US major banks are increasingly offloading credit risks in a darker corner of the financial market. According to insiders, institutions like J.P. Morgan, Morgan Stanley, and U.S. Bancorp are increasingly utilizing synthetic risk transfers to reduce potential dangers in their credit portfolios and thereby decrease their capital requirements. The so-called Credit-Linked Notes (CLN) are highly complex derivatives that banks sell to Private Funds at attractive returns of 15% and more.

On Wall Street, this new focus on synthetic risk transfers marks a pivot. Since the 2008 financial crisis, large US institutions have been less involved in this market segment. Stricter regulations increasingly complicated opaque credit transactions – authorities still had vivid memories of the disruptions caused by Credit Default Swaps (CDS) that significantly intensified domino effects after the collapse of Lehman Brothers.

In the aftermath of the financial crisis, European regulators established clear rules for risk management through securitization, where underlying loans remain on the banks' balance sheets. According to the ECB banking supervision, 30 institutions in the Eurozone executed 118 significant risk transfers (SRT) last year, with a total volume exceeding 170 billion euros – a value significantly surpassing previous years.

The majority of these transactions were not traditional securitizations but rather 72 synthetic transactions based on properly serviced loans. "Banks often prefer synthetic securitizations," says the ECB banking supervision. "Because these are usually cheaper and easier to execute, as direct interaction with the collateral provider is established."

For a long time, the Federal Reserve was more conservative than European regulators and allowed synthetic risk transfers only on a case-by-case basis. However, this year, the oversight has somewhat relaxed its standards and outlined conditions on its website under which it is willing to approve capital relief. J.P. Morgan is reported to have worked on transactions totaling $2.5 billion in recent months to reduce capital requirements for its corporate and consumer loans. In September, Morgan Stanley received approval for Credit-Linked Notes in a new structure.

The global issuance volume for CLN (Credit-Linked Notes) is estimated to reach $20 billion in 2023, according to Denver-based investment manager Arrowmark Partners. Analysts at J.P. Morgan state that banks typically sell 10% of their loans with a loan-to-value ratio of 60 to 97% – representing a high-risk category – through such synthetic transfers. Extrapolating from this, it can be estimated that loans totaling nearly $200 billion may receive fresh capital relief this year. In 2016 and 2017, the figures were $60 billion each year, indicating an increase of almost $40 billion from the previous year.

J.P. Morgan estimates that US banks hold a total of $2.8 trillion in loans eligible for securitization through CLN. Since not all of them may qualify for capital relief, analysts project the potential market volume for these derivatives to be up to $220 billion. With the increasing issuance of these credit instruments, which function somewhat like insurance against defaults, banks are preparing for significantly stricter capital requirements.

The regulators are working on the implementation of the global banking package Basel III. However, according to the industry's perspective, the Federal Reserve and other regulatory bodies, in the wake of the collapses of Silicon Valley Bank, Signature Bank, and First Republic Bank in the spring, have been prompted to significantly tighten their rule proposals. This move is seen as going beyond the framework agreed upon by international regulators in 2017. The proposed minimum requirement for Common Equity Tier 1 (CET1) capital for U.S. bank holdings is set to increase by a combined 16%, according to drafts from July.

The originally scheduled market consultation for the regulations, set to end in November, was extended by regulators until mid-January due to the high demand for discussion. During the third-quarter earnings season, many bank executives expressed their frustration with the proposals. David Solomon, CEO of Goldman Sachs, referred to the plans as dangerous for the stability and competitiveness of the U.S. financial market.

Ultimately, industry leaders like J.P. Morgan CEO Jamie Dimon may have no choice but to swallow the regulatory broth served up. This could potentially increase the attractiveness of synthetic risk transfers, as financial institutions, while paying high interest on these credit instruments, may find them relatively less costly than building reserves for higher external capital risks on their books.

The surge in CLN volumes represents an extreme manifestation of the trend seen in recent years, where funds and credit risks have increasingly shifted towards Private Funds. Companies such as Ares Management and Blackstone are actively participating in synthetic risk transfers, eagerly seizing opportunities or expanding their capacities – similar to how private credit managers acquire mortgage or consumer loan portfolios from banks.

However, while banks with deposit operations in the United States are operating within an increasingly stringent regulatory framework, alternative managers are subject to less rigorous controls. Analysts express concern about the overall declining asset quality highlighted by rating agencies such as S&P and Moody's, as the growing shift of credit risks to darker corners of the market could pose a risk to financial stability.

Fitch also emphasizes the impact of the CLN boom on the banks themselves. While institutions may boost their Common Equity Tier 1 (CET1) capital ratios through risk transfers, creating room to stimulate lending, this could weigh on broader capital ratios, which would then need more attention. Net capital relief from CLN could even have a negative impact on the ratings of the banks. This is especially true for mid-sized banks, which have already been under particular pressure since the spring.