REGULATORS have a tough balancing act.

They want a safer financial system, but they do not want to kill bank profitability. They want more lending, but they have required banks to have more cash and equity to buffer against unexpected losses. They have sought to standardise trading, but they do not want to stymie innovation.

These conflicting desires have led regulators, particularly in Europe, to sign off on banks selling some of the risk tied to the loans they make to hedge funds and other investors using derivatives. This lowers the amount of capital that banks have to hold to buffer against loan losses. Last year, they sold about US$6 billion (RM26.58 billion) of such synthetic risk-transfer notes, protecting as much as US$100 billion of debt on their books, Himesh Shah, a managing director at Christofferson Robb & Co, said in a Bloomberg article last Thursday (see chart).

But that risk does not magically disappear. These individually crafted transactions look a lot like the synthetic collateralised debt obligations (CDO) made infamous amid the 2008 financial meltdown. And here is where things start to get more interesting: Some of these hedge funds and others want to earn more money on these deals than, say, just a mere 11% or 12% coupon payment. So they are borrowing money from banks to juice their profits. In other words, banks are lending money to hedge funds to invest in derivatives that guarantee losses on loans held by banks. It is all pretty dizzying.

Nomura and Credit Suisse are among the most active banks providing leverage to hedge funds for this purpose, according to Bloomberg reporters Alastair Marsh and Donal Griffin, who cited confidential sources. These firms are also reportedly trying to make it easier for investors to buy and sell these notes.

From the banks’ perspective, it makes sense. Regulators have handed them a paradox — they want banks to lend more but take less risk. The answer for many firms has been these synthetic risk-transfer agreements.

To be clear, these transactions do not seem as dangerous as many derivatives crafted in the run-up to the 2008 crisis. They are generally fully funded, meaning that investors have to put cash aside to cover any potential losses on loans that are still held by the issuing bank. (In the past, investors often promised to cover losses without having to prove that they would be able to do so.)

But the fact that investors are embracing these securities — and that banks are helping leverage them up — should be sounding alarms. This is a risky market, even in the post-crisis era. Recall Banco Espirito Santo, the Portuguese bank that was forced to restructure in 2014, which sold credit-linked notes tied to a €2 billion (RM9.54 billion) pool of commercial loans. Investors of those notes appeared to wake up to the risk way too late.

Complicated derivatives are not inherently bad, but financial sleight of hand simply moves risk out of direct sight. The introduction of leverage into the mix only makes it more dangerous. — Bloomberg