Are credit-linked notes a good way for regional banks to avoid risk?

Regional banks are turning to a new tool to free up space on their balance sheets and transfer some credit risk to non-bank investors.

These instruments, known as credit-linked notes or synthetic risk transfers, are becoming increasingly popular as regulators Try to tighten capital requirements The impact on large lenders following last spring’s banking crisis.

Through CLNs, banks bundle large amounts of loans to auto borrowers, businesses or other bank customers and issue “notes” to investors tied to the credit performance of those loans. By transferring some of the risk of borrower default to investors, banks reduce their exposure to default risk and can therefore hold smaller buffers against default risk.

Banks that have recently conducted multi-billion dollar CLN transactions include U.S. Bank Huntington Bank AG of Minneapolis, Columbus, Ohio and Santander Holdings USA, the U.S. subsidiary of the Spanish banking giant SantanderLawyers and consultants working on CLN say more such deals will follow now that banking regulators have approved the arrangements.

“I don’t think this is going away. You’re going to see more and more of this,” said Greg Hertrich of Japan’s Nomura Bank, who provides balance sheet strategy for Bank of America. Give suggestion.

Hertridge said CLN is a “very natural evolution” of the bank’s efforts to ensure capital is deployed in as many ways as possible. CLNs are similar to the credit default swaps that banks have long used effectively, although they are safer in terms of security. Banks obtain funds from investors upfront, eliminating the “counterparty” risk of investors not paying.

Their popularity caught the attention of Capitol Hill, including Democratic Sen. Jack Reed of Rhode Island. Ask the banking supervision department These transactions transfer risks outside the highly regulated banking system to less regulated non-bank investors, although some industry observers note that this trend is the result of tighter bank regulation.

Rules for banks would become even stricter under a package of proposals from the Federal Reserve and other regulators. All-out attack The proposed rules would result in a significant increase in the capital buffers banks need to hold to protect against losses from defaulted loans. Bankers said such a large increase was unjustified and would prompt them to cut lending, but regulators said it would make them safer.

But CLN’s growth has also been accompanied by loan losses, ranging from credit card arrive Commercial loans, is constantly increasing and eating into banks’ capital. CLNs offer banks a way to shed some of their risk and boost their capital levels, allowing them to better absorb losses.

Still, Warren Kornfeld of ratings firm Moody’s Investors Service warns that CLNs don’t offer the broad protection offered by ordinary capital. He believes shareholders’ equity can cover any type of loss, from loan losses to operating losses, which could result from regulatory action by regulators, cyberattacks or other unforeseen problems.

“Through the issuance, the bank’s equity will become stronger. The equity will make up for all the losses,” Kornfeld said.

He added: “Is there a place for these transactions? Possibly. But banks also need to make sure they understand in what circumstances it would be beneficial for them to do these transactions. What areas does it cover and what areas does it not cover?”

Former FDIC Chairman Sheila Bair also warnedIn times of stress, the CLN market may dry up and the risk transfer that banks rely on may no longer exist.

But Michael Bright, president of the Structured Finance Association, said, A column in the Financial Times argued By transferring risk to the broader bond market, they “provide valuable additional options for protecting the banking system.” Additionally, they open up space for banks to lend more to consumers, he added.

Banks wanting to issue CLNs have been seeking permission from the Federal Reserve, whose capital rules have long allowed banks to transfer loan risk through credit default swaps, thereby lowering capital requirements. The argument is that CLNs essentially replicate a key aspect of the credit – the default swap transaction – and should therefore be eligible for the same treatment.

The Fed has approved Morgan Stanley’s request in recent months, U.S. BankHuntington and Santander Holdings’ parent company has issued CLN in Europe, and regulators have long been open to it.

Bank lawyers and industry consultants said the Fed’s approval should lead to more activity by CLN.

“Now that they’ve become more comfortable with it, I think you’ll see these start to become more prominent,” said Greg Lyons, co-chair of the financial institutions group at law firm Dempton.

Nonetheless, the Fed did not fully open the door to CLNs and told these banks that they could not issue more than $20 billion of CLNs, or 100% of their total capital.

Michael Barr, the Fed’s vice chairman for supervision, told a Senate hearing last year that the Fed “has very strong transparency into bank transactions” and was monitoring any risks associated with third-party transactions. But he also noted that regulators are “much less visible” to hedge funds and private equity funds that bought CLN Given that they offer attractive yields and solid credit performance.

Missy Dolski, global head of capital markets at investment firm Värde, said the asset types best suited for CLN have “low loss histories, high credit quality, but very punitive risk weights.”

Car loans have become a specialty of CLN Santander, U.S. Bank and Huntington.

For example, Huntington entered into a CLN deal tied to $3 billion in prime indirect auto loans. By shifting risk off its own balance sheet, Huntington was able to shift the risk weight of its loans from 100% to 20%; so instead of having $3 billion in risk-weighted assets in its capital, it now has only $600 million RWA.

Dorsky said other bank loans with high credit performance that are suitable for CLNs include revolving credit lines extended to investment-grade companies, capital call lines provided by lenders to investment company general partners and “warehouses” provided to investment companies. loan. The mortgage companies then quickly sold the loans to Fannie Mae and Freddie Mac.

“From an investor’s perspective, you can get compensated for exposure to lower-loss asset classes that you might not otherwise have access to,” Dorsky said.

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