U.S. banks have found a new way to unload risk as they scramble to adapt to tighter regulations and rising interest rates.
JPMorgan Chase, Morgan Stanley, U.S. Bank and others are selling complex debt instruments to private-fund managers as a way to reduce regulatory capital charges on the loans they make, people familiar with the transactions said.
These so-called synthetic risk transfers are expensive for banks but less costly than taking the full capital charges on the underlying assets. They are lucrative for the investors, who can typically get returns of around 15% or more, according to the people familiar with the transactions.
U.S. banks mostly stayed out of the market until this autumn, when they issued a record quantity as a way to ease their mounting regulatory burden.
“We simply have to take it because they’re judge, jury and hangman," JPMorgan Chief Executive Jamie Dimon said when asked about new capital regulations at an investor conference in September.
Regulators have been raising capital requirements for years, and they proposed even tougher measures after the banking panic that began in March. Higher interest rates are eroding the value of banks’ investment portfolios, which can also eat into regulatory capital levels.
In most of these risk transfers, investors pay cash for credit-linked notes or credit derivatives issued by the banks. The notes and derivatives amount to roughly 10% of the loan portfolios being de-risked. Investors collect interest in exchange for shouldering losses if borrowers of up to about 10% of the pooled loans default.
JPMorgan has been working on $2.5 billion worth of deals in recent months to cut capital charges on about $25 billion of its corporate and consumer loans, the people familiar with the transactions said.
The deals function somewhat like an insurance policy, with the banks paying interest instead of premiums. By lowering potential loss exposure, the transfers reduce the amount of capital banks are required to hold against their loans.
Banks globally will likely transfer risk tied to about $200 billion of loans this year, up from about $160 billion in 2022, according to a Wall Street Journal analysis of estimates by ArrowMark Partners, a Denver-based firm that invests in risk transfers.
Private-credit fund managers, including Ares Management and Magnetar Capital, are active buyers of the deals, according to people familiar with the matter. Firms including Blackstone’s hedge-fund unit and D.E. Shaw recently started a strategy or raised a fund dedicated to risk-transfer trades, some of the people said.
The deals embody a deep shift on Wall Street, where hedge funds, private-equity firms and other alternative investment firms that buy private credit are becoming increasingly important to how finance functions.
Private-credit investment managers don’t yet have the same name recognition as the big banks, but have become formidable rivals, increasingly taking over bread-and-butter businesses such as corporate lending. The firms have also been buying up the banks’ portfolios of mortgages and consumer loans.
Banks started using synthetic risk transfers about 20 years ago, but they were rarely used in the U.S. after the 2008-09 financial crisis. Complex credit transactions became harder to get past U.S. bank regulators, in part because similar instruments called credit-default swaps amplified contagion when Lehman Brothers failed.
Regulators in Europe and Canada set clear guidelines for the use of synthetic risk transfers after the crisis. They also set higher capital charges in rules known as Basel III, prompting European and Canadian banks to start using synthetic risk transfers regularly.
U.S. regulations have been more conservative. Around 2020, the Federal Reserve declined requests for capital relief from U.S. banks that wanted to use a type of synthetic risk transfer commonly used in Europe. The Fed determined they didn’t meet the letter of its rules.
“Nobody knew when the impasse would break," said Kaelyn Abrell, a partner at ArrowMark.
The pressure began to ease this year when the Fed signaled a new stance. The regulator said it would review requests to approve the type of risk transfer on a case-by-case basis but stopped short of adopting the European approach.
The Fed allowed capital relief for a new credit-linked note structure at Morgan Stanley in September and published a response to some of the questions it had received from banks about risk transfers.
Before the recent change, the Fed’s reluctance had left some banks increasingly frustrated, according to the people familiar with the transactions. The tension grew in recent years as new rules came into effect, including a capital requirement tied to annual stress tests.
In 2022 and 2023, higher interest rates pushed down the value of bonds the banks held. That too weighed on the big banks’ regulatory capital levels.
More capital rules are on the way. This summer, U.S. bank regulators announced a proposal to further implement Basel III requirements that could increase capital charges by about 20% and penalize businesses that bring in big fees, including banks’ wealth-management and trading arms. The Basel Endgame, as it is called in industry parlance, came out stiffer than some banks had hoped, prompting them to halt stock buybacks.
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