What Is Risk Participation?
The term risk participation refers to an off-balance-sheet transaction in which a bank sells its exposure to a contingent obligation to another financial institution. Risk participation allows banks to reduce their exposure to delinquencies, foreclosures, bankruptcies, and company failures. Banks can transfer the exposure they have to risk on any type of obligation, including loans and banker's acceptances.
- Risk participation is an agreement where a bank sells its exposure to a contingent obligation to another financial institution.
- It allows banks and financial institutions to cut down their risk of exposure to foreclosures, corporate failures, and bankruptcies.
- These agreements are often used in international trade, although they remain risky.
- Syndicated loans can lead to risk participation agreements, which sometimes involve swaps.
- Financial industry groups have sought to clarify regulatory oversight that could be applied to risk participation agreements with respect to swaps.
How Risk Participation Works
As noted above, risk participation is an agreement between two financial institutions. Also commonly called risk sharing, it allows one financial institution to sell and, therefore, share part or all of the exposure to a contingent obligation. This is commonly done to offset the risks associated with a loan, banker's acceptance, or some other type of contingent obligation.
Risk participation agreements are often used in international trade. But these agreements can be very risky because the participant has no contractual relationship with the borrower. That's because the relationship is between the borrower and the original lender and doesn't directly include the institution that purchases the risk. The overall benefit lies in the fact that the purchasing party is able to generate a new revenue stream and, therefore, diversity its income sources.
Syndicated loans can lead to risk participation agreements if lenders engage in certain actions. For instance, an agent bank may work with a syndicate to finance a large loan. The banks would work out an agreement, including the amount that each participating institution would offer toward the loan. This would determine how much risk each participant is willing to assume.
Some members of the financial industry 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 ensure risk participation agreements would not be treated the same as swaps by the Securities and Exchange Commission (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.
Industry groups have sought to ensure risk participation agreements are not treated as swaps by the SEC.
A financial industry association sought clarification because its members did not believe risk participation agreements shared traits with underlying swaps. This information was communicated in a letter issued by the Financial Services Roundtable to the SEC in 2011.
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 speculative intent and other traits of credit default swaps.
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.
Example of Risk Participation
Here's a hypothetical example to show how risk participation works using the example of a syndicated loan. As noted above, a syndicated loan may be offered through an agent bank working with a syndicate of other lenders when a borrower needs a very large loan.
Participating banks will likely contribute equal amounts toward the overall total needed and pay a fee to the agent bank. The terms of the loan may include 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.