dominos falling

Banks are increasingly offloading credit risk to hedge funds and other investors in risk-transfer transactions, S&P Global Ratings reports.

In a new report, S&P said banks are increasingly using vehicles such as credit default swaps and credit-linked notes to package off some of their credit risk to third-party investors.

While European banks have typically been the leading issuers of these kinds of vehicles, there’s increasing activity from U.S. and Canadian banks, the rating agency said.

“[Risk transfer] volumes have steadily increased over several years, with activity led by European banks and supplemented more recently by Canadian and U.S. peers,” it said.

And, while these vehicles are often designed primarily to help gain capital relief, banks are also increasingly using them “to actively manage loan portfolios” — which allows them to reduce lending concentrations in certain sectors, or even to specific borrowers, boosting their overall lending capacity.

These transactions are moving credit risk to the shadow banking sector — with hedge funds and private credit funds as the primary buyers — but large asset managers, insurers and pension funds are ramping up participation in these deals too, S&P said.

For the firms taking on the banks’ credit risk, these transactions offer “attractive premium income and exposure to a diverse range of borrowers and asset classes that may not be accessible in other markets,” the report noted.

Banks’ past efforts to shift some of their credit risk to other players — such as securitizations created in the years leading up to the financial crisis — “proved ineffective when economies came under stress,” S&P noted.

However, this time around, the “current transaction structures and regulatory requirements reflect lessons learned and result in genuine risk transfer.”

While the rating agency still sees “certain risks associated with the flow of credit to non-banks,” it also said it does not view these kinds of risk transfers to be a “material contagion risk.”

Ultimately, the final implementation of the Basel III capital rules will have a significant influence on the future for these sorts of deals, the report said: “The key question is whether increased capital requirements on loans will outweigh increased capital requirements on securitization positions.”

The direction taken by regulators in various markets on key details of the final Basel rules is expected later this year.