The Federal Reserve issued guidance last week on risk-shifting for large banks, advising institutions that engage in transactions to reduce risk to ensure that residual risk is reflected in their capital assessments.
“In general, the Federal Reserve views a firm’s engagement in risk-reducing transactions as a sound risk management practice,” the central bank said last Friday. “There are, however, certain risk-reducing transactions for which the risk-based capital framework may not fully capture the residual risks that a firm faces on a post-transaction basis.”
The Fed pointed to instances in which a company transfers portfolio risks to a counterparty—potentially a thinly capitalized special purpose vehicle, or SPV—that would be unable to absorb losses equal to the risk transferred, as well as those in which a firm transfers risk to a “sponsored” affiliate entity, which may also be unable to absorb losses.
“These residual risks arise because the effectiveness of a firm’s hedge involving a thinly capitalized SPV counterparty would be limited to the loss absorption capacity of the SPV itself,” the Fed said. “In cases involving unconsolidated ‘sponsored’ affiliates of the firm, the residual risk arises from the implicit obligation the sponsoring firm may have to provide support to the affiliate in times of stress.”
In the case of a risk transfer transaction involving an SPV or counterparty with limited loss-absorption capabilities, the Fed staff will determine the difference between capital required to cover risk-hedged exposures before the transaction and the counterparty’s ability to loss-absorption resources.
The Fed said a commitment by a third party to provide capital in times of financial distress would not be counted as part of the counterparty’s loss-absorbing capacity.
It also advised against risk-shifting transactions with “sponsored” affiliates, saying the transactions “generally do not involve effective risk transfer because of the sponsored entity’s ongoing relationship with the firm and… the implicit obligation that the firm may have to provide capital to the sponsored entity in a period of financial stress affecting the sponsored entity.”
“Supervisors will strongly scrutinize risk transfer transactions that result in substantial reductions in risk-weighted assets, including in supervisors’ assessment of a firm’s overall capital adequacy, capital planning, and risk management through CCAR,” the guidance reads. “Based on an assessment of the risks retained by the firm, the Board may in particular cases determine not to recognize a transaction as a risk mitigant for risk-based capital purposes. Firms should bring these types of risk transfer transactions to the attention of their senior management and supervisors. Supervisors will evaluate whether a firm can adequately demonstrate that the firm has taken into account any residual risks in connection with the transaction.”