Why banks are selling their best loans

Banks are selling high-quality corporate loans to private credit managers and other institutional buyers, when they might be growing their balance sheets or putting spare cash into yielding assets. Capital management has turned defensive. Selling good loans looks odd while margins are rising. Regulatory capital arithmetic explains it.

A spring of forced sellers

The first wave of sales came from necessity. After Silicon Valley Bank, Signature Bank and First Republic failed between March and May, several regional lenders scrambled to raise liquidity and reassure depositors. PacWest was the most visible, selling whole lending businesses and loan portfolios to private credit and real estate investors rather than risk another run. Those deals were about survival, and the prices reflected it.

The more telling sales are the ones made by healthy banks. Lenders with stable deposits and comfortable profits are also packaging performing loans for sale or buying credit protection on them. They are not short of cash. They are short of something else: room under capital rules that are about to get tighter.

Sell loans, save capital

Coming changes under the Basel III Endgame framework will raise capital charges on corporate lending. By selling performing loans, banks free up risk-weighted capacity and shed the risk of borrowers being downgraded. They also lift their capital ratios without issuing dilutive new shares. Private credit funds, which manage some $1.5 trillion and still hold large sums of uncalled capital from their investors, are happy to buy.

The mechanics are straightforward. A bank's core capital ratio divides its equity by its risk-weighted assets. There are two ways to raise it: add equity, by retaining profits or selling shares, or shrink the denominator. Selling a loan does the second at once. The risk-weighted assets attached to it disappear, and the capital that supported it becomes available for buybacks, for new business with better returns, or simply as a buffer against the new rules. The price of doing so is usually a small discount to the loan's face value, booked as a loss. For a bank that expects its capital requirement to rise, a modest one-off loss that releases capital permanently is a trade worth making, even on a loan it would happily have held to maturity.

The rulebook is almost here

American regulators are expected to publish their version of the Endgame rules within days. Michael Barr, the Fed's vice chair for supervision, previewed the direction in a speech on 10 July, saying the changes would amount to roughly two percentage points of additional capital for the largest banks and that tougher standards should apply to banks with $100bn or more in assets, not only the giants. That second point matters for the regional banks, which had expected lighter treatment.

Banks do not have to wait for the final text to act. Rules of this kind are phased in over several years, but investors and rating agencies judge banks on their projected ratios under the new regime. A bank that can show it will comfortably meet future requirements without cutting its dividend earns a better share price today, and selling loans is the quickest way to get there.

Where the loans go

Private credit grew up in the space banks vacated after 2008. Tougher capital rules and the 2013 federal guidance on leveraged lending pushed banks away from risky corporate loans, and direct lending funds, backed by pension funds, endowments and insurers, stepped in. The industry has since moved up the quality ladder. Buying seasoned, performing loans from banks at a modest discount gives these funds exactly the assets their investors want: floating-rate income from established borrowers.

The funding structures are different too. A bank finances its loans with deposits that can leave at short notice, as this spring showed. A private credit fund finances them with capital that investors have committed for years and cannot withdraw on demand. In that sense the loans are moving to holders better suited to keep them. Insurers affiliated with the large alternative asset managers are particularly keen buyers, since long-dated, higher-yielding credit matches their annuity liabilities.

Another route is the synthetic risk transfer, common in Europe for years, in which a bank keeps the loans but pays investors to absorb the first losses on a portfolio. The loans stay on the bank's books and its customer relationships are intact, but the regulatory capital charge falls. Expect more of these deals in America if regulators give them a clear treatment.

Who gains and who loses

The clearest winners are the large private credit managers, who acquire good assets without having to originate them, and bank shareholders, who get stronger capital ratios without dilution. Borrowers are mixed. Companies whose loans move to private funds often face stricter terms and less flexibility if they run into trouble, and small and mid-sized firms that relied on regional banks may find new credit harder to get as those banks shrink.

Regulators face a subtler cost. Every loan that moves from a bank to a fund leaves the supervised system. The Fed and the FDIC can examine a bank's loan book in detail; they see far less of what happens inside private credit vehicles, which report to investors rather than supervisors.

The case for concern

The strongest counterargument is that this looks like the pre-2008 originate-to-distribute model, in which banks sold loans and mortgages off their books only for the risks to return during the crisis through funding lines and guarantees. If banks lend to private credit funds that buy their loans, the risk has changed shape rather than left the banking system. That is worth watching closely, particularly the leverage banks provide to the funds.

Even so, the current sales look more like prudent balance-sheet management than a hidden crisis. The loans are performing, the buyers are long-term investors, and the motive is a known rule change rather than concealed losses. Nobody should read these sales as distress. Banks are hoarding capital before the new rules bite, and private credit funds will end up holding a growing share of the best corporate loans. Over the next year, as the Endgame proposal is finalised, the steady drip of portfolio sales is likely to become a flood, with mid-sized borrowers finding their lender has changed from a bank to a fund.