SRT Swells to $43 Trillion, Emerging as a 'Time Bomb' in Global Financial Markets

Is the Subprime Crisis Repeating?

To Avoid Regulatory Capital Burdens

US and European Banks Rush to Issue

Similar to 'Financial Crisis Fuse' CDO

Distorts Bank Asset Soundness on the Surface

Concerns Over Transmission of Insolvency Among Banks

Participation from Capable Institutions like Pension Funds

"Investment Risk Not Significant" Counterarguments

SRT (Significant Risk Transfer), which is rapidly expanding, is being pointed out as a new time bomb in the global financial market. This is because not only large European banks but also small and medium-sized US banks are rushing to avoid the capital regulation burden of financial authorities, and it is expected that $30 billion will be newly issued this year alone. There are growing concerns that the issuance structure is similar to the collateralized debt obligations (CDOs) that triggered the 2008 global financial crisis, which could distort banks' capital adequacy and threaten the stability of the financial system.

"Expected to Swell to $90 Billion by 2030"

According to Bloomberg, the global SRT issued from the beginning of the year to September totaled $16.6 billion. Issuance is rapidly increasing even after October, and it is estimated that the issuance amount will reach up to $30 billion by the end of the year. This is a 25% increase compared to the previous year.

Simply put, SRT is a transaction where banks transfer credit risk related to loan bonds to other investors to escape the burden of loan regulations. When banks make retail loans such as auto loans, they are required to accumulate regulatory capital to prepare for loan defaults. By issuing SRT, a type of credit-linked security, and transferring some default risk to other investors, banks can reduce the burden of capital accumulation.

SRT investors receive periodic interest until maturity and can recover the full principal at maturity if there are no significant events. If a default occurs in the underlying assets, the investor bears the loss. Depending on the risk level of the underlying assets, the expected return rate ranges from 8% to 12% per annum.

The SRT market was formed when Basel II, the bank capital soundness standard, allowed regulatory capital relief through SRT in 2004. With the implementation of Basel III scheduled for next July, European banks, facing increased capital expansion burdens, are moving to reduce risky assets, leading to rapid market growth. In the US, SRT transactions are increasing even faster due to growing pressure to strengthen capital regulations since last year. According to Pemberton Asset Management, it is estimated that by 2030, more than 110 banks will participate in SRT issuance, with annual issuance swelling to $90 billion.

Intensifying Debate Over Risk Levels

The problem is that the surge in SRT issuance distorts banks' asset soundness. When a bank issues SRT, there is no change in the actual capital size, but the regulatory capital ratio (capital/risk-weighted assets) increases, inflating the bank's lending capacity. The International Monetary Fund (IMF) pointed out that "as banks' SRT issuance increases, it appears that banks' capital adequacy is improving on the surface," but "in fact, the bank may be unable to raise capital due to weak fundamentals and poor profitability."

There are also concerns that the instability of the banking system could expand. If SRT investors borrow money from one bank to invest in another bank's SRT, the 'interconnectedness between banks' increases, raising the possibility of chain risks in the event of a crisis. Sheila Bair, who was the head of the Federal Deposit Insurance Corporation (FDIC) during the 2008 financial crisis, said, "SRT reminds me of mortgage-backed securities, which were the transmission path of the financial crisis," and "SRT transactions through borrowing should be banned." In fact, BofA, which recently issued $90 million worth of SRT linked to a $1 billion loan, has banned borrowing from other banks to invest in its own SRT.

Counterarguments are also strong. It is argued that SRT is fundamentally different from derivatives that expanded the 2008 financial crisis because the issuing bank holds the underlying assets and only partially transfers credit risk to investors. Also, many SRT investors are long-term investors such as pension funds and insurance companies, which have high liquidity and payment capabilities, countering the crisis theory.

Kim Eun-jung, kej@hankyung.com