More Transparency Needed For Bank Capital Relief Trades by OFR

By Jill Cetina, John McDonough, and Sriram Rajan

Banks have significant incentives to reduce their required regulatory capital by transferring credit risk to third parties. But public data needed to analyze such activities are scant. One exception is that banks now report the use of credit derivatives for regulatory capital relief. This activity recently totaled $38 billion in notional value for 18 banks. The authors find the median bank engaging in these transactions could have improved its risk-based capital ratio by 8 to 38 basis points, and one by as much as 388 basis points. However, this analysis is incomplete, relying on just one vehicle for measurement, and more data are needed.

Banks invented credit derivatives two decades ago to transfer credit risk on their portfolios to third parties. While the reported use of credit default swaps (CDS) for regulatory capital relief is small compared to the total credit derivatives market, this brief argues that it can be material for some banks’ regulatory capital.

Capital relief transactions may have benefits to banks. But, even if real risk transfer is involved, these transactions can pose financial stability concerns by increasing interconnectedness, transforming credit risk into counterparty risk, and obscuring capital adequacy to investors and counterparties. And while bank supervisors have extensive data about banks, they may have less information about the nonbanks who are selling credit risk to those banks and ultimately bearing the risk of loss.

The financial crisis illustrated the potential dangers. When AIG came under stress in 2008, European banks faced losing some of the $290 billion in CDS protection they had purchased from the company for regulatory capital relief. The Federal Reserve Bank of New York considered those exposures in its analysis of the potential systemic impact of an AIG bankruptcy before deciding to assist the company.

Despite efforts on the part of industry and the regulatory community since the financial crisis to increase the use of central clearing of OTC derivatives, including credit derivatives, a material share of credit default swaps and other credit derivatives still are not centrally cleared due to their origination pre-crisis, ongoing lack of contract standardization, and other factors. However, even in a world where credit derivatives used to obtain capital relief were all subject to central clearing, interconnectedness concerns would remain.

In the Basel III reforms, international bank regulators sought to restore confidence in regulatory capital measures by penalizing securitizations at the core of the crisis, dramatically increasing the capital requirements associated with some securitization tranches. Basel III also increased banks’ capital requirements for exposures to other financial firms, presumably to reduce interconnectedness. But regulatory capital relief is still allowed for banks that obtain credit protection through CDS, total return swaps, and eligible guarantees.3 Research on this important topic is limited.

Banks do not report enough information about these types of transactions for market participants, most notably investors and counterparties, to analyze their impact on banks’ regulatory capital. U.S. bank regulators revised banks’ regulatory reporting forms in 2009 to include more information about the notional value of their credit derivative exposures, including their use for capital relief.5 However, this information does not include the impact of these transactions on risk-weighted assets or risk-based capital and includes only credit derivatives, not guarantees or synthetic securitizations which can also provide capital relief to banks.

This OFR brief uses these partial data to estimate how much capital relief banks now obtain from credit derivatives. We also note that little can be discerned from confidential CDS transaction data about these transactions. More data are needed about these and other types of regulatory capital relief trades for investors and counterparties to monitor and analyze their potential risks.

Regulatory Capital Relief

Regulatory capital is the amount of capital a bank is required to hold to protect it from potential losses. U.S. banking supervisors allow financial institutions to calculate their regulatory capital with a risk-based formula that requires holding more capital for risky assets and loans and less capital for relatively safe assets, such as excess reserves at the central bank or Treasury bills.

One measurement of a bank’s regulatory capital cushion is its risk-based capital ratio, which is calculated by dividing a bank’s regulatory capital by its risk-weighted assets. A bank can improve that ratio by purchasing credit protection to reduce its risk-weighted assets.

To see how a bank can structure regulatory capital relief, let’s look at a hypothetical bank required to hold capital equal to 8 percent of its total risk-weighted assets. A relatively safe asset held by a bank might be assigned a 100 percent risk weight, requiring 8 cents of capital for every dollar of the asset. A more risky loan is assigned a 750 percent risk weight, requiring 60 cents of capital for every dollar of the asset. A bank’s riskiest assets are assigned a 1,250 percent risk weight, requiring one dollar of capital to back every dollar of the asset (8 percent times 1,250 percent = 100 percent).

Bank Capital Relief

Bank Capital Relief

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