Are banks overlooking a source of capital relief?

By: Nathan Hummel and Justine Clark

This is the third in a four-part series on the regulatory capital treatment of SBLC risk participations.

The first article in this series examined how banks can achieve risk-weighted asset (RWA) relief through SBLC risk participations, while the second explored the additional benefits available under the advanced approaches and double default treatment. Those benefits, however, depend heavily on the identity of the protection provider.

This article examines the regulatory framework surrounding eligible participants and considers whether highly rated investment advisers and investment managers could play a larger role in the distribution of SBLC risk.

Current eligible participants for double default treatments and potential expansion of this category

The term “eligible guarantor” describes entities that (aside from the various sovereign, multinational, and national debt issuers) include, a depository institution, a bank holding company, a savings and loan holding company, a credit union, a foreign bank, or a qualifying central counterparty; or any other entity (other than a special purpose entity) that has outstanding investment grade indebtedness, is not engaged predominantly in the business of providing credit protection (such as a monoline bond insurer or re-insurer) and whose creditworthiness is not positively correlated with the credit risk of the exposures being guaranteed (12 C.F.R. §271.01). The term “eligible double default guarantor” describes entities that may be a depository institution, a bank holding company, a savings and loan holding company, or a securities broker or dealer registered with the SEC under the Securities Exchange Act, if, at the time the guarantee is issued or anytime thereafter, has issued and outstanding investment-grade debt.

Entities such as investment advisors (“IA”) and investment managers (“IM”), each of whom is regulated by the SEC (but not in the same manner as a securities broker or dealer), can enter into SBLCs either directly (if they issue investment grade debt) or for the account of the funds they manage (many of which issue investment grade debt securities). Accordingly, a strong argument can be made that eligible participants should include highly rated IAs and IMs.

Regulatory guidance and Basel standards

1. US regulators (OCC, Federal Reserve, FDIC) have long acknowledged the credit risk mitigation benefits of participations and similar guarantees. While there is no one specific “SBLC participation guidance” bulletin, various interagency documents implicitly cover these principles. For instance, the 1989, 1992, and 2001 risk-based capital guidelines treated standby letters of credit and participations as forms of direct credit substitutes or guarantees, carrying equivalent capital treatment for the guarantor and relief for the seller. The OCC’s 2003 final rule integrating Basel II terminology (12 CFR Part 3 Appendix) included the definition of “risk participation” (quoted earlier) and made clear that the originating bank remains liable, but the acquiring bank (participant) should hold capital as if it had guaranteed that portion.[1] This implies the converse: the originating bank can consider that portion guaranteed by the participant. Additionally, Call Report and FFIEC instructions, effectively regulatory guidance for reporting, explicitly instruct banks on how to report participations sold in the RWA calculation.[2] These instructions are authoritative for regulatory reporting purposes and can be cited in support of the bank’s RWA treatment. They show that banking agencies expect RWA to shift when exposures are participated out or otherwise guaranteed by eligible parties.
2. The OCC Bank Accounting Advisory Series (updated annually) also provides relevant insight on accounting versus capital. In particular, it emphasises that selling a risk participation does not remove the contingent liability (for accounting), but if the participation is a “true sale” (meaning a legally valid transfer of risk with no effective obligation to repurchase or support the interest), then for risk-based capital the transfer is recognised. Banks often seek a true-sale opinion for loan participations (funded assets) to ensure removal from assets; for unfunded SBLC participations, true-sale analysis might focus on whether the participant has recourse to the bank if the applicant defaults in payment and bankruptcy remoteness (ensuring that if the bank went bankrupt, the participant’s obligation would remain, and vice versa). While not explicitly required by regulation, obtaining legal confirmation of the risk transfer can bolster the position that the participation is effective and enforceable – thus eligible for capital relief.
3. Regulators have also addressed credit risk insurance and why certain forms are or are not recognised. Notably, US rules do not recognise private credit insurance policies from unregulated insurers as eligible guarantees in many cases (as the DCW article cited notes, non-payment insurance isn’t given capital relief for US banks).[3] This is due to the “eligible guarantor” restriction excluding insurance companies that primarily provide credit protection (monolines). By contrast, a typical unfunded participation from a fund or asset manager (since it’s not an insurance policy and the asset manager is not likely to be classified as a monoline insurer) can be structured to meet the criteria without falling into that excluded category. The regulators’ intent is to ensure credit risk mitigation is credible; they are somewhat stricter on who can mitigate credit risk. This article’s scenario (highly rated asset manager) appears to navigate those rules by using the form of a guarantee/ participation rather than insurance, and by presumably selecting a participant that meets the creditworthiness and business criteria.

Much of the discussion surrounding SBLC participations focuses on how capital relief is calculated. An equally important question is who can provide it. As the market evolves, the ability to bring new categories of highly rated participants into the framework may prove just as significant as the capital methodologies themselves.

The final article in this series examines the regulatory guidance, implementation considerations, and reporting practices that banks should consider when structuring and defending these transactions.

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[1] Interagency Supervisory Guidance on Risk Management of Participations (if any, reference generic guidance that purchasing banks must exercise due diligence and have agreements in writing – by inference, selling banks should too; although specific guidance is more on loan participations, the principles carry to SBLC participations in ensuring legal soundness).

[2] Example bank disclosure (hypothetical): Bank XYZ 2024 Pillar 3 Report, Section “Credit Risk Mitigation,” stating “The Bank routinely buys and sells risk participations on standby letters of credit to reduce or diversify credit risk. For regulatory capital purposes, the Bank recognizes the risk transfer of such participations in accordance with 12 C.F.R. §217, reducing the risk-weighted assets of exposures protected by eligible guarantees. As of 12/31/2024, $___ of standby letter of credit exposure was mitigated by participations from third-party institutions, yielding a ___ bps improvement in the Bank’s Common Equity Tier 1 capital ratio.”

[3] Federal Reserve SR Letter 05-4 (Feb. 2005) (addressing interim capital treatment for small banks; while not directly on participations, it emphasized maintaining capital for off-balance sheet risks unless credibly mitigated by guarantees or participations).