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Opinion Credit
In September, the Fed said financial institutions could transfer risk to SPVs
by Duncan Sankey
Duncan Sankey
Portfolio director and head of credit research
Cheyne Capital
The Fed’s reading of Basel 3.1 could double capital requirements — so it’s just as well it is softening on risk transfers
A recent Bloomberg article alluded to the possibility, as yet unconfirmed, of Wells Fargo issuing a significant risk transfer (SRT) transaction to seek capital relief on a portfolio of subscription lines (credit extended to private equity). This follows the Fed reportedly granting authorisation last year for an SRT to be issued by Morgan Stanley.
While Europe — where the product has been around for two decades — accounts for the bulk of the roughly USD 500bn of SRTs outstanding, the entrance of US banks into the fray could constitute a huge enlargement of the addressable market. Regulatory developments underpin both the US banks’ desire to seek capital relief through SRTs and their ability to do so.
Of all the factors weighing on US banks to raise capital, the most daunting is the interpretation of Basel 3.1 (“Basel 3.1 Endgame”) by the Federal Reserve, FDIC and Office of the Comptroller of Currency (which is to be implemented from 1 July 2025). SIFMA/ISDA’s quantitative impact studies suggest that proposals in their current format relating to the fundamental review of the trading book could raise capital requirements by 73% under a modelled approach and by over 100% under a regulator-set standardised approach, with still higher capital requirement uplifts for individual businesses. In addition, proposals for counterparty credit risk and CVA risk frameworks could, according to the impact studies, raise capital requirements on derivatives and security financing transactions businesses by 25%.
Haircut floors may impact US bond liquidity
Among the most contentious parts of the proposal is the plan to oblige banks to require a minimum amount of collateral (‘a haircut floor’) from unregulated financial institutions for certain securities financing transactions that are not centrally cleared. Such floors are almost entirely excluded from the implementation of Basel 3 in the EU/UK, and their deployment in the US could impact bond liquidity and stymie the USD 5tn US repo market.
Other studies (Morgan Stanley/Oliver Wyman) contend that the planned approach to Basel 3.1 in the US could burden US wholesale banks disproportionately, leading to a risk-weighted asset uplift of 35% compared to only 15% for their EU peers. The total addition for the largest US banks could, including CVA and operational risk treatment, aggregate to as much as USD 1.8tn and constitute a six point drag on earnings (without business adaptations) at a time when bank valuations are already languishing.
There is good reason to think the final impact on capital requirements will be less swingeing than these numbers suggest. The banking industry is fighting an aggressive rearguard action against the proposals and would appear to have the ear of Fed chair Jerome Powell. He castigated the proposals as “unlike anything I have ever seen” and intimated that Basel 3.1 Endgame faces “broad and material changes”. Even the Fed’s vice-chair of supervision Michael Barr, who is spearheading the initiative, is allegedly open to concessions. However, the initial proposal — a key Biden policy initiative — did clear and the flurry of bank runs last spring has added to the impetus for more exacting capital requirements.
Fed re-evaluates SRTs for capital relief
If and when US banks need to react to more demanding capital requirements, it seems the Fed has made it easier to do so using SRTs. Although the Fed had soured on SRTs — due in part to poor recovery on the credit-linked notes of some institutions that unspooled in the Great Financial Crisis — in September 2023 guidance it acknowledged that a financial institution could transfer the risk of a portfolio of on-balance sheet exposures to a special purpose vehicle (SPV) using credit derivatives. The Fed also said that the institution could recognise the credit risk mitigation of the collateral from the cash proceeds of the note issued by the SPV, as long as the deal met the Fed’s definition of a synthetic securitisation.
The path would therefore appear open for US banks to avail themselves of the growing SRT market, with benefits for banks and investors alike.
