Senate Banking Committee Member Asks Fed to Better Regulate Credit Risk Transfers
Commentary by Sebastian Souchet
Senior member of the Senate Banking Committee Jack Reed (D-RI) urged the Federal Reserve to "place additional guardrails" around credit risk transfer transactions ("CRTs").
In a letter to Federal Reserve Chair Jerome Powell, Senator Reed explained that "CRTs, also known as synthetic risk transfers, are transactions where banks pay investors, often private equity firms, to assume potential losses on loans that the banks have originated." Senator Reed warned that the volume of CRTs, "which banks use to reduce capital requirements by offloading risk to private funds," has been increasing, and poses greater risk to the banking system. This year, he said, US banks "executed around 20 transactions totaling an estimated $17 billion."
Senator Reed questioned whether CRTs genuinely transfer credit risk to outside investors or simply concentrate it among a few Wall Street banks. Citing a Reuters' article, he compared CRTs to complex and opaque financial products like collateralized debt obligations that contributed to the 2008 financial crisis. He warned that efforts to circumvent stronger capital and regulatory requirements established after the 2008 crisis could expose the financial system to new risks, particularly since banks are not required to disclose any information regarding CRTs.
Senator Reed requested the Federal Reserve:
- require public regulatory reporting through bank call reports and systemic risk reports of information regarding each bank's use of CRTs;
- establish quantitative limits on banks by (i) using CRTs to reduce capital requirements and (ii) treating CRT proceeds as unrestricted cash;
- ensure that the stress testing methodology expressly considers the ways that risk purportedly laid off through CRTs could affect the banking system in an economic downturn; and
- assess the risks associated with CRTs based on supervisory experience to date, "including an analysis of whether CRT instruments have truly laid off credit risk and are working as intended."
Commentary
CRTs have long been a topic of concern for US prudential regulators and policymakers (see, e.g., a 2015 paper from the Office of Financial Research emphasizing the need for more data on banks' CRT activities). To that point, Senator Reed's August 2024 letter to the Federal Reserve follows his November 2023 letter that also urged the US prudential regulators to "evaluate the risks associated with 'synthetic risk transfer' transactions, which allow banks to reduce their capital requirements by offloading risk to private market investors." In the November 2023 letter, Senator Reed requested that the US prudential regulators provide the following information: (i) the volume of synthetic risk transfers conducted by institutions under each prudential regulator's supervision for the each of the past ten years; (ii) the amount by which institutions have been permitted to reduce their capital over the same time period; (iii) the degree to which the identity and regulated status of a bank's counterparties affects the availability of synthetic risk transfers; (iv) whether there should be limits on how much capital can be reduced for different classes of assets, especially consumer loans; and (v) an assessment of the risks to individual banks and of systemic risks based on experience to date.