(Bloomberg) -- The European Central Bank, wary of lenders' over-reliance on synthetic risk transfers, is urging issuers to use other ways of securitizing assets, according to people familiar with the matter.
In a forthcoming opinion, the ECB will argue that shifting credit risks off the balance sheet through so-called synthetic significant risk transfers could expose banks to refinancing risks during market stress, according to people familiar with the matter. Instead, the ECB wants banks to carry out more deals known as cash SRTs that get rid of the actual loans and not just the attached credit risk, the people said.
The move by the EU's top banking regulator is the latest sign that regulatory scrutiny of synthetic SRTs is growing as the deals enjoy an unprecedented boom that has made them one of the most popular instruments for banks to manage their balance sheets and free up capital. Large European banks increased the volume of synthetic securitizations by 85% in the first half, with the resulting capital relief helping them to return money to investors or fund growth.
The ECB will weigh in on forthcoming securitization rules for the 27-country bloc touted as a way to stimulate the economy, said the people, who asked to remain anonymous as the formal view has yet to be made public. While the ECB broadly supports the European Commission initiative, it's wary of instruments that could make banks vulnerable in a credit crunch.
A spokeswoman for the ECB declined to comment.
European banks are boosting issuance of synthetic SRTs because they're cheap and currently easy to sell given rampant demand for yields which at times run in the double digits. The transactions allow banks to free up capital for more profitable lending, and ultimately more generous payouts to shareholders.
Synthetic SRTs rely on credit derivatives to insure loan risk without actually removing the loan from a bank's books. Other types of asset-backed securities, including some SRTs, remove both the loans and their associated risk. The maturities of these securities tend to be longer than the underlying loans, ensuring there's no gap during which the bank remains exposed to the risk of the securitized assets.
Refinancing Risk
On-balance sheet instruments can leave banks exposed to losses on securitized assets. SRTs usually have shorter maturities than the loans they insure. That creates refinancing risk because banks have keep going back to investors to cover those gaps.
The ECB is worried about a scenario in which demand for synthetic SRTs seizes up and banks lose the relief they'd been counting on from the market, the people said. To bring their capital ratios back into line, banks could be forced to issue new equity, cut dividends or in extreme cases abruptly pull back lending.
"A freeze in the synthetic securitization market would expose banks to higher capital requirements than they had anticipated when originating the loans," according to a May report from the European Systemic Risk Board.
These synthetic transfers now dwarf cash SRTs, ECB data shows, accounting for more than 90% of all SRT transactions among the banks overseen by the ECB in 2023. Such deals are "faster and easier to execute but, unlike cash transactions, have no secondary market," the ECB noted last year.
Others are concerned about rampant and indiscriminate growth. A majority of respondents in a Bloomberg Intelligence survey released in June favored limits on the issuance of SRTs. Around 72% of the 50 firms taking part in the study, including issuers and investors, favored a regulatory ceiling on SRT issues for banks. Among them, more than half said that banks' guardrails should be in the form of a maximum percentage of their loan books.
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