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OFR: More Transparency Needed For Bank Capital Relief Trades 

June 15, 2015

Jill Cetina, John McDonough, and Sriram Rajan, ValueWalk

Banks have significant incentives to reduce their required regulatory capital by transferring credit risk to third parties. But public data needed to analyze such activities are scant. One exception is that banks now report the use of credit derivatives for regulatory capital relief. This activity recently totaled $38 billion in notional value for 18 banks. The authors find the median bank engaging in these transactions could have improved its risk-based capital ratio by 8 to 38 basis points, and one by as much as 388 basis points. However, this analysis is incomplete, relying on just one vehicle for measurement, and more data are needed.

Banks invented credit derivatives two decades ago to transfer credit risk on their portfolios to third parties. While the reported use of credit default swaps (CDS) for regulatory capital relief is small compared to the total credit derivatives market, this brief argues that it can be material for some banks’ regulatory capital.

Capital relief transactions may have benefits to banks. But, even if real risk transfer is involved, these transactions can pose financial stability concerns by increasing interconnectedness, transforming credit risk into counterparty risk, and obscuring capital adequacy to investors and counterparties. And while bank supervisors have extensive data about banks, they may have less information about the nonbanks who are selling credit risk to those banks and ultimately bearing the risk of loss.

Read more: ValueWalk

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