Regulatory arbitrage datapoint of the day

April 8, 2009


This chart comes from an excellent new publication by Goldman Sachs, called “Effective Regulation: Avoiding Another Meltdown”. On the left hand side is the amount of capital that a bank would need to have if it had $100 of mortgages on its balance sheet: 5%, or $5. Once it securitizes those mortgages and they become RMBS, however, the capital needed drops to $4.10.

Of the $4.10, 40 cents is comprised of capital provisions against the triple-B tranche of the RMBS. But if the bank then repackages that triple-B tranche into a CDO, that capital requirement drops still further, to 35.5 cents.

In all these cases, the total amount of risk in the bank is unchanged — we’re assuming the bank is just repackaging, here, and not actually selling anything. But just by dint of structuring and repackaging, if you turn a loan into an RMBS and then a CDO, you manage to reduce your capital requirements — and thereby increase your return on equity — substantially.

Goldman has four principles it would like to see implemented so as to avoid a repetition of the current disaster; they all make perfect sense. The first is for regulators to spend a significant amount of time looking at the system as a whole, rather than just the individual institutions within it: one big cause of the current crisis was that while the system could cope with any one institution’s assets going bad, no one realized how high correlations were, and that if one institution’s assets went bad, hundreds of other institutions’ assets would all be going bad as well, all at the same time, with systemically-devastating consequences.

The second principle is simple, and tries to prevent the regulatory arbitrage in the chart above:

Securitized loans should, in aggregate, face the same capital requirements as the underlying loans would if they were held on bank balance sheets.

The third and fourth principles are essentially the converse of the second: if you treat securities like loans, then you should treat loans like securities. That means marking them to market at origination, both in commercial banks and at investment banks.

None of this would be sufficient to prevent another crisis, but it’s a good start. And well done to Goldman for being out in front on this, as far as the banking industry is concerned, even as many other banks are still lobbying for mark-to-market regulation to be repealed.


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