According to the Smart Finance App, regional U.S. banks are reaching complex and costly deals with hedge funds to avoid the turbulence that followed the collapse of Silicon Valley Bank last year, while Wall Street smells the scent of becoming rich.

Huntington Bancshares, based in Ohio, has recently reached an agreement to sell investors part of the risk of borrowers defaulting on loans. This helps the bank meet newly proposed standards that make it look healthy in the eyes of regulators. This transaction, called comprehensive risk transfer on Wall Street, provides an attractive investment for private debt fund managers such as Ares Management and Blackstone with abundant cash. People familiar with the matter said that Bayview Asset Management, a fund that participated in Huntington Bancshares' transaction in December last year, will earn as much as 15% from this trade and similar ones made for SoFi Bank.

Others are also making such trades, including large regional banks such as Utah-based Ally Bank and North Carolina-based Truist Financial, which are selling the risks of billions of dollars in loans, according to data provider Finsight and Fed letters to these banks.

Regulators are forcing banks to comply with stricter rules to protect themselves from confidence crises, such as the bankruptcy of Silicon Valley Bank and the recent crisis that rocked New York Community Bancorp. Analysts say that ultimately risk transfer should help stabilize banks and resume activities such as share buybacks and acquisitions. Ken Usdin, a banking analyst at Jefferies Financial, said, "You might call it active defense. They are optimizing regulatory capital, but are paying the price for it."

New regulations are coming.

U.S. banks are preparing for new rules announced after the collapse of regional banks last year, which are expected to force mid-sized banks to meet capital requirements that previously only applied to large financial institutions. Russ Hutchinson, CFO of Ally Bank, said at a recent investor meeting that "we expect to be in capital preservation mode as the situation develops." He said that risk transfer "has become a very attractive way for us to reduce risk-weighted assets and preserve effective capital."

Historically, U.S. banks have created a financial cushion by selling stocks or loans to increase capital. Many of the loans they hold were issued at low interest rates, meaning that if they sold them now, they would incur losses. Selling new shares could push down already battered share prices. However, at the end of last year, the Fed offered U.S. banks another option, allowing them to increase regulatory capital through risk transfer, a tool long used by European banks.

Raymond James structured products trader Kathy Jones said the U.S. has completed about 20 synthetic product deals totaling $17 billion, compared with about $190 billion in Europe. She said the U.S. could quickly surpass Europe once smaller regional banks start using the product. It is reported that a letter from the Fed shows that Merchants Bancorp, based in Indiana and of relatively small scale, has been given approval to conduct a comprehensive risk transfer this month.

Banks can transfer risk in two ways: by selling so-called credit-linked notes to investors to boost their balance sheets; or by buying credit insurance from investors, who use cash as collateral and are paid interest or premiums by banks, while investors are responsible for losses from loan defaults caused by insurance loans. Both options can offset default losses of up to 12.5% on loan pools.

Wall Street's hot product.

Last fall, banks such as JPMorgan and Morgan Stanley issued a series of synthetic risk transfers for themselves. Now they are arranging transactions for regional banks - while charging fees and hoping to start trading these instruments when the market is large enough. Morgan Stanley helped Huntington Bancshares raise capital for its deal with Bayview. JPMorgan is currently pitching a transaction that transfers Ally Bank's risk to investors, as well as a Huntington Bancshares risk deal that doesn't involve Bayview.

Others are preparing for when small banks can issue risk transfer. Private credit fund Crayhill Capital Management has hired investment banker Tom Killian as a consultant. Tom Killian helped develop the bond market backed by community bank priority securities in the first decade of this century. According to a source close to Tom Killian, he has held informal talks with banks and regulatory authorities about risk transfer issues with the aim of ultimately helping small banks enter the market.

For asset management companies, bank risk transfer offers high returns and is also a new product to sell to investors eager to enter the hot private credit market. BlackRock, private equity fund expert KKR and French insurance company AXA have all released reports to sell their products.

Bayview has proposed a workaround for these complex trades: borrowing in the bond market to increase returns. Bayview manages about $20 billion in assets, specializing in buying mortgage and consumer loans, often from banks like Huntington Bancshares. Insiders familiar with the fund manager said the company has been selling risk transfer transactions to banks for at least five years.

Bayview proposed selling credit default swaps (a form of insurance) from Huntington Bancshares to reduce capital costs for its pool of around $3 billion in auto loans.The bank agreed to pay a 7.5% premium annually, while Bayview promised to compensate the bank for any overdue auto loans for up to seven years, with a maximum compensation of US$375 million, 12.5% of the total loan amount.

To fulfill this commitment, Bayview issued approximately $315 million in bonds with a blended rate of approximately 6.75%. The cash from the bonds went into an interest-bearing account. Over time, these bonds will be repaid using Huntington Bancshares' premiums, money in the account, and accrued interest. Bayview will pocket the difference in income. However, if auto loan defaults exceed Bayview's expectations, the fund may suffer losses.