Banks are increasingly using financial instruments called synthetic risk transfers (SRTs) to manage their lending and balance sheets more efficiently. Although the name sounds complex, the SRT concept is straightforward: banks transfer the credit risk of certain loans to other investors while keeping the loans on their books. This allows them to maintain valuable customer relationships while reducing balance sheet constraints.
This arrangement has become particularly appealing when regulatory capital requirements significantly exceed the actual risk of the loans. Consider prime auto loans, for example. Regulators require banks to treat these loans as relatively risky assets, but the historical data show they actually perform quite well. Moreover, the capital requirement for an auto loan to a customer with a perfect credit score is the same as for a borrower who frequently misses car payments and therefore has a much lower credit score. This disconnect between required capital and actual risk creates an incentive for banks to either reduce their lending or find ways to better align their capital with the true risks.
In this blog post, we examine how these synthetic risk transfers work and why they make economic sense for banks, and consider their potential benefits for credit availability. Using a real-world example from a recent bank transaction, we demonstrate how SRTs can help banks continue making profitable loans while maintaining appropriate risk-management practices.
As shown in the case study, the economics are compelling: a bank could increase its return on equity (ROE) from 9 percent to 13 percent on a prime auto loan portfolio by using an SRT, while simultaneously reducing its risk exposure. The transaction makes sense because the reduction in capital costs (approximately $15.5 million in the example) exceeds the cost of credit protection ($5.5 million). Moreover, the bank can then deploy the freed-up capital on other profitable opportunities.
ROE: The Preferred Measure of Bank Profits
Let’s look first at how increased capital requirements, such as those originally proposed under Basel III Endgame, create incentives for banks to reallocate their scarce capital to business segments whose profitability is not diminished by regulatory changes.
Return on equity (ROE) is the primary measure of profitability used by banks and therefore the one we use here.[1] ROE is widely considered the most effective measure of bank performance and the best predictor of shareholder value creation. Banks with higher ROEs benefit from stronger internal capital generation and greater free cash flow, allowing them to either reinvest in their business or distribute surplus capital to shareholders. As a result, investors assign higher price-to-tangible book value (P/TBV) multiples to banks with higher ROEs, reflecting their potential for faster book-value growth.
Figure 1 illustrates the relationship between return on tangible common equity (ROTCE) and P/TBV for banks with total assets above $100 billion. ROTCE is a more refined profitability measure than ROE. This increased precision results from the exclusion of intangible assets (such as goodwill and other intangible assets) and preferred equity from its denominator, thereby focusing solely on tangible common equity that can be readily valued.
The line graph in Figure 1 shows a strong positive correlation between ROTCE and P/TBV multiples, indicating that banks generating higher returns on their tangible equity generally have higher market valuations. Although not explicitly shown in the graph, another crucial factor influencing investor valuations is ROTCE’s volatility. Banks that consistently deliver both higher and more stable ROTCEs tend to generate superior shareholder returns over time. Conversely, institutions with more volatile ROTCEs typically receive lower valuations from investors. This pattern reflects investor preference for predictable, sustainable earnings streams over more volatile returns.
ROE and Capital Requirements
How do increased capital requirements reduce bank profitability and create incentives for banks to shift their capital to other assets? Let’s use prime auto loans to illustrate the answer.
Under the standardized approach (SA), all prime auto loans currently have a risk weight of 100 percent. However, when banks use their own internal models under the advanced approaches (AA), the risk weight assigned varies with the loan portfolio’s risk level. For a bank with an auto loan portfolio having an average FICO score above 740, the risk weight would be significantly lower: about 33 percent. Table 1 compares the ROEs of these two approaches.
Let’s consider a bank with a $3 billion loan exposure and a 7 percent capital requirement.[2] We’ll assume a CECL charge of 1.5 percent of the loan amount.[3] When using the standardized approach with a 100-percent risk weight, the required capital is $255 million. In contrast, with the internal model’s 33 percent risk weight, the required capital drops to $114 million. Since the actual risk is identical, the post-tax spread charged to customers (net of expenses) remains the same at 0.75 percent (or 75 basis points). However, because the required capital is much lower under the internal models, the ROE differs significantly: 9 percent when using the 100 percent risk weight under the standardized approach, versus 20 percent when using the risk weight that better reflects the actual exposure risk.
This example demonstrates why regulatory capital increases unaligned with actual risk discourage banks from making certain types of loans. This is the core issue when regulators increase capital requirements for U.S. banks in a way that isn’t tied to exposure risk. When risk and capital requirements diverge and overcapitalize the risk, banks respond to these incentives by either pulling back on credit availability to those exposures or looking for ways to better align capital requirements to risk exposures. Of course, if capital requirements are closely tied to risk, ROEs would be higher because banks charge wider spreads on riskier loans.
Synthetic Risk Transfers at Work
An SRT allows a bank to reduce its risk exposure by hedging that exposure through credit derivative transactions. This structure offers dual benefits: the bank reduces risk-weighted assets while keeping the underlying loans on its balance sheet, which preserves their client relationships; and the decrease in RWA raises the loan portfolio’s ROE.[4] This transaction is especially beneficial when the portfolio’s actual credit risk is considerably lower than what is implied by regulatory capital requirements (e.g., prime auto loans and jumbo mortgages).
In the United States, SRTs are typically structured as fully funded transactions, where banks receive the entire protection amount in cash at inception, often through proceeds of a credit-linked note (CLN) or other derivative transaction (Figure 2). The CLN can be issued through one of two methods: either directly by the bank itself, or through a special purpose entity (SPE). When using a SPE structure, the transaction does not require regulatory approval, and the cash proceeds need to be deposited in a dedicated trust account. This feature protects investors from the risk of potential bank failure.[5]
When the bank issues a CLN, it agrees to pay investors a return that compensates them for taking on a portion of the loan portfolio’s credit risk. This return varies with the underlying loan risk, typically ranging from a spread relative to the relevant reference rate (depending on whether the rate is fixed or floating, but usually SOFR) from 2 percent for prime auto loans to up 15 percent for leveraged finance.[6] The bank’s repayment to counterparties is contingent on the loan pool’s performance. If loans default, the principal amount owed to investors is reduced by the realized loss. While the bank continues to pay interest on the debt, it does so based on this lower principal balance.
The bank may choose to retain the first loss position of the loan pool to be able to negotiate a lower risk premium to investors for the transfer of credit risk. The size of the risk protection tranche is determined by the loan pool characteristics and the risk-weight of the exposures. This is typically structured to achieve the lowest risk weight permitted under the Simplified Supervisory Formula Approach.[7] For a reference portfolio containing loans with a 100 percent risk weight, a 20 percent risk weight on the senior tranche is usually achieved by setting the tranche thickness to 12.5 percent. In the example we discuss next, we set the first loss at 1.5 percent and the risk protection (mezzanine tranche) at 11 percent.[8]
The upfront funding of CLNs also eliminates counterparty credit risk: the bank holds the cash and can retain it if the counterparty defaults. This represents a positive distinction from the structures used before the Global Financial Crisis.
The Economics of SRTs: Prime Auto Loans
In this section, let’s return to our example of prime auto loans to describe the economics of SRTs, which closely resembles a recent SRT transaction conducted by a large regional bank in the second quarter of 2024.[9]
In the transaction outlined in Figure 3, the bank has a $3 billion portfolio of prime auto loans. To achieve a 20 percent risk weight for the senior tranche, the advance rate (or senior tranche thickness) is set at 87.5 percent. This means about $2.6 billion of the exposure carries a risk-weight of 20 percent. The bank retained the first loss position of 1.5 percent, subject to a 1,250 percent risk weight.[10] The mezzanine tranche is hedged through a CLN sold to investors, with the proceeds deposited in a cash collateral account at a custodian bank. As a result, the post-trade risk-weight of the $3 billion exposure decreases from 100 percent to 38 percent.[11]
Post Trade RW = (1.5% x 1250%) + (87.5% x 20%) + (11% x 20%) = 38%
As shown in Table 2, the risk-weighted assets would decrease from $3 billion pre-trade to about $1.2 billion post-trade. Under the same assumptions as before, this reduces the required capital from $255 million to $124 million, with a cost of capital of $15.1 million.
According to the quarterly earnings report, the bank pays investors a fixed interest rate of 7.2 percent with a weighted average maturity of nearly two years. Based on the prevailing two-year SOFR rate, the spread on the CLNs is about 2.4 percent. The cost of credit protection, on a post-tax basis, amounts to $5.5 million, or 18 basis points of the $3 billion exposure.[12]
Cost of credit protection = (1 – 0.30) x 2.4% x $330M = $5.5M
Although the cost of credit protection slightly reduces the bank’s implied net income, the capital relief enhances the return on equity for the prime auto-loan portfolio. In this example, we show that by engaging in a SRT transaction, a bank could increase its ROE from 9 percent to 13 percent. Moreover, the bank’s risk from the loan portfolio is lower.
However, under the 33 percent risk weight scenario, the bank would lack the incentive to engage in the SRT transaction and incur the cost of credit protection, since the ROE of this loan portfolio would already be at 20 percent.
An alternative way banks assess whether to proceed with a SRT is to simply compare the reduction in the cost of capital against the incremental cost of credit protection. As shown in Table 3, the $15.5M reduction in capital cost exceeds the $5.5M cost of credit protection. In addition, the bank’s decision will depend on how profitably it can deploy the freed-up capital.
Conclusion
We’ve discussed how, when regulatory capital requirements significantly overstate the risk of loan portfolios, SRTs allow banks to continue to make such loans and still earn acceptable returns on equity. Using prime auto loans as our example, banks have strong incentives to engage in these transactions when regulatory capital requirements significantly exceed economic capital needs. The economics are particularly attractive when the standardized approach risk weights are much higher than those implied by banks’ internal models.
SRTs are not only useful when there is a large mismatch between regulatory capital and economic capital. In Europe, where internal ratings-based approaches already align capital more closely with risk, banks still actively use SRTs to diversify their funding sources, manage concentration risk and optimize their overall capital structure. This suggests the total value proposition of SRTs extends beyond just addressing inefficiencies in regulatory capital.
[1] For a more detailed explanation of why banks target ROE, see the paper by George Pennacchi and João A.C. Santos, “Why Do Banks Target ROE?”, Journal of Financial Stability, No. 855, June 2018, available at https://www.newyorkfed.org/research/staff_reports/sr855.html
[2] The common equity tier 1 capital requirement equals the sum of a 4.5-percent minimum requirement plus a 2.5-percent capital conservation buffer, for simplicity.
[3] That amount approximates the loan’s expected lifetime losses.
[4] If the junior exposure is sold through a traditional/cash SRT, the assets are removed from the bank’s GAAP balance sheet.
[5] See https://www.federalreserve.gov/supervisionreg/legalinterpretations/reg-q-frequently-asked-questions.htm.
[6] See PIMCO, “SRT Market Update,” U.S. Banks Embrace Risk Transfer En Masse, PIMCO Capital Markets.
[7] See the Simplified Supervisory Formula Approach securitization tool available on the FDIC’s website at https://www.fdic.gov/capital-markets/regulatory-capital/
[8] The first loss tranche usually corresponds to the expected loss and the mezzanine tranche to the unexpected loss.
[9] See Ally Financial Inc. 2Q 2024 Earnings Review (July 17, 2024), p. 12; https://s2.q4cdn.com/753234398/files/doc_financials/2024/q2/Ally-2Q-2024-Earnings-Presentation.pdf.
[10] More precisely, banks must either apply a 1,250 percent risk weight or take a capital deduction. Most banks choose the capital deduction, since their high capital ratios would make the 1,250 percent risk weight more costly.
[11] A zero percent risk weight could be applied to cash on deposit, even at a third-party bank, depending on how the cash proceeds are allocated for investment.
[12] We have included both federal and state taxes.
