SRTs Preserve Loss-Absorbing Capacity in Bank Resolutions

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U.S. banks are increasingly using significant risk transfers (SRTs), or synthetic securitizations, to manage credit risk and optimize regulatory capital. This paper examines how SRTs can preserve third-party loss-absorbing capacity outside a failed bank's receivership estate and give the Federal Deposit Insurance Corporation (FDIC), as receiver, valuable discretion to enforce, transfer, or exit credit protection arrangements depending on their economic value at the time of the bank's failure.

Why it matters

SRTs can reduce the FDIC's costs and protect the Deposit Insurance Fund by preserving external loss-absorbing capacity that remains available to the receivership even after a bank has failed. The optionality created by SRTs can also facilitate orderly resolutions by reducing uncertainty about credit losses on the failed bank's assets, making them more attractive to potential acquirers.

The details

The FDIC's treatment of a failed bank's contracts depends on whether they constitute 'qualified financial contracts' (QFCs) under the Federal Deposit Insurance Act. Directly-issued credit-linked notes (CLNs) are typically not QFCs and are subject to the FDIC's broad discretionary powers, including a 90-day stay on counterparty remedies, the authority to enforce contracts, and the power to selectively repudiate burdensome contracts. In contrast, third-party credit default swap (CDS) transactions generally are QFCs subject to a more constrained safe harbor, which preserves counterparty close-out rights after a one-business-day stay.

• The FDIC has 90 days following its appointment as receiver to evaluate directly-issued CLN contracts and decide whether to enforce or repudiate them.
• The FDIC has until 5:00 p.m. (Eastern time) on the business day following its appointment as receiver to evaluate third-party CDS contracts and decide whether to transfer them to a bridge bank or allow them to terminate.

What they’re saying

What’s next

As policymakers evaluate the growth of synthetic risk transfer markets, consideration of how SRTs operate in bank receivership may inform a more complete assessment of their role in financial stability.