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How Banks Make Risk Disappear

Source: Wikipedia Commons.

There are a number of way to meet new capital obligations. You could retain earnings, rebalance your portfolio to favor more conservative strategies, or shore up on less risky assets.

But the fact is, while these are great tactics in terms of meeting the requirements, they're not that great when it comes to juicing returns. What if there was a way to have your cake and eat it, too? 

Enter the regulatory capital trade
Also known as capital relief trades, these are essentially insurance policies that help banks get risk off the books. It looks like a credit-default swap: a third party charges an annual fee in exchange for taking on some of the risk associated with an asset (generally a loan). Officially, the bank gets to keep the asset, but the risk goes off the books, and for this service, the bank pays annual fees of 15% or more.

Is this a thing? 
Deals are usually conducted privately, unless a bank wants to publicize one for some reason (like to get better rates), so it's hard to assess the scope of these activities. Bloomberg reported in September that disclosed trades by European banks have totalled at least $30 billion since 2009, and one hedge fund alone has reportedly invested $1 billion in such deals since its inception 2011. Citigroup (NYSE: C  ) insured the bulk of a $1 billion shipping loan book with Blackstone in 2012. 

Other large banks that are known to have participated in such trades recently include Credit Suisse (NYSE: CS  ) , Deutsche Bank (NYSE: DB  ) , and UBS (NYSE: UBS  ) . But considering the general lack of publicity, it is entirely likely that this is a much bigger deal than we realize.

But how bad can it be? 
To be fair, new regulations require American and European funds to carry low-risk collateral against the trades. And of course, investors in hedge funds are generally sophisticated and have a long-term time horizon -- if they're willing to shoulder the risks, you might think, why not? 

Well, it's not so simple. Transferring risk doesn't make it go away, it just transfers it. While a pension fund is unlikely to go under, a hedge fund insuring several large banks could -- especially if the collateral for the trade was borrowed. What happens then? 

More importantly, such trades make banks more opaque rather than more transparent. As investors, we don't know who is sitting on the other side, and whether we can trust that the risk associated with a deal (or several) won't come rushing back into the bank's hands if things go wrong. 

That's where I get concerned -- without insight into what's happening, how can you adequately assess the risks?

Big banking's little $20.8 trillion secret
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Anna Wroblewska

Anna began her career in finance as a college intern at a hedge fund, and she hasn’t been able to escape its siren song ever since. She’s done academic research at Harvard Business School and UCLA, was the COO of a wealth management firm, and now writes about finance, economics, behavior, and business.

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