Last week, several press reports slammed synthetic credit risk transfers (CRTs) on grounds that the biggest U.S. bank in this sector which is of course the biggest global bank ever – JPMorgan – is creating new and serious risks when it scores SCRTs. It’s easy to assume that anything “synthetic” is more dangerous than the “natural” way a bank absorbs credit risk, but this is simply not the case as a whole lot of financial crises make all too clear. SCRTs are a rare example of a complex structured deal that gives the issuing bank a safe, sound way to reduce its capital requirements. Regulatory arbitrage, yes, regulatory evasion, no. The real risk SCRTs actually pose lies in the way some banks are using “natural” credit – i.e., loans – to lever up SCRT investors in ways dangerous to everyone but the SCRT issuer.
Let me explain. FedFin laid out how SCRTs work in a September 2023 report following conditional FRB approval of the first of these deals since the great financial crisis. One of the hard-learned GFC lessons was that structured financial instruments can be toxic due to opacity to regulators, counterparties, and even bank sponsors. Given this, the regulator’s SCRT okay has several significant strings attached.
Most importantly, the bank making use of the credit-linked notes (CLNs) usual in these deals must issue the notes via a bankruptcy-remote vehicle and get cash or like-kind collateral to enjoy any regulatory-capital offset. In short – and this is very short given SCRT complexity, these deals are no riskier to the issuing bank than any other credit exposure backed by high-quality collateral.
This is not to say that SCRT is risk-free. For the issuing bank, collateral could be rehypothecated or otherwise elusive when needed. This is, though, a risk common to all collateral, not just that backing SCRT.
So far, so good for SCRTs, but there’s a catch: non-issuing banks are increasingly lending to SCRT counterparties so these investors can leverage up the returns they expect from the SCRT position. The SCRT position is usually the collateral for these loans, but this collateral is far, far less sure than the cash-equivalents backing the issuer’s exposure to the SCRT investor. As a result, the bank may reduce its risk a bit with SCRT collateral, but its regulatory-capital requirement is unchanged from what it would have been without this high-risk collateral.
And a good thing too. At the least, a SCRT investment is subject to significant valuation uncertainty and almost-certain illiquidity, especially under stress. Further, just as an issuing bank might rehypothecate its SCRT collateral, an investor might double- or triple-pledge its SCRT position. An issuing bank should be able to replace temporarily-misplaced collateral because cash equivalents are highly liquid and readily available in the repo market; opaque, idiosyncratic SCRT collateral, not so much.
Just because banks do something that looks risky because it’s new, structured, complex, and confusing doesn’t mean the bank is actually taking on undue risk. Conversely, just because a bank is doing something that comes naturally such as making a loan doesn’t make it safe. I’m not the least bit sure highly-leverage SCRT investors know what they’re buying to get the high returns they expect, but that’s on them. Or it should be – God save us from another Fed bailout of investors who should know what they’re doing and thus pay the price for doing it wrong.