SRTs are a form of synthetic securitization, often called “on-balance-sheet securitization,” in which a bank offloads a portion of a loan portfolio’s credit risk through a contract, typically a credit derivative or guarantee, without fully selling or removing the loans from its balance sheet.
In Europe, where the market was born, the investor typically acquires mezzanine loan risk by selling (writing) a credit default swap (CDS) and, in the United States, through a credit-linked note (CLN). The primary protection sellers are public and private credit funds, which are attracted by competitive yields, access to high-quality diversified credit exposures, and the ability to tailor risk via tranches. Banks pay for this protection because it allows them to transfer part of their loan risk to investors, which in turn reduces their regulatory capital requirements and frees up capital for new lending at a lower cost than raising equity.
The originating bank retains the first loss (junior) tranche[2]. The investor, who does not have specific knowledge of the pool’s underlying loans (only generic details like maturity, ratings, and industry) earns a fixed premium or coupon. If defaults in the portfolio occur, the bank absorbs the first loss while the investor covers losses up to the mezzanine tranche limit.
The bank retains the client relationship, loan administration, and interest income to maintain “skin in the game,” which is a regulatory requirement. But since it shed a portion of the portfolio risk, the bank is permitted to reduce capital against the loans.
SRTs are typically engineered for capital relief and risk management. On the former, Basel capital rules are widely viewed as excessively penalizing certain assets. For example, auto loans require disproportionately high capital despite extremely low default rates. SRTs allow banks to reduce risk-weighted assets (RWAs) by 50% to 80% in many transactions. In addition, by transferring risk without shrinking their balance sheets, banks can reduce geographic, borrower, or sector concentration risk.