Sen. Reed calls on Fed to reform credit risk transfers

Federal Issues U.S. Senate Senate Banking Committee Credit Risk Federal Reserve

On August 1, Senator Jack Reed (D-RI), a member of the Banking Committee, called on the Fed to create stricter regulations on credit risk transfer (CRT) transactions, which are transactions banks use to offload credit risk to private funds and investors. As outlined in the letter, the Senator noted that CRT transactions have increased in activity, citing deals worth about $17 billion this year, and that it is expected to grow by “30% to 40% each year for the next two years.” The Senator warned that such rapid CRT growth could engender a new financial crisis if these transactions continue without adequate oversight. The Senator emphasized that as CRTs increase in complexity and become leveraged through loan instruments, they pose more significant risks to the banking sector. High leverage in CRT transactions could lead to a situation where banks may face substantial losses if riskier loans within CRTs default simultaneously, questioning whether leveraged CRTs “truly transfer credit risk.”

The Senator’s letter to the Fed highlighted the need for greater transparency and regulation. He urged the Fed to require public reporting on banks’ use of CRTs, including details on the amount of risk transferred, the counterparties involved, and the credit quality of assets. The Senator warned that without a comprehensive understanding of the risks associated with CRTs, efforts to circumvent stronger capital and regulatory requirements could expose the financial system to new vulnerabilities reminiscent of those that contributed to the 2008 financial crisis. He called on the Fed to take specific actions:

1. Require public regulatory reporting of each bank's use of CRTs.

2. Establish quantitative limits on banks using CRTs to reduce capital requirements, treating CRT proceeds as unrestricted cash, and providing leverage to nonbanks for CRT investments.

3. Ensure that stress testing methodology considers the impact of CRTs on the banking system during economic downturns or financial crises.

4. Update the response to the letter dated November 30, 2023 with an assessment of the risks associated with CRTs based on supervisory experience.