Major financial institutions devise innovative methods to mitigate risk

Sat Apr 06 2024
Ramesh Sridharan (917 articles)
Major financial institutions devise innovative methods to mitigate risk

U.S. banks have discovered a fresh method to offload risk as they work to adjust to stricter regulations and increasing interest rates.

According to insiders, JPMorgan Chase, Morgan Stanley, U.S. Bank, and other financial institutions are offering intricate debt instruments to private-fund managers. This strategy aims to lower the regulatory capital charges associated with the loans they provide.

These synthetic risk transfers can be quite costly for banks, although they are still more affordable than bearing the full capital charges on the underlying assets. According to insiders, these investments can be quite profitable for investors, often yielding returns of 15% or higher.

U.S. banks refrained from entering the market until this autumn, when they issued an unprecedented amount in order to alleviate their increasing regulatory burden.

“We must accept it as they have the authority to make decisions,” commented JPMorgan Chief Executive Jamie Dimon when questioned about the impact of new capital regulations at an investor conference in September.

Regulators have been steadily increasing capital requirements for a considerable period of time, and they have recently put forth even more stringent measures in response to the banking panic that commenced in March. Increased interest rates are gradually diminishing the worth of banks’ investment portfolios, potentially impacting their regulatory capital levels.

Investors typically exchange cash for credit-linked notes or credit derivatives issued by the banks in these risk transfers. Approximately 10% of the loan portfolios being de-risked consist of notes and derivatives. Investors receive interest in return for assuming the risk of potential losses in case borrowers, representing approximately 10% of the pooled loans, fail to repay.

JPMorgan has been involved in a series of deals worth $2.5 billion in recent months, aimed at reducing capital charges on approximately $25 billion of its corporate and consumer loans, according to insiders.

The deals operate in a manner similar to an insurance policy, where the banks pay interest instead of premiums. By reducing potential loss exposure, the transfers decrease the amount of capital banks need to hold against their loans.

According to an analysis by ArrowMark Partners, a Denver-based firm specializing in risk transfers, it is projected that banks worldwide will transfer risk associated with approximately $200 billion of loans this year, which is an increase from the previous year’s estimate of about $160 billion.

Private-credit fund managers, such as Ares Management and Magnetar Capital, are actively purchasing the deals, as per individuals familiar with the matter. According to sources, several firms, such as Blackstone’s hedge-fund unit and D.E. Shaw, have recently launched a new strategy or raised a fund specifically focused on risk-transfer trades.

These deals represent a significant change on Wall Street, as alternative investment firms such as hedge funds and private-equity firms are playing a more prominent role in shaping the functioning of finance.

Private-credit investment managers may not have the same level of fame as the big banks, but they have emerged as strong competitors, gradually assuming control of essential sectors like corporate lending. The companies have also been acquiring the banks’ portfolios of mortgages and consumer loans.

After the 2008-09 financial crisis, the utilization of synthetic risk transfers in the U.S. significantly declined, despite being adopted by banks approximately 20 years ago. Complex credit transactions faced increased scrutiny from U.S. bank regulators, partly due to the role of credit-default swaps in exacerbating contagion during the collapse of Lehman Brothers.

Regulators in Europe and Canada established precise guidelines for the utilization of synthetic risk transfers following the crisis. In response to the implementation of Basel III regulations, European and Canadian banks have increasingly adopted the use of synthetic risk transfers.

The regulations in the United States have taken a more cautious approach. In 2020, the Federal Reserve rejected capital relief requests from U.S. banks seeking to utilize a form of synthetic risk transfer that is frequently employed in Europe. The Fed concluded that they did not adhere to its regulations.

“The duration of the impasse remained uncertain,” commented Kaelyn Abrell, a partner at ArrowMark.

There was a noticeable relief this year as the Fed indicated a shift in their approach. The regulator stated that it would carefully consider requests to approve the type of risk transfer on an individual basis, but did not choose to adopt the European approach.

In September, the Federal Reserve granted capital relief for a new credit-linked note structure at Morgan Stanley. Additionally, the Fed addressed some of the questions raised by banks regarding risk transfers.

According to insiders, prior to the recent change, certain banks were growing more and more frustrated with the Fed’s hesitancy. In recent years, the tension has been on the rise due to the implementation of new regulations, such as the capital requirement linked to annual stress tests.

During 2022 and 2023, the banks experienced a decline in the value of bonds due to the impact of higher interest rates. This also had an impact on the regulatory capital levels of the major banks.

Additional regulations regarding capital are forthcoming. In the summer, U.S. bank regulators unveiled a proposal to enhance the implementation of Basel III requirements. This proposal has the potential to raise capital charges by approximately 20% and impose penalties on businesses that generate significant fees, such as banks’ wealth-management and trading divisions. The outcome of the Basel Endgame was more stringent than anticipated by certain banks, leading them to suspend stock buybacks.

Ramesh Sridharan

Ramesh Sridharan

Ramesh Sridharan is our Stock Market Correspondent covering events and daily movements of stock markets in Asia. He is based in Mumbai