A major banking regulator moved on Friday to curb a type of financial maneuver that banks can exploit to make themselves look stronger than they actually are.
The Federal Reserve notified large banks that it was taking aim at so-called risk transfer transactions. Supporters of these complex deals say that they allow banks to protect themselves from future losses on loans or other assets. But regulators are concerned that banks may at times use them to evade the stiffer regulations that have been introduced since the 2008 financial crisis.
In its guidance, the Fed said it would “strongly scrutinize†risk-transfer deals that have a substantial impact on a bank’s balance sheet. Banks that have recently used such transactions include Citigroup, Credit Suisse and UBS. Pension funds, hedge funds and private equity firms may often be on the other side of risk transfer trades.
While risk-transfer deals have been around for years, the temptation to use them has risen as regulators have required banks to increase their capital. To get capital levels up, banks have cut their borrowing and now fund more of their operations with equity they have raised from selling shares. Such changes have made banks more stable. But some bankers claim the changes have made it harder for banks to achieve certain measures of profitability. Risk-transfer deals may offer a way for banks to bolster profits while avoiding the changes intended to make them safer.
A bank, for instance, may have entered a risk-transfer deal with a financial entity with which it is affiliated. There is a big danger with such an arrangement. If the affiliated entity cannot ultimately bear the losses that the bank has transferred in the risk-transfer deal, it may end up failing. And the bank may then have to bail out the entity because of its connection with it. In its guidance, the Fed noted that the bank would still have an “implicit obligation†to the transferred risks.
“Firms are discouraged from entering into such transactions,†the Fed wrote.
Its hard line on these types of arrangements may have been motivated by events during the financial crisis. Banks suffered big losses after they made good on obligations that arose from shadowy deals with affiliates.
The Fed, however, said it would be more tolerant of risk-transfer deals if they were struck with entities that were truly separate.
But it will still scrutinize these to make sure they do not lead to banks’ skimping on capital.
A bank may have $100 of loans, against which it has to hold $8 of capital. To free up all that capital, and get its capital requirement down to zero, the bank may do a deal that transfers the risks of all the loans to an unaffiliated entity. If that entity holds $8 of capital against the loans, regulators most likely will not object, since the entity in theory has the strength to absorb potential losses on the loans.
But if the entity that takes the risk of the loans only has $3 of capital held them, regulators will not be satisfied. They could make the bank hold $5 of capital against the loans to reflect the fact that entity does not hold the full $8 of capital against them.
The Fed said that it would scrutinize risk-transfer deals in the stress tests that it conducted on banks each year.
