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.
The full post is available at https://bpi.com/the-economics-of-synthetic-risk-transfers/