Synthetic Risk Transfers – How They Work & Example
Banks in the US use a clever method called synthetic risk transfers to handle the challenges of tough banking rules and the effects of higher interest rates.
This involves selling specialized financial products to investment funds.
This lets the banks protect themselves from some of the risks associated with the loans they give out.
It’s essentially offloading a portion of the risk to someone else in exchange for a fee.
Key Takeaways – Synthetic Risk Transfers
- Risk Offloading: Synthetic risk transfers allow banks to offload some of the risks of their loan portfolios to investors.
- This reduces the amount of capital they need to keep in reserve.
- Investor Returns: Investors in synthetic risk transfers can earn high returns – often around 15% (depends) – for accepting the potential risk of loan defaults.
- Regulatory Response: These financial tools help banks navigate tighter regulatory requirements by legally minimizing the capital charges they face under rules like those of Basel III.
- Example: We provide an example below of how synthetic risk transfers work.
How Synthetic Risk Transfer Work
Banks, like JPMorgan Chase and Morgan Stanley, create something akin to an insurance policy.
They issue what’s known as credit-linked notes or derivatives that are tied to the performance of their loans.
If some of these loans fail, the investors who bought these notes will cover the losses up to a certain percentage.
For taking on this risk, investors are promised a nice return, often somewhere around 15%.
Banks Can Hold Fewer Reserves
By doing this, banks can hold less money in reserve to cover potential loan losses, which is something regulators require.
This strategy has become especially important because the Federal Reserve, which oversees these banks, has gotten stricter about how much money banks need to keep on hand.
When interest rates go up, the value of some of the banks’ other investments goes down.
This means they would normally need to keep even more capital in reserve.
In the past, American banks didn’t use synthetic risk transfers much – particularly after the 2008 financial crisis because the rules were very strict.
Banks in Europe and Canada have been using it more because their regulators gave clearer rules after the crisis.
But things are changing in the US.
The Federal Reserve has started to allow these kinds of deals again, reviewing them on a case-by-case basis.
Investment Funds Becoming More Bank-Like
This shift is part of a bigger change in finance where investment funds are starting to do things traditionally done by banks, like lending money to companies (i.e., private credit and private lending).
The big banks are responding to new proposals that might require them to set aside even more money, which would impact their profits.
(The more they have to keep in reserve, the less they can make.)
So, by transferring some of the risk of their loans, banks can stay nimble and keep investing and lending without needing to hold as much capital in reserve.
Example of a Synthetic Risk Transfer
Let’s create an example with hypothetical numbers to illustrate how synthetic risk transfers work.
The Two Sides in the Synthetic Risk Transfer Deal
Let’s call our two entities in the synthetic risk transfer deal the following:
- BigBank USA (bank offloading risk)
- RiskTaker Fund (investment fund taking on the risk for a return)
Imagine BigBank USA has a portfolio of corporate loans worth $100 million.
Under regulatory requirements, BigBank USA needs to keep $8 million in reserve (let’s say 8% of the loan value) to cover potential losses if some of the businesses fail to repay their loans.
Now, BigBank USA decides to use a synthetic risk transfer to reduce the amount of reserve capital it needs to hold.
It issues credit-linked notes worth $10 million (10% of the loan portfolio value) to an investment fund, RiskTaker Fund.
Here’s what happens in the deal:
- BigBank USA: Pays a fee (in the form of interest) to RiskTaker Fund for taking on the risk. This fee is less than the $8 million they would have to keep in reserve.
- RiskTaker Fund: Provides $10 million upfront and agrees to cover losses on the loan portfolio up to $10 million (10% of the loans). In exchange, they get interest payments from BigBank USA that might give them an annual return of around 15% on their investment.
If businesses start failing and the loan portfolio loses value:
- If losses are $5 million: RiskTaker Fund covers the full amount, so BigBank USA doesn’t lose anything.
- If losses are $12 million: RiskTaker Fund covers the first $10 million, and BigBank USA covers the remaining $2 million.
Because of this deal, BigBank USA might only need to hold, for example, $4 million in reserve instead of $8 million because the risk of loss is partially covered by RiskTaker Fund.
This means BigBank USA now has an extra $4 million that it can use for other investments or loans.
Accordingly, BigBank USA is paying for protection against possible bad loans.
The lower capital requirements, risk reduction, and payment it receives from RiskTaker Fund enable BigBank USA to make more profit in excess of the interest payment(s) they have to make to RiskTaker Fund.
RiskTaker Fund is betting that the loans will perform well enough that the returns on the interest will exceed any money they might have to pay out.
How Is the Return on Synthetic Risk Transfers Determined?
The return for investors in synthetic risk transfers is determined by the risk they’re taking on.
The higher the risk of loan defaults in the bank’s portfolio, the higher the potential return demanded by investors.
This compensates them for the possibility of losing their investment.
The specific return rate is set through negotiations between the bank and the investors, reflecting:
- the risk profile of the loan portfolio
- prevailing market interest rates, and
- investor appetite for such instruments.
It’s a balance between the risk of loss and the potential for profit.