The capital games that banks play

September 3, 2009

Treasury Secretary Timothy Geithner’s call for the global banks to set aside bigger capital cushions to better absorb losses on souring securities and ailing loans is a good idea. But that alone won’t be enough to prevent another crisis.

Regulators must also clamp down on the kind of AIG-engineered deals that legally enabled German, French, Dutch, Danish and other European banks to dodge existing capital rules and free up some $400 billion on their balance sheets.

It has become all too popular to characterize last year’s bailout of AIG as an attempt by the federal government to funnel about $50 billion to Goldman Sachs and a handful of other banks.

But the collapse of AIG would have caused even greater hardship for dozens of largely unknown European banks that entered into so-called “regulatory capital relief” transactions with the giant insurer.

In these deals, European banks purchased credit default swaps from AIG to reduce the amount of capital they needed to set aside to cover potential losses on corporate loans and residential mortgages sitting in those banks’ portfolios.

The banks bought these derivatives, largely in 2007, to navigate the changes in capital holding requirements under a switch from the Basel I international banking accord to a revised one known as Basel II.

These CDS deals, underwritten by the insurer’s AIG Financial Products division, essentially permitted the banks to transfer the risk of loss on corporate loans and home mortgages to AIG. And that meant the banks were able to set aside less capital in reserves — freeing up some $400 billion for other purposes.

This is why the inflating of the credit bubble was not just an American phenomenon but a game played by banks all around the globe.

In regulatory filings over the past year, AIG has parceled out more and more information about these regulatory capital relief transactions — often at the prodding of the Securities and Exchange Commission’s corporate finance department.

But, citing “confidentiality restrictions”, AIG has refused to disclose the names of the banks that entered into these transactions.

Congress, however, should force AIG to come clean. In a worst case scenario, these deals could still cause tens of billions in additional losses for the insurer.

The world did not end when AIG was compelled to divulge how much Goldman received as a result of the bailout. And it won’t happen now either, if AIG is forced to disclose the names of the European banks that engaged in this balance sheet chicanery.

In fact, AIG says it expects most of these regulatory capital relief transactions to terminate by the middle of next year. So what’s the harm?

If we’re truly determined to repair the global banking system and not simply put bandages on it, regulators and politicians must demand a full and open accounting of all the banks that played games with their balance sheets.

Among his Group of 20 colleagues, Geithner will find it much easier to lobby for stricter bank capital requirements if there are no secrets about the myriad financial instruments that banks across the globe used to give the appearance they had minimized risk.

It’s important to show that the financial game playing wasn’t confined to Wall Street and London.

And with those secrets unmasked, it will be far easier for regulators to take steps to prevent banks from taking advantage of the kinds of regulatory capital relief transactions that AIG excelled in.

I can’t think of a better way to mark the September 16 anniversary of the AIG bailout than a release of the names of all the banks that benefited either directly or indirectly from the government’s decision to prop up the insurance behemoth.


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