Significant Risk Transfers (SRTs)

A fundamental risk of banks is that they make long-term loans with short-term deposits. This creates problems if too much money is withdrawn by depositors within a short time, such as occurs with bank runs.

Banks profit from the small difference between the interest rates they charge for lending and the interest rates they pay for deposits. To increase profits, banks use considerable leverage. To help prevent bank failures, bank regulators require banks to hold significant capital to pay for potential losses. This reduces profitability, but banks can reduce potential losses and increase their profitability by offloading some of their credit risk to investors.

Some of their loans, such as mortgages, are securitized and sold as mortgage-backed securities, which are sold to the public. Banks are also selling some of their credit exposure to private credit firms and other alternative lenders, who have long-term capital, such as from pension funds or insurance companies. These transfers of risk are referred to as synthetic risk transfers or significant risk transfers, usually shortened to SRTs.

SRTs have gained in popularity as governments have been imposing tougher capital requirements of banks, based on the Basel III endgame. The Basel Committee on Banking Supervision is a panel convened by the Bank for International Settlements (BIS) in Basel, Switzerland, provided global regulators guidance as to minimum capital standards and other recommendations, so that banks can withstand loan losses during economic downturns. The Basel III endgame is a result of careful considerations in how to prevent bank failures in the aftermath of the Great Recession in 2007 to 2009. Before the Great Recession, banks relied on internal models that did not adequately assess risk, so the Basel committee recommended standardizing models for assessing bank risks and requiring that any internal models be approved by regulators. These risk models must also be based on the amount and kind of trading conducted by the bank and on the bank's historical losses.

SRTs help to reduce bank capital requirements. SRTs have been used longer in Europe since about 2009, but they are becoming more popular in the United States. SRTs are individually negotiated by private credit firms or institutional investors, such as pensions and insurance companies.

The terms of the SRT are negotiated between the issuing bank and investors. Buyers may negotiate for SRTs based on loans based on ESG guidelines or by excluding specific industries on so-called blacklists or by requiring minimum credit ratings on the underlying loans.

SRTs shift a small percentage, ranging from 5% to 15% of 1st losses on a pool of loans on the bank's balance sheet, to investors, who are essentially selling credit default protection. In return for assuming some of this risk, investors can earn more than a 10% return.

Banks create credit-linked notes to insure losses of up to about 15% of a group of loans, then sell these notes to private investors who earn 9.5% to 12%, paid quarterly or monthly. But some SRT transactions are based on guarantees rather than on the purchase of SRT notes, so the buyer would only have to pay for defaults. The payments to investors are premiums paid by the bank, not by the cash flows from the underlying loan portfolio. However, the risk may vary during the term of the contract; its value may drop if there are defaults within the portfolio.

Many SRTs are based on blind loan pools, where the borrowers are not disclosed. Even with their greater risk, demand is so strong that SRTs based on blind pools pay as little as 0.2% more than SRTs with disclosed borrowers. Buyers of SRTs based on blind pools rely on loss-based assumptions and ratings provided by the issuing bank. Investors should scrutinize replenishment clauses that may allow banks to replace maturing loans with loans of lesser credit quality.

SRTs are not part of the bank's liabilities. They are a credit hedge referencing a specific portfolio on the bank's balance sheet. This protection is based on collateral posted by the buyer with either the issuing bank or a third-party bank.

While collateral lowers SRT risk for the bank, some banking authorities are concerned with buyers using leverage to buy SRTs to increase the returns since an economic downturn could cause many defaults, which could cause a negative feedback loop where buyers could default on loans, creating an additional risk in addition to the defaults on the underlying loans. Nonetheless, SRTs help to increase bank profitability, and there have not been any significant problems in Europe, so SRT's may be used more to mitigate the burden of increased capital requirements.