Credit Risk Transfers a Net Positive for European and US banks, For Now

By downloading or listening to this podcast, you are agreeing to Moody's Legal Terms and Conditions, found at moody's.com slash disclaimer, including that the information provided is not investment or financial advice, and that Moody's will not be liable for losses arising from your use of the information. I'm Danielle Reed, and this is Moody's Talks, focused on finance. I'm joined today by two banking team analysts, Farouk Khan in London and Warren Kornfeld here in New York, to talk about the use of significant risk transfer transactions, or SRTs, by banks in Europe and in the US, where, by the way, they're known as credit risk transfers, or CRTs, and also some of the risks that come with these transactions.

Just a note on those acronyms you just heard, SRTs and CRTs, we're going to be using these interchangeably in today's conversation. Now, I understand this kind of transaction is starting to pick up, especially in Europe, and these are of interest as private credit transactions, notably at a time of some economic volatility. Farouk and Warren, hi, and thanks for joining. Glad to be here again.

Hi, Danielle. Thanks for having me. So to start with, let's define the terms significant risk transfer or credit risk transfer. What are they and are those two terms interchangeable?

Warren, maybe you can answer that one. So, Danielle, as you said at the outset, yes, SRTs and CRTs are interchangeable. SRTs are used generally in Europe, CRTs are generally used in the U.S.

Both are transactions through which banks transfer a portion of credit risk from a specified pool of loans to a third party. So, for example, on a pool of loans that totals $100, the first 12.5% or $12.5 may be transferred to a third party.

The bank sometimes which needs the risk of expected losses, say, first 25 basis points, and then transfers everything above that 25 basis points up to that $12.50 to one or more third parties. Now, these third parties, in other words, what they're doing is they're providing credit protection up to the set amount of total losses. It's just a specified reference pool of loans.

And in return, the third parties, they receive interest payments, which are basically insurance payments from the bank. Now, these transactions are not standardized. They are private deals, Daniel, as he said at the outset. They're worked out.

They're structured on a bilateral basis between the bank and the third parties. And they take all sorts of different forms from credit-lip notes, the curateye structures, credit-to-fall swaps. And most of these transactions, as we'll get into in a little bit, they are fully collateralized. This means that the third parties who are covering those future losses, they provide the maximum amount of losses that they might have to cover in cash up front at the onset of the transaction.

Okay, so in other words, there's not a lot of worry there about counterparty risk, which is the risk that the third-party provider of credit protection would fail and wouldn't be able to cover any hypothetical loan losses, or not all of them. That's precisely right, Danielle. Fully collateralized deals means no worry about counterparty risk. Having this cash provided up front to the bank, the counterparty risk that the bank is exposed to is effectively negated.

So then what's our view on SRTs versus standard bank capital? I think what's important to recognize is that SRTs are increasingly another option for banks in capital management. Banks can manage their capital by raising equity, retaining earnings, contracting their balance sheet, having asset disposals, or even changing their business mix. And when it comes to SRTs, we do consider them to be broadly a lower form of capital than actual common equity.

If they start being used extensively then that could create some dependence issues from banks The key thing is that SRT transactions are also complex in terms of modeling and legal documentation They require strong risk management capabilities from banks, and that's in addition to their business as usual risk and operational management. So, Parikh, I agree with that. I'd just like to add that we do consider that when the risk-weighted capital benefit from CRTs gets to around 100 basis points, then that could lead to a little more concern from a credit standpoint.

So what's driving these transactions? What's the motive for banks to do them in the first place? And what's in it for the protection sellers? Warren, maybe you can take this one.

So if the bank is able to show that they have transferred a significant amount of credit risk for a portfolio of loans. And regulators might not require them to hold as much capital as a risk-weighted regulatory capital ratio is approved from that credit risk transfer transaction. This potentially allows the bank to make more loans. However, to date, the amount of capital leak from SRTs and CRTs for the banks we've surveyed is really not huge.

It's generally relatively modest, a modest credit positive for the banks. For the protection sellers, they're interested in the returns that they get from these transactions, which today have reference pools of high-quality loans. So we believe that the risk-reward appears to be attractive for both the banks as well as those credit protection sellers. So for context, how big is the scope of these types of deals?

I mean, are banks doing a lot of these transactions? Farouk, what is it like in Europe? The hype of activity is actually pretty significant in Europe and it's bigger than in the US, although Warren can speak to that. In 2024, the International Monetary Fund published some figures on this and they reported that since 2016, 1.

1 trillion in assets have been securitized using SRT globally, with Europe accounting for two thirds of that total. According to another trade association, the AFME, the reference pool for new European SRT transactions grew to 156 billion euros in 2024. That's up from 77 billion in 2021, which is a compound annual growth rate of 26%, which is high. And just the last point on this, this all together, this all means that the SRT market is now approaching the size of the European public securitization market, which itself has an annual issuance level of around 240 billion euros.

Okay, thanks for that. And what about the size of the market then in the U.S.? So Farouk, I agree.

It appears that the CRT activity in the U.S. appears to be less than in Europe. And really, quite honestly, it looks like it would be quite a bit less.

In the U.S., we surveyed 69-rated banks. only 15 of these 69 banks, or 22%, have actually to date issued CRT transactions.

They reference around $150 billion in assets. And with respect to the banks, of these 15 banks, the number of transactions was also quite modest with a median of three. Now, no surprise, larger banks were much more likely to have issued CRTs with 42% of the 26 rated banks with assets of more than $100 billion having completed CRTs. The capital impact today of these 15 banks is quite modest, with an increase in their common equity tier one or CET1 ratios of around 25 basis points.

Now, does the growth have anything to do with updated Basel III capital rules? And Farouk, if you could just explain what that means for listeners who don't already know, that would be great. Sure. So for bank capital setting, regulators globally, they generally follow a standard set of guidelines and that set out by the Basel Committee for Banking Supervision Now to your question yes definitely These changes are driving SRT issuance As we discussed earlier SRTs are a tool to help banks manage increased regulatory capital requirements and capital in general.

And if these requirements are going up, then that in and of itself is a driver for SRT issuance. And under the update, there's actually going to be a limits on how much of a benefit banks can use when they assess their risk-weighted assets from internal risk-based models. And that will be a driver for SRT issuance from a bank perspective. And Warren, what about in the US?

So in the US, activity in CRT transactions increased in 20.2, following the significant run-up in interest rates, which led to a decline in banks' economic capital because of lower market values and lower yield in fixed-rate assets. Those fair value declines contributed to the regional bank stress events that occurred in the spring of 2023. Right.

And can you maybe go into a little more detail on the impact of Basel III on CRT issuance in 2023 in the U.S.? Sure, Danielle. So in July of 2023, U.

S. regulators proposed substantial increases to capital requirements for large banks. And as Fruick said, these are known as either U.S.

, the Basel III endgame. With those proposed potential substantial increases in capital, many banks did seek ways in 2023 into 2024 to improve the regulatory capitalization levels with CRTs becoming a popular option, especially with equity valuations suppressed at that time. However, as the banking environment has continued to stabilize over the last couple of years and became apparent, particularly towards the latter part of last year, that the Basel III endgame proposal would likely be modified to result in a sheerly lower increase in capital levels, the number of new CRT issuers slowed a bit.

So Warren, after CRTs increased in 2022 and 2023, now they've slowed over the last year or so, but also overall activity is lower in the U.S. than in Europe, right? So again, yes, activity is lower in the U.

S. And yes, activity did slow in the U.S. You know, with the decreased need with the basically reduced Basel III endgame potential impact.

And the reason as to why we think there's less activity in the U.S. versus Europe is probably two main drivers. So U.

S. regulators, particularly since the free financial crisis, have been more conservative about recognizing capital relief through CRTs. Regulators are concerned about the complexity and opacity of these transactions, as well as having banks potentially becoming over-reliant on them. Basically, it's a question of the quality of capital, equity versus non-permanent capital, that CRTs only cover credit risks and only cover the credit risks on a specific pool of assets.

What risks are we concerned about or do you think that regulators might be looking at? So it's a couple of points here. I mean, the first is just that lack of transparency. These are private transactions.

So it's really just not a lot of information. that possible correlation of risk. The market generally does not know who was issued, on which assets transactions cover, how much protection has been transferred, what is the bank's capital benefit, and so on. Then you have that concentration of investors in both Europe as well as in US.

There's only a small number of investors providing most of the credit protection on these transactions. Therefore, if banks become more and more reliant on CRTs, and these investors no longer wish to invest at the same cost, banks will need to look for other forms of capital. Another main concern I think Daniel and something that regulators are really paying attention to is how much banks are lending to investors with security given by SRT transactions I think the key thing is that if this is done extensively, and capital ratios might be going up on the face of it, but risk is actually retained within the banking system.

And it's important to know that this is actually happening already. In our survey of European banks, we found that around 20% of the surveyed banks had lent to SRT investors with security on SRT tranches. However, this kind of creates manageable interconnectedness and correlation risk for now. And I think in the US, this has not tended to date.

This hasn't been very material and appears to be a lot less than in Europe. One final point is that we also found in our surveys that 7% of banks are actually lending against collateral referencing their own SRT transactions. Whereas in the US, and Warren, correct me if I'm wrong, we found that almost without exception, this does not occur. Also, Europe is where there are currently some not fully collateralized SRT deals, right?

Farouk, are those going to grow? And are there any concerns around that? Yeah, I mean, from our survey of 14 large European banks, we found that around 10% of the SRTs in Europe are not fully funded. And we do expect them to grow as well.

Unfunded SRTs, they have lower pricing versus fund SRTs. Investors don't have to have their cash sitting aside for a long time either. And if regulators start to broadly permit their use, particularly in light of the increasing capital requirements we mentioned previously, then we'd expect their issuance to pick up. In terms of thinking about concerns around that, it really comes down to the counterparty risk that the bank would bear and whether in the event of loss, the credit protection seller delays in providing any protection that's due.

Just to give an example, I mean, if it could be the case where you have a large insurance company that's highly rated, providing credit protection on an unfunded basis, then it could be seen to be a manageable level of counterparty risk. So what would drive growth in these CRT or SRT transactions in the future? Warren, what about from the US bank's perspective? So, considering we did, you know, responses indicate that most new CRT issuance over, you know, 2025 into 2026, it's likely going to come from banks that have already issued such transactions.

And those banks, again, you know, that have been the most active are the larger banks, the ones with $100 billion or more in assets. We expect to see maybe a few new issuers, one, two, three. But most of the respondents in our survey that have not issued CRTs said they're unlikely to do so in 2025. However, we do think that a bank's capitalization or economic capital comes under pressure, say, from increased charge-offs or higher interest rates.

We might see renewed interest in CRTs in the U.S. from U.S.

banks. Farouk, what about in Europe? What's your view of future demand for SRTs? If we think about how quickly the market has grown in Europe, that's not only driven by a need for banks to use tools for capital management, but also by strong investor demand.

And we expect this to continue from both sides, from the investor and also from the bank perspective, especially when we think about the upcoming regulatory rules that we've already discussed. And according to a recent report by the European Systemic Risk Board, The asset class has also had negligible delinquencies in Europe up to this point. So investors get a good return on their investment and banks get capital relief. A win-win.

Farouk and Warren, thank you so much for joining. And a big thank you, as always, to our listeners. Please tune in again soon for future episodes of Moody's Talks podcasts. Thanks for listening to this Moody's Talks podcast.

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