What is Risk Participation

Risk participation is a type of off-balance-sheet transaction in which a bank sells its exposure to a contingent obligation such as a banker's acceptance to another financial institution. Risk participation allows banks to reduce their exposure to delinquencies, foreclosures, bankruptcies and company failures.

BREAKING DOWN Risk Participation

Risk participation agreements are often used in international trade but these agreements are risky because the participant has no contractual relationship with the borrower. On the upside, these transactions can help banks generate revenue streams and diversify their income sources.

Ways Risk Participation Agreements Are Used

Syndicated loans can lead to risk participation agreements if the lenders engage in certain actions. When a borrower seeks a large sum of financing a syndicated loan might be offered through an agent bank that works with a syndicate of other lenders. The participating banks will likely contribute equal amounts towards the overall total needed and pay a fee to the agent bank. Within the terms of the loan, there may be an interest swap between the borrower and the agent bank included. The syndicate banks could be called upon in a risk participation agreement to shoulder the risk of the creditworthiness for that swap. These terms are contingent upon default by the borrower.

There have been some members of the financial industry who have sought to clarify some of the regulatory oversight that could be applied to risk participation agreements with respect to swaps. In particular, there was a desire to see that risk participation agreements would not be treated the same as swaps by the SEC. From certain perspectives, risk participation agreements could be regarded as something that should be regulated as swaps under the Dodd-Frank Wall Street Reform and Consumer Protection Act because of the structure of the transactions.

A clarification was sought by a financial industry association because its members did not believe risk participation agreements shared traits with underlying swaps. For example, risk participation agreements would not transfer any part of the risk of interest rate movements. What is transferred is the risk related to a default by the counterparty. The association also argued that risk participation agreements do have the speculative intent and other traits of credit default swaps.

Furthermore, the association said that the agreements serve as banking products to better manage risks. Keeping them from being regulated as swaps was also in keeping with the leeway granted to banks to engage in swaps that are done in relation to loans.