In this advisory, we assess the regulatory and policy prospects for efforts such as the one reportedly under way at Credit Suisse to use risk-transfer structures to reduce the capital cost of operational risk. Although operational risk is generally given short shrift in capital calculations, it is a significant cost to banks such as CS that focus on investment banking, asset management, custody, and other services that are capital-light from a credit- or market-risk perspective. Any structure that reduces operational risk-based capital (ORBC) thus has significant strategic value if it can not only be pulled off in the market, but also accepted by home and host regulators.
We conclude that transactions of this sort may satisfy home-country regulators under certain circumstances under the current Basel ORBC framework (a hold-over from Basel II). However, as noted in our analysis of Basel’s ORBC rewrite (see FSM Report OPSRISK18), the Basel III ORBC standards would, if finalized, effectively bar risk mitigation, including through structured notes.
Banks focused on structured operational-risk transfers may well – and rightly – be betting that it will take Basel at least a year to finalize its new ORBC rule and that the new approach would then not demand an end to risk transfers until transition periods end in 2018 or, more likely, 2019 or 2020. They doubtless are also seeking to capture the opportunities presented by market demand for structured products (especially in Japan and other negative-rate markets) and reinsurer eagerness to find high-return product.
However, Basel has been focused for the last several years on what it calls high-risk credit transfers that, even though not directly barred, have been discouraged by unflattering global and national attention. Structured operational-risk transfers face similar sanction absent considerable care.
Importantly, operational-risk transfers have implications outside the regulated banking sector. FSOC has asset-management operational-risk on its radar and could prove more receptive to structured transfers than U.S. banking agencies, especially if the SEC favors them. The GSEs have also undertaken an extensive series of credit-risk transfers akin in several respects to what is known to date about the CS operational-risk deal. Given the significant and potentially systemic impact of GSE operational risk, the agencies and/or FHFA may well explore similar transactions if bank risk transfers succeed.
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