It often seems like significant risk transfer can't catch a break.
This low profile but important part of the securitization market is where banks offload multi-billion euro portfolios of loan risk to investors, usually through synthetic securitization, carving the risk into tranches.
Supporters believe SRT performs a useful function, helping banks clean out their risk portfolios, making space for fresh loans that support economic activity.
But negative media coverage and some ill-advised commentary from apparently poorly informed financial authorities has created a fraught situation around the use of leverage in SRT.
Chief bugbear for the worriers is banks lending to investors that buy the risk-bearing tranches of SRT securitizations. This is sometimes done through securities financing transactions.
Observers fear this means the risk is not really leaving the banking system.
The Lady admonishes
Every new regulatory update on the matter seems to sting practitioners, who argue that SRT is being singled out for concern. Meanwhile banks are allowed to freely finance the risks in other banks through instruments such as additional tier one capital.
Last week, the Bank of England’s Prudential Regulation Authority wrote a stern letter to the chief financial officers of regulated firms, warning them of its concerns about SRT.
“We have identified that for certain financing portfolios, banks have adopted an imprudent approach associated with the recognition of collateral for regulatory capital purposes, resulting in a potential undercapitalisation of the risks,” the letter said.
It was referring in part to banks financing SRT investments through securities financing transactions.
Essentially, the PRA is worried that some banks are including illiquid assets such as SRT tranches, repackaged into a tradeable format through SFTs, in their trading books rather than their banking books, without sufficient evidence to justify the liquidity that implies. This is allowing them to apply a lighter regulatory capital treatment.
Right track
Some in the market are certainly concerned about the PRA's move, but the regulator is well within its rights.
In fact, the market should welcome and engage with its approach.
Crucially, it accepts the principle that banks can finance SRT investments. The PRA is not questioning whether SRTs should be financed, but how that financing is capitalised.
At points during the debate on the issue, that has not been a given for all regulators.
The PRA’s letter also suggests it accepts that financing an SRT can be very different from owning the SRT directly.
A key mitigant of risk for banks financing SRT investments is that in most cases the financing is subject to daily margining.
For a bank to lose any money, the investor would need to default on its loan and then the SRT would need to fall in value by more than the calculated margin before it could be sold.
The strength of that protection clearly depends on whether a bank can margin accurately and on the speed and price at which an SRT can be sold. The more transparent and active the secondary market, the easier it is.
The PRA’s concerns are directed at precisely these issues, highlighting the risks of “collateral with material unobservable parameters, significant illiquid basis risks or other important factors which cannot be reliably modelled”.
SRT practitioners will tell you that you can sell if you must, but it might take some time and it might not be at the best price.
So far, that has applied even during periods of stress, including the recent US tariff chaos, sources say.
Further, by most accounts, it is getting easier to sell many SRTs, as deals get syndicated more broadly and issuers and shelves establish themselves.
The PRA, however, is asking for more track record to give credit to that liquidity for some assets.
The downside is that this creates a chicken and egg situation. If you take action that reduces the demand for SRT investments, you reduce their liquidity.
Watchful eye
But the PRA has to be a little cautious — prudence is in its name. SRTs, and as a result SRT financing, are growing extremely quickly. The market is not now big enough to pose a serious systemic risk and most of those involved do think it is capitalised appropriately.
It absolutely makes sense for the regulator to keep an eye on it, however, and the PRA’s approach suggests it understands where the risks could lie.
The letter concludes by asking for details of financing and how that financing is capitalised by banks.
“Subject to the responses received, we will consider the need for further engagement with firms, either on a bilateral or cross-firm basis,” it says.
It seems a sensible way to start.