(Bloomberg) -- Concerns around the quality of assets being bundled into significant risk transfer are rising among market participants and the opaque transaction could increase risks to financial stability, according to the International Monetary Fund.
SRTs, one of the hottest trades on Wall Street, could create “negative feedback loops” during periods of stress because if leverage is used by buyers then “substantial risk” remains within the banking system but capital coverage is lower, the IMF said in a report on financial stability. The transfers may also mask a traditional lenders’ resiliency, because they improve a bank’s buffers while leaving the overall capital level unchanged.
The watchdog also pointed out that increased use of SRTs may signal an inability “to build capital organically because of weaker fundamentals and profitability performance. Furthermore, over reliance on SRTs exposes banks to business challenges should liquidity” from the market dry up.
SRTs became a popular tool in Europe in the aftermath of the financial crisis to help cash-strapped banks meet capital requirements and are now spreading to the US. The transfers boost solvency ratios for lenders, freeing up capital to allow them to invest in more profitable businesses.
The double digit returns on offer from the risk transfers, which sees the buyer take on the risk for the first losses, has drawn many new investors in this year, some of whom are buying blind loan pools that have been securitized into an SRT.
For now, the pools used in the wider SRT market seem to be of higher quality assets, according to the IMF report.
Still, “financial sector supervisors need to closely monitor these risks and ensure the necessary transparency regarding the SRTs and their impact on banks’ regulatory capital,” the report warns.
Corporate Lending
Corporate leverage is now at the highest levels since the aftermath of the financial crisis, the IMF found, and cash buffers are dwindling. In commercial real estate, some banks may face challenges from office property concentration.
The report also found that hedge funds were catalysts and victims during the August market turmoil triggered by the yen carry trade. That trade saw them short Japan’s currency and go long on US equity futures.
“Many hedge funds reportedly reached risk limits and received increased margin calls, which forced them to rapidly close their positions, erasing the year’s returns for many,” according to the report.
--With assistance from Greg Ritchie.
(Updates with comments on corporate credit, CRE and hedge funds from first paragraph below Corporate Leverage subheadline.)
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