What Is Risk Participation?

Risk participation is 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. 

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, a banker's acceptance, or some other type of contingent obligation.

Risk participation agreements are often used in 澳洲幸运5官方开奖结果体彩网:international trade. However, these agreemen﷽ts can be very risky because the participant has no contractual relationship withꦰ 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 can generate a new revenue stream and, therefore, diversify 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 tha🅺t each participating institution would ofಞfer toward the loan. This would determine how much risk each participant is willing to assume.

Speci𒀰al Conꩵsiderations: Swaps and Risk Participation

Some members of the financial industry have sought to clarify some of the regulatory oversight that could be applied to risk participation agreements concerning swaps. In particular, there was a desire to ensure risk participation agreements would not be treated the same as swaps by the 澳洲幸运5官方开⛎奖结果体彩网:Securities and Exchange Commissio🔜n (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 a🍨nd Consumer Prote🙈ction Act because of the structure of the transactions.

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 Financi🐽al 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 澳洲幸运5官方开奖结果体彩网: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 concerning loans.

Example of Risk Participation

Here's a hypothetical example to show how risk participation works using the example of a 澳洲幸运5官方开奖结果体彩网:syndicated loan. As noted above, a syndicated loan may be offered through an agent bank working with a syndicate 💝of 𒆙other 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.

The syndicate banks could be called upon in a risk participation agreement to shoulder the risk of the creditworthiness of that swap. These terms are conti✤ngentꦡ upon default by the borrower.

The Bottom Line

Risk participation agreements help banks reduce their exposure to certain risks, such as defaults and bankruptcies, by selling a portion of that risk to another financial institution. These agreements allow lenders to diversify their risk and are often seen in international trade and syndicated loans.