Banks and private debt firms are often cast as competitors. But even competitors can be friends with benefits. A growing number of U.S. banks are shedding loan book risk by purchasing credit derivatives from hedge funds, private equity firms and asset managers that are key players in private debt. These transactions — known as synthetic risk transfers — do just what their name implies: They transfer risk from heavily regulated banks to private debt firms that aren’t subject to the same level of scrutiny. That’s not necessarily a bad thing. In certain circumstances, it “takes risk that's highly concentrated in a specific institution and spreads it out over a lot of investors,” Brian Graham, a partner at Klaros Group, told MM. That can provide a bank with more flexibility to lend or expand. But these transactions are also indicative of how the U.S. has pushed “more and more activity — even aside from synthetic risk transfers — out of the banking system to non-bank players,” said Graham, who leads the firm’s strategy, finance, capital, M&A, partnerships and stakeholder engagement practices. “Those are direct results of choices we've made about the cost burdens and constraints we're going to put on banks.” “We have visibility into banks,” he added. “We don't have visibility into these [private debt] entities, quite often. And all the things that are designed to be shock absorbers for the banking system … they don't exist for those guys.” The lack of visibility into private debt has been a long-standing concern for top regulators like SEC Chair Gary Gensler and outgoing FDIC Chair Martin Gruenberg. The growing popularity of synthetic risk transfer strategies at domestic institutions will only lead to more questions about the interconnections between banks and opaque private investment firms. Synthetic risk transfers have been a common investment product in Europe for some time. A growing number of U.S. institutions began relying on the strategy last year after the Federal Reserve issued guidance that clarified how risk transfers could provide relief from bank capital requirements. They function a lot like insurance. The banks pay investment firms to absorb unexpected losses on nonperforming loans. The investment firms post collateral to cover any defaults. The benefit to the bank is that it allows it to reduce risk without having to sell loan assets that, in the current rate environment, would likely be marked as a loss. It also provides an avenue for larger regional banks to come into compliance with the Fed’s capital requirement proposal (h/t to Matt Wirz at The Wall Street Journal). Private debt firms like synthetic risk transfers because it’s a lucrative and fast-growing market. BlackRock’s private debt team believes that there will soon be “rapid growth in volume as a result of regulatory changes and increasing comfort among bank issuers and institutional buyers.” As the market grows, expect regulators to get more questions about how these products work and their potential risks. Sen. Jack Reed (D-R.I.) has already sent up flares to the Fed airing his concerns. They make banks (and government-sponsored enterprises like Fannie Mae and Freddie Mac) “look better capitalized than they are,” Mark Calabria, the former director of the Federal Housing Finance Agency, told MM. “Show me examples of this that aren't connected to regulatory arbitrage.” IT’S MONDAY — When in doubt, your MM host will nod and say “arbitrage” if a source is describing a trade he doesn’t fully understand. If you’d like to explain things to me in the simplest terms, send tips and suggestions to ssutton@politico.com or on Signal at 925.216.7576.
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