Federal Reserve’s Capital Relief Change Eases Path to Basel III

The Federal Reserve Board has added a powerful weapon to banks’ capital relief arsenal: direct credit-linked notes. Though not new to banks, CLNs weren’t expressly permitted as a synthetic securitization strategy under Regulation Q until September 2023.

As banks vigorously explore viable capital mitigation options ahead of looming Basel III Endgame requirements, the Federal Reserve’s clarification couldn’t have come at a better time.

In response to the 2008 financial crisis, the Basel Committee on Banking Supervision established Basel III standards to pressure international banks into strengthening their ability to resist economic downturn and remain liquid in the face of recession and other global events. Compliance is expected by July 2025 unless held up by the rulemaking process.

The Federal Reserve says most CLNs issued from banks to note purchasers through a special purpose vehicle will automatically qualify for capital relief. It indicated a willingness to review whether direct CLNs—issued from a bank to a note purchaser without the use of an SVP—would qualify for capital relief on a case-by-case basis.

Regulation Q

The Federal Reserve has long set and adjusted minimum regulatory capital requirements in Regulation Q, which it promulgated pursuant to the Banking Act of 1933.

In accordance with Basel III, the Federal Reserve is expected to increase those capital requirements in July 2025. Regulation Q provides the framework to calculate the amount of capital a bank must maintain at any given time by assigning different risk weights to various assets.

Banks can effectively lower the risk weight of an asset to zero by offloading risk to a third party, such as private equity. This can be done either through traditional securitization, where the bank transfers ownership of an asset and moves it off its balance sheet, or through synthetic securitization, where the bank transfers the risk but maintains control of the underlying asset.

Increasingly, banks are turning to synthetic securitization because that can be flexibly structured with regard to asset types and characteristics. Issuers like CLNs because the bank maintains ownership of the reference asset in the risk transfer trade. CLNs are safer than the credit default swaps that contributed to the 2008 financial crisis, as issuers are simply relieved of their obligation to repay the purchaser part or all the principal of the note if there is a default on the underlying asset.

Before September 2023, there was some hesitation around using CLNs versus other synthetic instruments, as banks didn’t know if they would qualify for capital relief. Now, banks have an answer: SPV CLNs qualify automatically because they clearly meet the conditions outlined in Regulation Q for synthetic securitization. This approach is in line with what the European Central Bank has allowed for some time and will allow US banks to more freely issue SPV CLNs for capital mitigation.

Because SPV CLNs have tax and regulatory implications, many US banks would rather issue direct CLNs. Direct CLNs, however, don’t qualify automatically for capital relief because they don’t fall as neatly into the definition of synthetic securitization.

Under Regulation Q, the Federal Reserve can review direct CLNs and lower the risk weight of underlying assets. Regulators have indicated their analysis will focus on two questions: Is a credit derivative or guarantee involved? Is the relief of the repayment obligation of the issuer once the note is sold sufficient to be deemed a recognized credit risk mitigant equivalent to collateral?

To answer the first question, the issuer will need to demonstrate that the direct CLN program has features that make it akin to a credit derivative. The only guidance thus far is that the program’s custom documentation should be similar to the standardized documentation used for other derivatives, such as from the International Swaps and Derivatives Association.

On the second question, the approval in December 2023 of several direct CLN programs seems to demonstrate that the Federal Reserve views the issuer’s relief of repayment of some or all of a note’s principal in the event of a default sufficient—in exchange for the cash consideration paid for the note up front.

While it’s not the clear answer some hoped for, the Federal Reserve has at least given banks a path forward when using direct CLNs as a capital mitigation strategy, even if they still need regulators’ stamp of approval.

Robust CLN Demand

The Federal Reserve’s clarification on CLNs came a day before it approved Morgan Stanley’s request to treat CLNs as a synthetic securitization. Santander Holdings followed suit in December. More banks are expected to transfer risk to private equity firms and hedge funds that seem to have an appetite for both SPV and direct CLNs right now.

Of course, not everyone likes CLNs. There is concern that widespread use of CLNs could result in less regulatory oversight of the overall financial system as risk is transferred to private equity and non-bank entities through synthetic securitization. However, these concerns are likely overblown, especially given the comparatively widespread use of synthetic securitizations in Europe and the absence of bank failures resulting from such use.

When Basel III Endgame requirements go into effect next year, banks in the US will have less liquidity to generate new business unless they take action to reduce risk. With robust demand for CLNs right now, expect to see them in heavy rotation as a capital relief strategy in 2024 and beyond.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Cris Cicala is partner in the New York office of Stinson with focus on corporate, finance, and banking matters.

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