North American banks are increasingly using significant risk transfers (SRTs) to manage risk and support their capital ratios.

This could affect S&P Global Ratings' future analysis of banks' creditworthiness and potentially add to systemic risks.

We have published several commentaries on how SRTs--commonly referred to as credit risk transfers (CRTs)--work, European bank SRT activity, and factors we consider when assessing the creditworthiness of SRT transactions (see Related Research).

In this article, we focus on SRT activity by banks in North America and answer several common questions.

Frequently Asked Questions

Why do banks conduct SRTs?

Banks transfer risk to nonbanks for capital and risk management purposes. By purchasing credit protection (or selling a portion of the credit risk) on specific assets through SRTs, banks can lower the amount of capital they must hold against those assets and boost shareholder returns.

Banks also use SRTs to manage risk, regardless of the impact on capital. They may use SRTs--even on low risk assets--to effectively reduce their exposures and concentrations by asset type, borrower, or other metrics--sometimes to avoid breaching related internal limits.

How does S&P Global Ratings factor SRTs in its bank analysis?

We believe well-designed SRTs can reduce a bank's credit risk exposures, boost its capital, and strengthen its financial positions. However, that depends on how and to what extent the bank uses SRTs and how it deploys any capital that is freed up.

For most banks, particularly in the U.S., SRT issuance has not been substantial enough to date to materially affect our assessment of creditworthiness. Disclosure in public and regulatory filings is limited.

However, as usage grows, SRTs could affect our view of a bank's risk position and positively affect our calculation of its S&P Global Ratings risk-adjusted capital (RAC) ratio--our proprietary measure of banks' capital adequacy. While SRTs have not affected our capital analysis of U.S. banks yet, they likely will have a greater effect as issuance grows.

We also consider how a bank utilizes the risk reduction and capital improvement from SRTs. A bank could conceivably redeploy capital into new risks and potentially accelerate its growth. It could also effectively use SRTs to fund greater shareholder payouts, leaving it with a capital position that is no stronger than prior to the transactions.

What forms do SRTs take?

Banks transfer risk through a variety of strategies. They can simply sell assets or securitize them in the cash securitization market.

They can also buy credit risk protection without selling or transferring assets. In these transactions, referred to as synthetic securitizations, a financial contract ties to a specific reference asset portfolio. The reference portfolio is split into tranches with a junior or first-loss piece, sometimes a mezzanine tranche, and a senior tranche. The bank (the protection buyer) sometimes retains the risk on the junior piece and sells the risk on the mezzanine tranche (see chart 1). Alternatively, it may simply retain the risk on the senior tranche and sell a first-loss junior piece to the protection seller, a structure that appears prevalent in the U.S.

Chart 1

The two most common structures we have observed from U.S. banks are:

• Directly issued credit linked notes (CLNs): A bank issues a CLN to third-party investors as senior unsecured notes with a set maturity and interest rate. The CLN can be partially or full written down if the reference portfolio has certain credit events, allowing the bank to offset losses on the assets with forgiveness of the debt it owes.
• CLNs issued through special purpose entities (SPEs): A bank or third-party sets up an SPE, and the bank purchases protection from the SPE through a credit default swap (CDS) on a reference pool of assets. The SPE in turn issues a CLN to third-party investors tied to the same reference pool.

These strategies are funded, meaning the bank (or SPE) receives cash at the initiation of the transaction, which eliminates any counterparty risk and is an important component in receiving capital relief.

Chart 2

Chart 3

What challenges exist with SRT structuring in the U.S.?

We understand that banks in the U.S. often have sought to execute directly issued CLNs because of potential disadvantages with other risk transfer strategies.

For instance, setting up SPEs that execute CDS can trigger certain legal and regulatory implications, including registration requirements with the U.S. Commodity Futures Trading Commission.

That said, until 2023 it was unclear if directly issued CLNs were eligible for regulatory capital relief in the U.S. Under capital rules, such transactions must meet the regulatory definition of synthetic securitizations.

In September 2023, the Federal Reserve (Fed) clarified the regulatory capital relief available on directly issued CLNs. It has also affirmatively responded to letters from eight banks seeking capital relief on specific directly issued CLNs over the past year. Those banks include Ally Financial Inc. (BBB-/Stable/A-3), Huntington Bancshares Inc. (BBB+/Stable/--), JPMorgan Chase & Co. (A-/Positive/A-2), Merchants Bancorp (unrated), Morgan Stanley (A-/Stable/A-2), Santander Holdings U.S.A Inc. (BBB+/Stable/A-2), Truist Financial Corp. (A-/Stable/A-2), and U.S. Bancorp (A/Stable/A-1).

However, the Fed also placed some limitations on the use of those transactions. In each letter, it said the given bank could receive capital relief on the specific transaction and "substantially identical" transactions up to an aggregate outstanding reference portfolio principal amount of the lower of 100% of the bank's total capital or $20 billion.

Six of the eight banks were seeking capital relief on directly issued CLNs tied to auto loans. For two of those banks, we estimate that the limitation equated to more than 100% of their outstanding auto loans, suggesting they could conceivably use directly issued CLNs on substantially identical transactions to cover all or most of their auto loans. For the other four banks with auto loan transactions, the maximum allowed on substantially identical transactions would equate to 30%-80% of their auto loans.

In other words, these banks generally could transfer a substantial amount of risk on auto loans. That said, we also believe the six banks would have to ask the Fed for capital relief on directly issued CLN transactions tied to types of assets other than auto loans.

The letters to the two other banks did not indicate what types of loans were included in the reference pools.

It also appears that U.S. banks have utilized third parties to set up SPEs in certain SRT transactions. That may allow them to avoid potential legal and regulatory implications from SPEs but still realize the benefits of the SPE structure.

How quickly are SRTs growing in the U.S. banking sector?

Disclosure is limited, but third-party industry data suggest issuance is growing quickly from a small base. Outside of the banking industry, Fannie Mae and Freddie Mac have been large users of risk transfer transactions for several years.

Bank issuance appeared to pick up after the Fed clarified the capital relief available on directly issued CLNs. Prior to that, some banks had used directly issued CLNs even if the capital relief benefits were unclear.

Notably, some of the eight banks that pursued capital relief from the Fed have issued multiple directly issued CLNs. We have also seen other types of transactions.

For instance, Valley National Bancorp (BBB-/Negative/--) entered an SRT with a CDS in June 2024 related to $1.5 billion of its $1.8 billion auto loan portfolio. Huntington Bancshares has not only directly issued a CLN, but it also completed an SRT transaction with a CDS on a pool of auto loans in 2023. We believe a third-party established the SPE in that transaction and issued a CLN related to the pool of auto loans.

Still, issuance in the U.S. has likely continued to trail activity in Europe. Banks there commonly use synthetic securitizations with SPEs to transfer risk and may have faced fewer challenges to do so compared to those in the U.S.

What types of assets are U.S. banks transferring risk on and why, and how does this compare to Europe?

In recent years, banks in the U.S. have executed SRT transactions on auto loans, residential mortgages, mortgage warehouses, capital call lines, and other assets.

Many of these SRTs related to loan classes that arguably have limited credit risk, such as prime auto loans, residential mortgages, and capital call lines. We believe banks may be choosing those asset classes--despite their already low-risk nature--to reduce concentrations, for relative ease of execution, and for capital management purposes. This owes to the standardized capital requirements that apply to these assets.

Banks may view those requirements as somewhat punitive relative to the risk of the associated assets. For instance, prime auto loans and capital call lines typically carry standardized regulatory risk weights of 100%, although those asset classes have histories of low credit losses. That can make selling SRTs to third-party investors capital efficient and accretive to earnings.

The dynamic differs in Europe where banks have greater ability to use internal models--rather than standardized risk weights--to determine regulatory capital needs. As a result, corporate loans represent the largest asset class that European banks have transferred risk on.

In the U.S., in addition to the standardized approach, the largest banks also measure their risk weighted assets through an advanced approach, which allows for the use of internal models. Still, the standardized approach usually serves as their binding constraint.

In addition, there are operational challenges related to data and surveillance. A bank will have to provide substantial information on underwriting, loss histories, and ongoing payment activity. Diligence by the investor and execution of the initial SRT on an asset class can take an extended period, although this may make facilitating similar transactions easier.

Who is investing in SRTs?

Industry data suggest that credit funds have been the most common buyers of SRTs with a mix of asset managers, insurance companies, pension funds, and others accounting for the remainder.

In the U.S., SRT participants have indicated that investor demand has been high relative to the supply.

The banks selling the risk and investors buying it have viewed this as a beneficial trade for both sides. Investors can earn elevated yields on the trades with the banks viewing the capital and risk management benefits as accretive to profitability.

Are banks in Canada conducting SRTs?

Most large Canadian banks have increased the use of SRTs, primarily targeting corporate and commercial loan exposures. We expect this will continue under the country's early implementation of the final Basel 3 capital standards. Bank of Montreal (A+/Stable/A-1) has been the largest issuer of SRTs in Canada.

Chart 4

How might the implementation of the final set of Basel 3 standards affect SRTs in the U.S.?

If implementation for U.S. banks ultimately results in a tightening of capital requirements, it could incentivize further use of SRTs.

However, we are uncertain when and how U.S. regulators will implement the final set of Basel 3 standards. Furthermore, implementation may result in more conservative capital requirements on securitization exposures, which could affect the structuring and desirability of SRTs for banks.

In July 2023, U.S. regulators issued a proposal for Basel 3 implementation that they estimated would result in a significant rise in minimum capital requirements for large banks. However, Fed officials have since indicated that the original proposal could change meaningfully, resulting in a less significant rise in minimum capital requirements. It is unclear when regulators will provide further details on their plans.

The July 2023 proposal included an important change in the calculation of capital requirements relating to securitizations. All else being equal, this could force large banks to hold more capital against securitizations, including the types that result from SRT transactions. Such a change may hit the desirability of SRTs and change how they are structured and priced.

Could SRTs add to systemic risks in the financial system or provide unexpected problems for banks?

Shifting risks inside and outside of the banking sector can create new and opaque risks and add to leverage in the financial system. To date, we do not believe that SRTs in the U.S. have added materially to systemic risks, but how the market grows and evolves will be an important consideration.

For instance, we have not seen evidence of banks providing significant financing to nonbanks in aggregate to purchase SRTs, although there is a lack of reliable data. Banks providing any financing are most likely doing so on a secured basis.

The investment funds that purchase SRTs tend to have limited leverage and long-term capital commitments. Banks could provide financing to them through capital call lines (also known as subscription lines), but these are generally secured by commitments from the limited partners of the funds rather than the fund assets.

Banks could also provide financing to buyers through other types of secured funding, although this typically comes with significant haircut requirements.

We will continue to monitor how the market evolves and what risks it poses to banks and the financial system.

Related Research

• Banking Brief: Barclays And Santander Lead European Banks' Significant Risk Transfer Activity, Nov. 6, 2024
• ABS Frontiers: The Credit DNA Of Synthetic Risk Transfer Securitizations, Sept. 3, 2024
• ABS Frontiers: Looming Basel 3.1 Rules Could Incentivize More Bank Securitization, June 3, 2024
• Banks Ramp Up Credit Risk Transfers To Optimize Regulatory Capital, Feb. 22, 2024