NEW YORK--(BUSINESS WIRE)--The October completion of regulatory risk retention rules for US banks' loan and structured finance exposures could increase banks' appetite for regulatory capital trades (reg cap trades), says Fitch Ratings. Risk retention rules for US banks are stipulated under Section 941 of the Dodd-Frank Act and essentially require banks to retain 5% of their loan and structured finance originations, subject to certain carve-outs.
The purpose of reg cap trades is to provide important levers for banks to efficiently manage capitalization levels. However, Fitch believes that over the long term, the ultimate effectiveness of many trades will depend on the appropriateness of their structures. Novel, complex and highly structured transactions can be ripe for unexpected outcomes -- both for bank sellers and third-party buyers.
Reg cap trades tend to be uniquely structured (or bespoke) credit risk transferences through an outright asset sale, or they can be executed through a credit default swap (CDS). Some bank participants may view the CDS execution as preferable because retaining and servicing loan assets are core functions that most banks use to support their business positioning. There is limited public disclosure with respect to reg cap trade activity, but Fitch is aware of modestly increased activity in the space, with risk transference facilitated by private equity funds, business development companies and other entities that can be broadly characterized as components of the shadow banking industry. To the extent that the parties assuming the credit risk via reg cap trades are less regulated, shadow banking type entities, this could be a meaningful contributor to growth of shadow banking.
Fitch believes that reg cap trade buyers and sellers can face significant challenges in balancing the risk-transfer benefits with the associated complexity. For example, banks may not have transferred as much risk as believed, or third parties may have assumed more or different risks than expected. In addition to losses, this could lead to litigation and/or reputational damage. Furthermore, transparency around reg cap trades is often limited, which could exacerbate actual or perceived risks to reg cap trade buyers and sellers under stress.
Credit risk transfers that are direct, explicit, irrevocable and unconditional could minimize the potential for such unexpected outcomes for the banks. With proper risk management processes, prudential regulators can, in theory be satisfied that banks are managing credit risk transfers effectively when calculating capital requirements.
The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.