SRTs not sounding any alarms - despite the headlines

Last Friday, the European Banking Authority (EBA) published its semi-annual Risk Assessment Report. It is always a good read, as it provides a summary of trends in the banking sector and highlights risks that might be emerging in parts of the banking system. The overall tone of the report was as positive as one might expect from a semi-annual risk report by a banking regulator. While highlighting that geopolitical tensions are high and tariffs might impact certain industries and the broader macroeconomic picture, it also emphasized that banks’ profitability, liquidity, and capital remain strong—and that these trends have not been affected by the increased volatility observed in the first half of the year.

The press was quick to react with an incendiary headline about Significant Risk Transfer (SRT) transactions. Despite Europe pioneering this market three decades ago, SRTs have recently drawn renewed attention as banks have increasingly used them to optimize their capital. In a nutshell, SRT is a kind of securitisation that banks use to transfer the credit risk of a specific loan portfolio to investors, who receive a coupon in return. Typically, the securitisation involves the bank retaining the senior notes on their balance sheet while selling to investors the first-loss, most subordinated tranche. As a result of no longer carrying significant credit risk on the specific loan portfolio, the bank’s capital ratio improves via a reduction in the denominator (the risk-weighted asset component).

The article suggests that the SRT market has “prompted alarm from the EU banking watchdog.” In reality, the EBA discussed SRTs in Box 3, which spans two of the report’s 86 pages. In this section, the EBA explains that banks have used SRTs more frequently than in the past, with European banks accounting for half of the SRT market globally. They also discuss the impact SRTs have on the economy: “Through securitising exposures, banks can free up capital for new deployment and, for example, to extend new loans. This is of benefit for the economy, as it enables banks to expand lending without for example raising new capital.” This is commonly referred to as “capital relief.”

One of the EBA’s roles is to keep systemic risks in check. We therefore welcome the fact that the EBA points out what the theoretical risks of any instrument are and how are those risks evolving vis a vis the thresholds they deem appropriate. First, they mention that the size of the capital relief due to SRTs ranges from a few basis points (bps) to 100bps, depending on the bank. The regulator would not want to see a very large percentage of capital relief on banks’ balance sheets. In their words “Considering an average CET1 ratio of around 16.0%, the relief thus seems to be limited”. Second, they note a risk of a maturity wall for the banking sector. If a big portion of the SRT market matured in the same quarter for example, then banks capital ratios might be vulnerable to market conditions as it would be possible that large amounts of capital relief evaporate at the same time if investors do not roll the SRTs as and when they mature. The report states: “Banking sector-level supervisory reporting data do not indicate any such maturity wall.”

Third, and related to the previous point, they discuss the importance of a diverse, long-term investor base for SRTs, rather than participants investing merely “for a trade.” From page 58 of the report : “data indicate that private credit funds are the main investors in relative terms (around a third), followed by other investment funds (18%), insurance companies (14%) and pension funds (13%), which shows the interlinkages in the financial sector. Even though the investor base is not evenly distributed, it is still well distributed between different kinds of investors. This might also help to facilitate that, going forward, SRT investors will be available.” Lastly, the EBA highlights the importance of monitoring the interlinkages between non-bank financial institutions (NBFIs) and the banking sector. For example, if an investor buys an SRT transaction from a bank and then the same bank facilitates funding to that investor, then you could have a somewhat circular risk “as in the end a private credit fund’s SRT investment would become an implicit risk for a bank that invests”. This also underlines that there are leveraged buyers in the space, not unlike other asset classes, and that there is a risk that if funding dries up for whatever reason, then demand for SRTs could weaken.

In our view, the EBA’s opinion about the SRT sector is not negative, and there are no alarms going off in the report’s brief discussion of the topic. Furthermore, we would also underscore that there was no mention of systemic risks stemming from the credit quality or the structure of SRTs. In other words, the theoretical risks currently do not relate to outsized losses for SRT investors due to lax credit standards or poorly structured transactions. We also take comfort in the fact that SRT transactions require regulatory approval. If, at some stage in the future, the EBA were to change its assessment of the SRT market and genuine concerns arose, we have no doubt that local regulators would toughen their stance on approving new SRT transactions.