ECB paper highlights financial stability risks from synthetic risk transfers

A new European Central Bank working paper identifies three key risks to financial stability stemming from synthetic risk transfers (SRTs). The study finds that banks use SRTs to offload capital-expensive loans, reduce monitoring efforts, and increase interconnectedness with non-bank investors.

Capital games and oversight gaps

Banks strategically select loans for synthetic risk transfers (SRTs) that are capital-expensive relative to their economic riskiness, effectively reducing their capitalization.

The study exploits the SME supporting factor, which causes an exogenous jump in risk weights, to causally show that a 15 percentage point higher risk weight increases the likelihood of an SRT by up to 70 percent.

As banks redeploy the freed capital, their loan portfolios become riskier relative to their capitalization.

Furthermore, the paper finds that banks significantly reduce their monitoring efforts for firms whose loans are synthetically transferred.

The frequency of updating probability of default (PD) estimates decreases by 12-25 percent on average, and up to 70 percent if the entire firm exposure is transferred.

This reduction in oversight is more pronounced when a larger share of a firm's exposure is synthetically transferred.

Tangled webs of finance

The study provides micro-level evidence of interconnectedness between banks and non-bank SRT investors through the loan market.

Banks are 57-66 percent more likely to sell SRTs to non-bank investors with whom they already have credit relationships.

This suggests a potential channel for risk transmission.

The market for SRTs has seen rapid growth, with over €1 trillion in assets synthetically transferred globally between 2016 and 2024, according to the IMF.

For euro area corporate loans, outstanding SRTs increased fivefold from €60 billion in 2018 to €300 billion by the end of 2024.

This expansion, coupled with the identified interconnectedness, underscores the need for closer scrutiny of these arrangements.

Unseen risks in plain sight

This study provides crucial, data-driven insights into the often-overlooked risks of synthetic risk transfers.

While SRTs offer regulatory capital relief, the findings suggest they can inadvertently incentivize banks to increase risk-taking and reduce monitoring efforts.

Regulators must now critically assess these mechanisms and the growing interconnectedness to safeguard financial stability effectively.