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British lenders are on the defensive after the Bank of England set a two-month deadline to respond to worries about liquidity risks in the fast-growing market for sharing credit risks with investors.
Bankers are trying to assess how widespread the BoE’s worries are after it sent a letter to lenders’ finance directors last week, warning of “prudential concerns” over the financing of certain risk-transfer transactions.
The central bank is zeroing in on the increasingly popular market for significant risk transfers — also known as synthetic risk transfers, or SRTs — in which investors take on credit risk from a bank’s loan portfolio in return for regular payments from the lender.
Some bankers fear the BoE’s intervention could increase the cost of financing for investors in SRTs, slow the growth of the market and reduce lenders’ ability to use them to free up capital to support extra lending.
Hedge funds, asset managers, credit funds and pension funds invest in the risk-transfer trades, many of them using funding from other banks.
The IMF raised concerns about this “round-tripping” last year, when it said in its financial stability report there was “anecdotal evidence that banks are providing leverage for credit funds to buy credit-linked notes issued by other banks”.
The US Federal Reserve and European Central Bank are also closely monitoring the rising use of such risk-transfer techniques to reduce lenders’ capital requirements. Fed chair Jay Powell told the Senate banking committee in February it was checking “on a case-by-case basis” to see if they “really do transfer risk successfully”.
The ECB this year introduced a “fast-track” approval process for SRTs. People close to the Fed and ECB said they did not have the same concerns as the BoE.
European banks accounted for almost two-thirds of the more than $1.1tn in SRTs done since 2016, according to the IMF, while US banks made up most of the rest. UK banks last year issued about £30bn of such risk transfers, up from roughly £20bn the previous year, according to the BoE.
The BoE said it had observed “an imprudent approach” in how banks were classifying the financing they provide via repurchase agreements — or repo — to investors against the credit-linked notes they buy from other banks.
Some banks are assigning financing for credit-linked notes to their trading book — meaning they can allocate less capital than if it was held in their banking book. But the BoE warned this was “resulting in a potential undercapitalisation of the risks”.
The worry is that the credit-linked notes cannot be sold easily, even if they are repackaged into a tradeable format, so they lack the liquidity required for collateral on funding that can be assigned to a bank’s trading book.
“Supervisors will be in contact with relevant firms to request a response to this letter,” the BoE said, adding it expected responses by June 11. “Subject to the responses received, we will consider the need for further engagement with firms either on a bilateral or cross-firm basis.”
The rules on which assets can be assigned to the trading book are set to be tightened under the new Basel III capital regime agreed by global regulators that the UK is due to implement by 2030.
One City executive said the BoE often sends such letters to “put all banks on notice, not just the ones where they have seen this” — even if the practices causing concern are only happening at a few banks.
But some in the sector fear the BoE could increase capital requirements for all banks providing such risk-transfer financing.
