OFR Urges More Transparency in Bank Capital Relief Trades

The Office of Financial Research ("OFR") argued that more transparency is needed for bank capital relief trades. OFR made its case in a paper submitted as part of its Brief Series.

Banks have "significant incentives" to reduce their required regulatory capital by transferring credit risk to third parties. OFR argues that there is scant public data to analyze such activities. While international bank regulators, through the Basel III reforms, increased the capital requirements associated with some securitization tranches, and increased banks' capital requirements for exposures to other financial firms, regulatory capital relief is still allowed for banks that obtain credit protection through the use of credit default swaps ("CDS"), total return swaps and eligible guarantees.

OFR argues that, although U.S. bank regulators revised banks' regulatory capital reporting forms in 2009 to include more information about the notional value of their credit derivative exposures, including their use for capital relief, this information does not include the impact of these transactions on risk-weighted assets or risk-based capital. The information only includes credit derivatives, not guarantees or synthetic securitizations which can also provide capital relief to banks.

The OFR paper uses this "partial data" to estimate how much capital relief banks now obtain from credit derivatives, ultimately concluding that more data is needed about CDS transactions and other types of regulatory capital relief trades for investors and counterparties to monitor and analyze their potential risks.

See: OFR Brief, "More Transparency Needed for Bank Capital Relief Trades," by Jill Cetina, John McDonough, and Sriram Rajan.