularity of SRTs reflects a broader trend of risk transfer within the banking sector, driven by regulatory pressures and the desire to optimize capital allocation. According to McKinsey & Company, risk transfer is becoming a “growing strategic imperative for banks.” The regulatory reforms implemented after the 2008 financial crisis simplified the process for banks to engage in SRT transactions, contributing to the recent surge in activity. As of , the European Central Bank (ECB) urged caution on synthetic SRTs in a securitization overhaul, wary of lenders’ over-reliance on synthetic risk transfers.
Since 2016, banks have executed SRTs referencing more than $1.1 trillion in underlying assets, with annual issuance reaching tens of billions of dollars. The question now is whether the current level of scrutiny is sufficient to manage the potential risks associated with this rapidly evolving market.
