WASHINGTON, DC – In an effort to strengthen the U.S. banking sector, protect the U.S. economy and investors, and hold banks accountable, U.S. Senator Jack Reed (D-RI) is urging top federal regulators to scrutinize the risks associated with ‘synthetic risk transfers’ – exotic transactions that allow banks to reduce their capital requirements by offloading risks to the opaque private market.

“I’m concerned we could be seeing a return to the pre-2008 exuberance through exotic forms of financial engineering, unless the banking agencies take a comprehensive and rigorous look at the risks.  These new transactions are different than the 2008 ones in critical ways, but the risks may yet not be fully understood,” said Reed, a senior member of the Senate Banking Committee, who sent a letter to Michael Barr, the Federal Reserve’s vice chairman of supervision, along with Federal Deposit Insurance Corporation (FDIC) chief Martin Gruenberg, and the acting head of the Office of the Comptroller of the Currency (OCC) Michael Hsu, urging the financial regulators to evaluate systemic risk associated with synthetic risk transfers. 

“I write to urge the banking agencies 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. I am concerned that synthetic risk transfers may not be conducted in a safe and sound manner by the banks under your supervision and that they may increase risk across the financial system,” Reed wrote.

“According to industry reports and recent Federal Reserve legal interpretations, banks’ interest in synthetic risk transfers have picked up in recent months and years. These complex arrangements are a potentially lucrative way for banks to arbitrage the capital rules by selling debt instruments or derivatives to unregulated nonbanks who assume the risk that a consumer or corporate borrower will default on a loan. While synthetic risk transfers are generally permitted, they have been strongly disfavored since the 2008 financial crisis when abuse of similar transactions magnified and obscured risks leading to devastating economic consequences,” Reed continued.  “Without a full assessment of the risks associated with synthetic risk transfers, I am concerned that widespread efforts to avoid stronger capital requirements put in place as a response to the 2008 crisis could expose the financial system to new risks.”

Reed’s letter notes the risks fall into two categories:

“First, synthetic risk transfers move risk outside the banking system into opaque private markets where it may not be adequately managed and cannot be properly measured. Private market investors who assume credit risk from banks include private equity funds, hedge funds, private credit funds, and other big nonbank financial institutions. They are not subject to consolidated regulation and supervision, do not need to meet risk management requirements, and do not need to make public disclosures. While synthetic risk transfers are purportedly designed to diversify and disperse credit risk among many players in the financial markets, these transactions may in fact have the opposite effect by concentrating risk among a small number of very large shadow banks.

“Second, synthetic risk transfers can encourage more risk-taking by banks. These transactions may free up additional capacity for banks to make more loans. But when risks of defaults and losses are shifted onto others, banks have fewer incentives to make prudent loans and to monitor how those loans perform. Instead of making additional loans, banks could take advantage of lower capital requirements through buying back shares or paying dividends to shareholders. But that may leave banks less able to absorb losses in a crisis.”

Given these potential risks, Reed is asking financial regulators to “take a very careful and judicious approach to synthetic risk transfers.”

He requested the following information from the Fed, the FDIC, and the OCC:

“1. Volume of synthetic risk transfers conducted by the institutions under your supervision for each of the past ten years.

2. The amount by which institutions have been permitted to reduce their capital over the same time period.

3. The degree to which the identity and regulated status of a bank’s counterparties affects the availability of synthetic risk transfers.

4. Whether there should be limits on how much capital can be reduced for different classes of assets, especially consumer loans.

5. Assessment of the risks to individual banks and of systemic risks based on experience to date.

Finally, if the banking agencies notice a significant increase in the use of synthetic risk transfers, I urge you to initiate a notice-and-comment process that would provide both for public input and for a public explanation by the agencies of their positions.”

Reed’s letter comes on the heels of a Banking Committee hearing earlier this month where he asked Barr, Gruenberg, and Hsu about oversight of synthetic risk transfers:

JACK REED: Well, thank you very much, Mr. Chairman. And I would note that the Federal Reserve recently approved synthetic risk transfers in which banks use derivatives to reduce their capital requirements by shifting risk of losses onto private equity funds and hedge funds having survived the 2008 and Dodd Frank when I hear derivatives, I get nervous.

When I hear synthetic, I get very nervous. Mr. Barr, what are the risks of the financial stability of banks are permitted to engage in these synthetic risk transfers on a significant scale and what guardrails are appropriate to protect the financial system and ensure that we don't relive the past?

MICHAEL BARR: Thank you, senator. It's an important question. We looked carefully at these sets of transactions. The transactions are different from transactions that we permit by rule under the existing authorities to offset credit risk that banks might face. We wanted to take a careful and cautious approach with respect to these transactions.

So we have approved them on a case-by-case basis subject to limitations. We're going to wait and see how those instruments perform. If they perform as intended, then they might be more generally available. If we see risks arising in those transactions, then we would limit their use for capital mitigation.

JACK REED: How much visibility do you have in the private equity and hedge funds that are involved in these transactions?

MICHAEL BARR: We have very strong visibility into the bank side of the transaction that is how the bank engages with third parties with respect to these risks. We'll be monitoring those risks. We have of course much less visibility into hedge funds and private equity funds. That is a long-standing issue in supervision.

JACK REED: Well, you know, I think you have to have really good perception of both sides of the transaction to conduct these because there's a possibility that one of the private equity firm could -- could be undercapitalized or mismanaged and the transactions would fail.

MICHAEL BARR: In these particular transaction, senator, the transaction that we approved, the cash is actually provided upfront to the bank and then it diminishes over time as the -- as the credit continues to perform. So in these particular transactions, I agree with you that that's a general concern. But in these particular transactions, the cash is actually provided at the beginning of the transaction rather than at the end of the transaction.

JACK REED: Thank you. Mr. Gruenberg and Mr. Hsu, do you see any risk to the financial system in these types of synthetic risk transfers?

MARTIN GRUENBERG: I think there is considerable uncertainty and we need to approach it with great caution and attention, senator.

JACK REED: Thank you.  Mr. Hsu?

MICHAEL HSU: So I agree. They do require heightened attention, especially when risk transfer is thought of as risk elimination, which is not. However when done appropriately in a safe and sound manner with controls, it can help to be part of an effective risk management program, but that does require a careful look.

Full text of the letter follows:

November 29, 2023

Dear Vice Chair Barr, Chair Gruenberg, and Acting Comptroller Hsu:

I write to urge the banking agencies 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. I am concerned that synthetic risk transfers may not be conducted in a safe and sound manner by the banks under your supervision and that they may increase risk across the financial system.

According to industry reports and recent Federal Reserve legal interpretations, banks’ interest in synthetic risk transfers have picked up in recent months and years. These complex arrangements are a potentially lucrative way for banks to arbitrage the capital rules by selling debt instruments or derivatives to unregulated nonbanks who assume the risk that a consumer or corporate borrower will default on a loan. While synthetic risk transfers are generally permitted, they have been strongly disfavored since the 2008 financial crisis when abuse of similar transactions magnified and obscured risks leading to devastating economic consequences.

Without a full assessment of the risks associated with synthetic risk transfers, I am concerned that widespread efforts to avoid stronger capital requirements put in place as a response to the 2008 crisis could expose the financial system to new risks. These risks seem to fall into two categories.

First, synthetic risk transfers move risk outside the banking system into opaque private markets where it may not be adequately managed and cannot be properly measured. Private market investors who assume credit risk from banks include private equity funds, hedge funds, private credit funds, and other big nonbank financial institutions. They are not subject to consolidated regulation and supervision, do not need to meet risk management requirements, and do not need to make public disclosures. While synthetic risk transfers are purportedly designed to diversify and disperse credit risk among many players in the financial markets, these transactions may in fact have the opposite effect by concentrating risk among a small number of very large shadow banks.

Second, synthetic risk transfers can encourage more risk-taking by banks. These transactions may free up additional capacity for banks to make more loans. But when risks of defaults and losses are shifted onto others, banks have fewer incentives to make prudent loans and to monitor how those loans perform. Instead of making additional loans, banks could take advantage of lower capital requirements through buying back shares or paying dividends to shareholders. But that may leave banks less able to absorb losses in a crisis.

Given these potential risks, I believe the banking agencies should take a very careful and judicious approach to synthetic risk transfers. In particular, I request the following information:

1. Volume of synthetic risk transfers conducted by the institutions under your supervision for each of the past ten years.

2. The amount by which institutions have been permitted to reduce their capital over the same time period.

3. The degree to which the identity and regulated status of a bank’s counterparties affects the availability of synthetic risk transfers.

4. Whether there should be limits on how much capital can be reduced for different classes of assets, especially consumer loans.

5. Assessment of the risks to individual banks and of systemic risks based on experience to date.

Finally, if the banking agencies notice a significant increase in the use of synthetic risk transfers, I urge you to initiate a notice-and-comment process that would provide both for public input and for a public explanation by the agencies of their positions.

Thank you for your attention to this matter, and I look forward to your prompt reply.

Sincerely,