Wall Street Banks Strike Capital Deals

Many of Wall Street’s banks are expanding the use of risk transfer deals to lower exposure from prime brokerage divisions. This allows them to free up cash to lend to hedge funds in pursuit of a great share in the strong-performing market.

These credit risk transfers, known as synthetic risk transfers, reduce the amount of capital they must use to guard against losses on the loans they have underwritten. SRT transactions involve entities such as banks and insurance companies paying investors to assume the credit risk from their portfolios, reducing the Protection Buyer’s risk of loss without removing the underlying assets from their books. This process applies to various assets, including mortgage loans, consumer or commercial loans, and corporate loans, and it also helps lower the regulatory capital requirements for the Protection Buyer under Basel III standards.

The use of SRTs for margin loans marks a large jump from corporate and consumer loans that traditionally underpinned capital relief trades. SRTs don’t only protect the downside but unlock the upside. Banks can now pursue these transactions to see growth in specific asset classes.

Despite this, banks find it difficult to complete SRTs for prime broking loans because they agree to strict confidential terms with clients and cannot reveal hedge fund positions. Just describing them can reveal trade secrets. Additionally, positions can change rapidly, which may result in changes to the collateral underlying credit risk transfer. Instead of relying on positions, investors must base their decisions on their view of the bank’s prime brokerage business and risk management policies, essentially betting on the financial infrastructure not to collapse. This is betting that the margin call mechanisms work and that they have enough liquidity to cover the position.

These SRTs work in the cases of money managers that may have separate investments in hedge funds, which could be included in the exposure. They can then assess the risk by checking the fund’s trading book.