Banks’ New Trick Could Mean Trouble for Everyone

If you’re unfamiliar with synthetic risk transfers, there’s a chance you’ll hear all about them when the next financial crisis hits. They’re the latest way for big banks to game rules designed to safeguard the system, and they’re growing fast. So far, regulators seem all but oblivious.

Financial resilience depends largely on one line in banks’ balance sheets: equity. Also known as capital, it’s funding from shareholders who, unlike creditors, have agreed to absorb losses. The more equity banks have, the better they’re able to keep lending in difficult times. Bank managers, however, prefer to use more debt, because it comes with various government subsidies and boosts key profitability measures in good times.

The largest global banks have lately been very successful in minimizing equity. They’ve fended off plans for incremental increases in both the US and Europe. As a result, their capital typically amounts to about 5% to 6% of assets, far less than what experts and research indicate would be needed to weather a severe crisis.

Yet the banks think that’s still too much. They’ve revived a practice from before the 2008 subprime-mortgage crisis: Reduce capital requirements by repackaging loans into securities and buying protection against losses from other financial institutions. The banks keep the assets, the risk purportedly goes elsewhere. Hence, synthetic risk transfer.

It's booming. The relevant pool of synthetically securitized assets amounted to €614 billion ($661 billion) at the end of 2023. New deals covering more than €200 billion in assets were struck in 2023, up from €55 billion seven years earlier. European corporate loans dominate, followed by auto and other retail loans in the US. Sellers of insurance, including private credit and pension funds, enjoy returns of 8% to 12%.

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