Banks Are Using Financial Engineering to Reduce the Risk on Loans

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(Bloomberg Opinion) — A type of financial engineering that proved to be toxic during the financial crisis is slowly making a comeback as banks try to offset the risk of their borrowers not repaying their loans.

Capital relief trades, or synthetic deals, are making a comeback — and Europe is about to refine the rules of the game. Getting those right will be crucial if we are to avoid a repeat of history.

The products all have one thing in common: They provide a cosmetic improvement to a lender’s balance sheet. They shunt the risk of a borrower defaulting away from the lender to other players in the financial system — in much the same way that loans were securitized, or sliced up and sold, before the financial crisis.

But these aren’t true disposals. Banks are, in effect, only taking out insurance against the risk of future losses by using derivatives. The actual loan remains on the books of the original bank — and the insurance allows the lender to reduce the amount of its own capital it has to set aside to cover the risk that the borrower defaults.

The incentives for both buyers and sellers of credit protection are becoming more compelling than ever. On one hand, European banks are still struggling to get their capital buffers to the levels required of them, a goal that is being complicated by the ongoing squeeze negative interest rates are putting on profits.

On the other hand, yield-hungry investors — from hedge funds to insurers — are only too keen to pick up some juicy returns in the era of, wait for it, negative interest rates.

The deals aren’t cheap. They tend to yield more than Additional Tier 1 bonds, which can be converted into shares if a bank’s capital ratio falls below a certain level.

But they do allow lenders to release a fair amount of equity without attracting public scrutiny. That’s just as well: With their valuations near record lows, banks would prefer not to raise fresh funds on the stock market.

What is far from clear is the extent to which synthetic transactions actually transfer risk given their complexity. In deals that aren’t funded, or collateralized, the buyer of the protection (the lender) remains exposed to the risk that the counterparty may not be able to make good on the pledge to cover credit losses.

Add to the mix a lack of transparency about where the risk is moving to in the financial system — the sellers of the protection tend to be more loosely regulated — and it will come as no surprise that watchdogs in the U.K. and the U.S. discourage these trades.

Because most of the deals tend to be private, bilateral agreements between banks and investors, data on the breadth and depth of the market is sketchy. Anecdotally, those active in this pocket of structured finance say that there has been a steady pickup in business over recent years. The market may have seen as much as 25 billion euros ($28 billion) of protection being sold, insuring portfolios of as much as 350 billion euros, according to data compiled by Structured Credit Investor.


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