ECB flags risks as banks shift loan exposure through SRTs

European banks are using synthetic risk transfers to cut the capital they must set aside against loans, a move that can support more lending while pushing some credit losses onto outside investors. For everyday investors, the issue is straightforward: a tool that makes banks look less exposed can still leave the financial system connected to the same risks in less visible ways.

A synthetic risk transfer, or SRT, lets a bank keep loans on its balance sheet while selling part of the credit risk to another party. That can happen through credit-linked notes or financial guarantees. Credit risk means the chance that borrowers fail to repay.

The appeal for banks has grown as European regulators have required more capital backing for loans. Tier 1 capital, the core capital banks use to absorb losses, is costly to tie up. Under an SRT, if a bank sells the first-loss exposure on a senior loan slice to an unrelated investor, the capital requirement on those loans can fall by 85% to 90%, according to the described structure.

The loans still sit on the bank’s books, and the bank still has to hold some capital against them. The outside investor, however, takes the initial hit if the loans default. The bank records losses only after losses pass a set threshold.

That setup can be profitable for both sides. Banks release capital that can support new lending. Investors buying SRT exposure receive loan-related payments along with an added risk premium for taking on the chance of losses. The market has expanded quickly since 2019, according to the European Central Bank analysis.

Who is buying the risk

The ECB found that government entities and the European Investment Bank are the main buyers of these instruments. More recently, pension funds, insurers and specialist investment funds have also become investors in SRTs, the ECB said.

The structure has echoes of credit products used before the 2008 financial crisis, when banks packaged loans and mortgages and sold exposure to investors that were expected to be able to absorb the risk. When losses arrived, those risks ended up causing problems for banks again.

SRTs are not identical to those older structures. One difference is that banks using SRTs still must keep some capital behind the loans even after selling first-loss exposure. The ECB analysis, however, identified several patterns that could increase pressure in a downturn.

• Banks appear more likely to use SRTs for riskier loans that carry higher capital requirements, according to the ECB. That gives banks an incentive to keep safer loans and transfer riskier exposures to outside investors.

• The ECB found that banks reduce monitoring after transferring loan risk through SRTs. Monitoring means the ongoing work of checking borrower health and enforcing loan terms. If the first losses sit with outside investors, banks have less direct exposure when defaults begin.

• The ECB also found links between banks and the investors buying SRTs. Banks are 57% to 66% more likely to sell an SRT to investors that already have a lending relationship with the bank, according to the analysis.

That last point is the most direct channel back to banks. The ECB estimates that banks effectively finance about 29% of SRT volume by lending money to investors, who then use those funds to buy the SRT exposure.

In plain English, some banks are selling credit risk to investors that may be borrowing from banks to buy it. That does not mean losses are guaranteed, and the ECB analysis does not say the market is already in crisis. It does show why regulators are watching a fast-growing market that can reduce capital needs on paper while leaving financial links in place.

This story draws on original reporting from Klement on Investing.