Synthetic risk transfer: five things to know

Banks worldwide are increasingly using synthetic risk transfer (SRT) instruments. They use them to protect their balance sheets against downside risk and free up cash by lowering capital adequacy requirements. Christoph Schwarz, Commercial Director, Ocorian shares five key elements to know about how SRT works, why more banks are adopting the tool and the mechanics of putting an SRT instrument in place.

The use of SRT – where banks and financial institutions transfer credit risk to investors without selling the underlying assets – is booming.

But how does SRT actually work, why are more institutions using the technology, and what is involved in executing an SRT transaction in practice?

Here are five key pointers covering what you need to know about how SRT works and why it has become so popular:

1. What is SRT, and how does it work?

SRT instruments are used by banks to reduce their risk-weighted assets and thereby relieve their capital requirements. This is done by identifying specific loan portfolios on balance sheets and putting a form of protection against losses in place for those portfolios.

This will typically involve the bank transferring a portion of the credit risk on these assets to investors, such as private credit funds, insurance companies or supranational institutions like the EIF and EIB. – in exchange for a fee.

2. Why is SRT seeing so much uptake right now? What are the benefits?

For regulatory reasons, banks must keep capital in reserve for risk assets they hold on their books to cover unexpected losses. This capital cannot be invested or deployed.

SRT is a way for banks to pass on some of this risk without having to sell the underlying assets. The protection that an SRT provides means that the bank doesn’t need to hold back as much capital for those assets.

This enables banks to manage their risk-weighted assets more efficiently and free up capital that would otherwise have to be set aside, allowing them to underwrite more loans, improve their overall risk profiles and their return on capital.

SRT is not a new technology, with the first SRT instruments in Europe already in use as early as 1998.  Europe has been the dominant market, accounting for more than two-thirds of the US$1.1 trillion of assets covered by an SRT since 2016, according to the IMF. However, SRT usage in the US has risen significantly since 2023.

3. How is an SRT structured?

A typical SRT sees the bank retain risk for the first layer of losses from a loan portfolio. Regularly, the thickness of the layer corresponds with the expected loss for the portfolio.

For example, if a bank has a €2 billion portfolio of SME loans, it would expect and account for a certain level of loss. An SRT would then be arranged to cover unexpected losses beyond this initial layer, capped within an agreed range.

Setting up SRT often involves establishing a special purpose vehicle (SPV) in a suitable financial jurisdiction (such as Luxembourg and Ireland for European transactions). The SPV will issue a credit linked note through Euroclear and Clearstream or a local clearing house. The proceeds will either be held in cash or in eligible assets in custody on behalf of the SPV to protect the bank in the event of unexpected losses. 

Other banks buy protection from highly rated insurance companies via a financial guarantee. In the event of losses, instead of drawing from a pre-funded cash pool, the counterparty settles the coverage amount directly.

4. What does the future hold for SRT?

SRT is now firmly in the mainstream and is attracting increased attention in the market.

The high volume of capital raised by private credit funds to support SRT deals, along with more insurers entering the market, points to an ongoing upward trajectory, particularly during a period of heightened macro-economic uncertainty, where banks and their regulators regard risk management as paramount.

When structured prudently and allocated to informed investors, SRT enables broader risk distribution and will strengthen the financial system.

5. How can Ocorian support in the SRT space?

We are an active service provider in the structured finance markets with extensive experience in helping our clients with their SRT transactions.

As a corporate service provider, we offer a full suite of services, covering all SPV administration requirements under the local securitisation law. 

We also support our clients as a paying agent, security trustee and bond trustee, handling all fee and coupon payments and protecting the investor’s interest in case of a default of the issuer.

In addition, we can help with the cash management of the collateral pool, protecting the loan portfolio against losses in line with local regulations.

Get in touch to know more about our full suite of capital markets services.