BAC Bank of America Corporation

By Michael Rapoport And Ryan Tracy 

Faced with new global regulations requiring them to strengthen their capital, big lenders in the U.S. and Europe have turned to a trading tactic that flatters their positions without actually raising extra funds.

Banks that have done such "capital-relief trades" include some of the largest in the world: Citigroup Inc., Bank of America Corp., Deutsche Bank AG and Standard Chartered PLC. But the Office of Financial Research, a U.S. Treasury office created to identify financial-market risks, is suggesting the trades run the risk of "obscuring" whether a bank has adequate capital and pose other "financial stability concerns."

The Securities and Exchange Commission and the Federal Reserve also have also voiced concerns about the trades.

Capital-relief trades are opaque, little-disclosed transactions that make a bank look stronger by reducing its "risk-weighted" assets. That boosts key ratios that measure the bank's capital as a percentage of those assets, even as capital itself stays at the same level.

In a capital-relief trade, a bank can keep a risky asset on the balance sheet, using credit derivatives or securitizations to transfer some of the risk to a hedge fund or other investor. The investor potentially gets extra yield and the credit risk of smaller borrowers in a way it would be hard for them to get otherwise, while the bank gets to remove part of the asset's value from its closely watched "risk-weighted asset" count.

Banks say the trades help them manage their risk, even if they don't go as far as a bona fide asset sale, and are just one tool among many they are using to meet new capital requirements.

Some say the Office of Financial Research is mischaracterizing the transactions, or that the trades didn't significantly affect their capital ratios. Bank of America, for example, disclosed $11.6 billion in purchased capital protection in 2014 regulatory filings, but said the impact of the trades on its capital ratios was less than 0.01 percentage point.

Critics fear the trades can spread risk to unregulated parts of the financial system--just as similar trades did before the financial crisis.

"It just seems like another repackaging of risk to mask who's holding the bag," said Arthur Wilmarth, a George Washington University law professor and banking expert.

The trades are allowed under banking regulations and securities laws, but recently have drawn attention in part because banks don't say a lot about them. The financial-research office said in a June report on the trades that banks should be required to disclose more about them.

Banks have made significant progress in increasing capital ratios to meet the new global requirements. This year, all 31 U.S. banks the Fed surveyed under its annual stress tests stayed above its minimum capital requirements for the first time, and the Fed said the banks' core capital would have been 8.2% of risk-weighted assets even under deep-recession-like conditions, up from 5.5% in 2009.

But they have more to do: The required capital levels for banks will rise dramatically by 2019 as governments implement new regulations known as Basel III. The Fed said in July it will require still more capital at the biggest U.S. banks.

While some banks have reduced their risk-weighted assets this year, 30 global banks that regulators label "systemically important" reported that total risk-adjusted assets increased about 11% between 2012 and 2014, according to data provider Bureau van Dijk.

The financial-research office said in the June report that 18 U.S. banks had disclosed in 2014 regulatory filings that they used $38 billion in credit derivatives for "purchased protection" for regulatory-capital purposes, up from 13 banks in 2009.

The Office of Financial Research didn't identify the banks, but a review of regulatory filings by The Wall Street Journal indicates that they include Citigroup, Bank of America, Goldman Sachs Group Inc. and Morgan Stanley.

Some of the 18 U.S. banks say the trades weren't driven by a desire to improve their capital ratios. "We don't enter into any transactions for the sole purpose of artificially reducing risk-weighted assets or increasing regulatory ratios," said a spokesman for Citigroup, which had $16 billion in purchased capital protection in the fourth quarter of 2014. He didn't specify the impact of the trades on Citigroup's capital ratios.

Goldman Sachs and Morgan Stanley declined to comment.

Standard Chartered PLC has done 12 capital-relief trades since 2005. In one, a March 2014 trade that was part of a series dubbed "Start," the bank transferred some of its risk on a pool of EUR1.5 billion ($1.67 billion) in loans to small and medium-size companies. Deutsche Bank unloaded some of its risk on EUR2.35 billion in loans earlier this year with another variant of a capital-relief trade, known as synthetic securitizations.

A spokesman for the Office of Financial Research said it is possible the trades have only a "minimal effect" on capital ratios, but the study showed the banks don't disclose enough information to draw that conclusion.

The Fed in 2011 said capital-relief trades "can significantly reduce a banking organization's level of risk" and has said in recent years it scrutinizes the trades based on pricing, rationale for the transaction, and other factors. Fed officials declined to discuss specific transactions.

The SEC's concern is that some capital-relief trades might not really get risk off a bank's balance sheet, said Michael Osnato, chief of the complex financial instruments unit in the SEC's enforcement division.

Wayne Abernathy, an American Bankers Association executive vice president, says it is important to recognize the distinction between "keeping the loan on your books without any cover, and sharing the risk with somebody else."

Firms that advise on or invest in the deals include Christofferson Robb & Co. and Ovid Capital Advisors LLC. "We were attracted to transactions that transferred well-underwritten loan risk," said Glenn Blasius, Ovid's CEO.

One worry about such trades is that they shift risk to funds and other investors that aren't as closely regulated as banks. Before the financial crisis, European banks bought $290 billion worth of credit default protection from American International Group Inc. for regulatory capital relief, the Office of Financial Research noted. That protection likely would have proven worthless had it not been for the bailout AIG received later.

Today's transactions are complex enough that regulators may miss some of the risks, adds Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corp., who favors stricter and simpler capital rules. "It's a little bit catch-as-catch-can," he said.

(END) Dow Jones Newswires

August 17, 2015 19:22 ET (23:22 GMT)

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