Watchdogs Should Incorporate SRTs Into Stress Tests, BIS Says

Financial watchdogs should consider including synthetic risk transfers in system-wide stress tests to better assess potential risks from the instruments, according to a paper published by the Bank for International Settlements.Author of the article:You can save this article by registering for free here. Or sign-in if you have an account.(Bloomberg) — Financial watchdogs should consider including synthetic risk transfers in system-wide stress tests to better assess potential risks from the instruments, according to a paper published by the Bank for International Settlements.Subscribe now to read the latest news in your city and across Canada.Subscribe now to read the latest news in your city and across Canada.Create an account or sign in to continue with your reading experience.Create an account or sign in to continue with your reading experience.Such exercises could help shed light on spillover effects between banks and other financial institutions such as insurers or private credit funds “under severe but plausible scenarios”, authors Michael Chui and Costas Stephanou at the BIS along with Prashant R. Babu from the Bank of England said. Use of the instruments, which are intended to insure loans against default, remains limited but is growing, and was equivalent to around 2% or less of total bank loans in the European Union, US, the UK and Canada at end-2024. Get the latest headlines, breaking news and columns.By signing up you consent to receive the above newsletter from Postmedia Network Inc.A welcome email is on its way. If you don't see it, please check your junk folder.The next issue of Top Stories will soon be in your inbox.We encountered an issue signing you up. Please try againInterested in more newsletters? Browse here.Banks use SRTs, which have expanded fivefold since 2016, to increase their solvency ratios, creating space to grow. They also can reduce reliance on less shareholder-friendly options such as issuing new equity. Instead of increasing banks’ and system resilience, SRTs may however become an “amplifier” of the contagion risks between banks and other financial entities, the report said. “Limited public disclosure and gaps in cross-sector and cross-border data – especially on investor funding structures, leverage and inter-linkages – raise the risk that SRT-related vulnerabilities build up unnoticed,” the authors said. “As the market expands, structures become more complex and banks rely more heavily on non-bank financial institutions for credit protection.”The Basel, Switzerland-based BIS highlighted a range of potential risks, including the practice of repackaging SRT investments into new financing vehicles, which in turn raise bank debt after getting an insurer’s guarantee.Capital ReliefCentral banks are increasing the monitoring of SRTs as part of a broader effort to identify links between banks and so-called non-bank financial institutions, a part of the financial system often under less stringent regulation thank mainstream lenders. “The growth in SRT issuance has facilitated the redistribution of risk from banks to non-bank financial institutions (NBFIs), thereby deepening the linkages between the two sectors.”Banks have used SRTs to provide protection to loan portfolios of almost €800 billion as of end-2024, the report said. They provided capital relief of around 43 basis points of Common Equity Tier 1 — a key measure for financial strength — for SRT-issuing banks, compared with sector-wide average CET1 levels between 14 and 16%.Banco Santander SA, Barclays Plc and BNP Paribas SA are among the most prolific issuers of SRTs, according to banks’ regulatory filings known as Pillar III. Around eight new banks have entered the market annually since 2016, raising the total number of SRT issuers above 100, the note said.Investors are using debt leverage to bolster returns, sometimes using structures which add “complexity and opacity,” which could “amplify contagion if one link fails,” the note said. Banks also place SRTs with insurers in a format known as unfunded credit protections, which potentially raise questions over the enforceability of such guarantees under stress scenarios.“SRT-related risks appear to be modest at present. However, this may change,” the note said. There is “need for enhanced monitoring of risks for individual banks and from a system-wide perspective.”On of top stress-tests, authorities should enhance information-sharing, including on a cross-border basis, on investor funding structures, leverage and inter-linkages. The adoption of internationally consistent securitization frameworks, together with policies to address NBFI vulnerabilities, would reinforce these safeguards.Postmedia is committed to maintaining a lively but civil forum for discussion. Please keep comments relevant and respectful. Comments may take up to an hour to appear on the site. You will receive an email if there is a reply to your comment, an update to a thread you follow or if a user you follow comments. Visit our Community Guidelines for more information.