(Bloomberg) -- It was supposed to be 2024’s hot credit trade for banks and money managers. Now US rulemakers are pouring cold water on it. 

Synthetic risk transfers were billed as the credit market’s solution to new, and potentially onerous, US bank capital rules designed to help ensure that banks have strong enough buffers against financial distress. Money managers from D.E. Shaw to BlackRock Inc. are buying them, with the latter forecasting that sales of the instruments could grow by as much as 30% to 40% a year.  

But last week, Federal Reserve Chair Jerome Powell said the US plans to change its proposed Basel III Endgame rules, and potentially completely remake them. When the dust settles, banks may have less incentive to use synthetic risk transfers to manage their capital requirements.  

It’s a potential major setback for money managers who had been looking to tap into a nascent market that, while risky, offers double-digit yields. Banks last year issued $25 billion of SRTs partially offloading the risk of $300 billion of loans, according to an estimate from Pemberton Asset Management.

“Alternative credit managers have spent the last 12 months trying to position for an opportunity that may not come to pass,” said Ben Hunsaker, head of structured credit at Beach Point Capital Management. 

Many Wall Street professionals saw the US as the biggest potential source of market growth, as its proposed implementation of the latest round of Basel III rules was widely seen as harsher than Europe’s, requiring more capital and giving banks more reason to cut their burdens with risk transfer deals. 

If US banks don’t end up embracing synthetic risk transfers as much as previously expected, growth in the instruments will probably be closer to the low double digits annually, said Alec Innes, co-head of financial risk & resilience at KPMG LLP, who advises banks worldwide about tools to bolster capital ratios.    

“Until the US rules are clear, it’s hard to know what the pace of growth will be,” Innes said. 

Even if Basel III Endgame rules in the US are watered down, SRTs will continue to be popular with banks in Europe and Canada — and in fact they will probably still be compelling to many Wall Street banks too. Before the shape and form of the new capital rules are known, US banks including JPMorgan Chase & Co. had become more-frequent issuers of SRTs heading into 2024. 

“We expect credit-risk transfers will keep happening even if capital charges are not as punitive as expected under the current proposal,” said Pratik Gupta, mortgage backed security strategist at Bank of America Corp. 

Wall Street firms face intense competition from shadow lenders who are, for example, winning some of the most highly-paid leveraged loans away from them through private credit loans. Some of the biggest buyers of synthetic risk transfers from banks are shadow lenders such as credit-focused money managers.   

“Private credit lenders have slowly cannibalized traditional bank revenue, but Powell’s latest comments may signal a stop to that momentum,” Beach Point’s Hunsaker said.

For their part, investors are still getting ready for an influx of American risk-transfer deals. Axa IM Alts, the alternative assets management unit of the French insurer, plans to boost its staff of US-based specialists, Milan Stupar, co-head of bank capital solutions & specialty finance at Axa IM Alts, said in an interview. 

Banks globally have been selling more of these securities in recent years. Bank of Montreal has been issuing SRTs for some time, and other Canadian banks have more recently joined in. In Europe, SRTs grew more commonplace after the financial crisis, providing an alternative for banks that faced punitive costs raising equity. Lenders have used them to stay within maximum risk and concentration to specific exposures. They also provide a hedge against future credit losses.

“Regulatory capital management is only one reason for using SRTs,” said Jonas Bäcklund, head of group structuring at Nordea Bank, which has placed the securities with international investors.  

Slower Transition?

In the meantime, the SRT market is taking encouragement from guidance released by the Fed in September on what types of transactions can be eligible for capital relief. Specifically, the regulator said passing on the risk of loans to a special purpose vehicle, which would then sell credit-linked notes to investors, can count as a synthetic securitization. Banks can also issue credit-linked notes directly but will have to ask for the Fed’s “reservation of authority” first.

“Our sense is that the Fed plans to simply tweak the proposed rules, rather than scrap the Endgame provisions, and that this should appease larger players,” said Matthew Moniot, co-head of credit risk sharing at Man Group. 

He still thinks this year will be the market’s busiest in history. But other market participants question how fast the pace of growth will be now. 

“The transition to a deeper market of SRTs in the US is on its way, but it’s going to be much slower than what people expect,” said Carlos Mendez, co-founder and managing partner at asset-based private credit manager Crayhill Capital Management. 

--With assistance from Cecile Gutscher.

(Adds Axa hiring plans in 13th paragraph)

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