Wall Street's Use of Complex Risk Trades Draws Regulatory Scrutiny
Banks increasingly use 'Significant Risk Transfers' to manage capital ahead of new rules, but watchdogs worry about hidden dangers.
Major global banks are increasingly turning to a complex form of financial engineering to free up capital, a move that is drawing intensifying scrutiny from regulators in both the U.S. and Europe. The instruments, known as Significant Risk Transfers (SRTs), are being used by Wall Street giants like JPMorgan Chase, Goldman Sachs, and Morgan Stanley to navigate stricter capital requirements, but they are also raising concerns about a potential buildup of hidden risks outside the traditional banking system.
SRTs allow a bank to sell the credit risk associated with a portfolio of loans—from corporate debt to mortgages—to outside investors such as private credit funds, asset managers, and other specialized financial institutions. By transferring this risk, banks can reduce their risk-weighted assets (RWAs), the denominator in the equation used to determine how much capital they must hold. The less RWA a bank has, the less capital it needs to back its lending operations, making it a powerful tool for balance sheet efficiency.
The use of these instruments is accelerating as the industry braces for the implementation of the “Basel III endgame” rules, which are expected to significantly increase capital requirements. According to analysis from Neuberger Berman, the proposals could swell RWAs by 20-25% for the largest U.S. banks, creating a powerful incentive to find capital-efficient solutions like SRTs.
The global SRT market is expanding rapidly to meet this demand. Issuance in 2024 is projected to reach between $28 billion and $30 billion, with some industry experts suggesting the market is on a “road to $200bn,” according to a report from Pemberton Asset Management.
However, this boom has not gone unnoticed by regulators. Their primary concern is whether the risk is truly and completely transferred from the bank's balance sheet. Watchdogs worry that in a moment of crisis, complex contractual obligations or reputational damage could leave banks exposed to the very risks they believed they had offloaded. This echoes the concerns that arose from the structured financial products at the heart of the 2008 financial crisis.
Furthermore, regulators are grappling with the opacity of the market. As risk moves from highly regulated banks to the less-regulated world of private credit and asset management, it becomes harder to monitor potential systemic vulnerabilities. The European Banking Authority (EBA) has recently warned about the potential for “circles of risks,” where banks might be indirectly funding the very investors who are buying the risk from other lenders. Both the EBA and the International Monetary Fund have called for a global supervisory investigation into the systemic threats posed by the burgeoning SRT market.
The debate places the financial industry at a familiar crossroads, balancing the need for innovative tools to manage capital and support lending against the regulatory imperative to prevent the next systemic crisis. As the SRT market continues its rapid growth, banks can expect further scrutiny and calls for greater transparency from watchdogs on both sides of the Atlantic.