Regulatory arbitrage datapoint of the day

By Felix Salmon
April 8, 2009

capitalcushion.tiff

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as the banking industry is concerned, even as many other banks are still lobbying for mark-to-market regulation to be repealed.

More From Felix Salmon
Post Felix
The Piketty pessimist
The most expensive lottery ticket in the world
The problems of HFT, Joe Stiglitz edition
Private equity math, Nuveen edition
Five explanations for Greece’s bond yield
Comments
8 comments so far

I wouldn’t be heartbroken if securities were subjected to somewhat higher capital requirements than loans, if just because of the agency costs they create; encouraging the originator of a loan to retain most of the exposure to the consequences of bad underwriting seems to me like a worthy policy aim. Letting banks, particularly small banks, diversify their exposure to other markets makes sense to me, but its benefits have surely been over emphasized in some places, and a gentle regulatory nudge in the other direction might be salutary.

Incidentally, I understand that part of the mark-to-market problem has been that banks have bought CDS protection on loans, and have been required to mark their hedges to market while not marking their loans to market. This results in an economic hedge, but not a financial or regulatory accounting hedge. It used to be that anything declared a “hedge” for something that wasn’t marked to market didn’t have to be marked to market, but they’ve tinkered with this a couple times in the last five years. Marking both to market makes most sense to anyone who comes from a trading background, but marking neither, in many cases, works almost as well. For maximal perversion, you need to treat them differently — much the same as with pools of loans before and after securitization. “Treat similar things similarly” is a good rule for regulation, and law in general. It’s not always so clean in practice as in theory, but it’s probably easier than what’s been cobbled together at this point.

This analysis only looks at “Pillar I” capital required under Basel II.

Under Pillar II, a bank is required to independently determine whether the Pillar I capital is sufficient. In cases where it ends up with less capital for rejigging the exposures without actually moving any risk to someone else, then the bank would need to top up the Pillar I capital.

In the example cited the amount of the top up should be sufficient to get you back to the original capital requirement.

There are problems with this approach because Pillar I capital shows in the Tier I ratio, and Pillar II capital only appears in the total capital ratio, but GS should acknowledge that regulators recognized the potential for arbitrage and tried to close it off.

Posted by Boring Cdn | Report as abusive

I agree with Boring Cdn. The most remarkable thing about the GS report is that it assumes that all banks always arbitrage regulatory capital — or in other words that no bank would ever consider holding a level of capital sufficient to protect from failure if the regulators did not require it to.

Makes me think that the only real solution is Simon Johnson’s “just break them up” method, so regulators can relax and let old-fashioned market forces do their job.

Posted by Anon | Report as abusive

Awesome find.

Reg capital arbitrage is not a new thing. Thanks for the post, but just a heads up one doesn’t have to change or securitize asset classes to achieve reg capital relief. one can simply resecuritize a single CDO tranche into 2 tranches to play the game. The rating agencies also benefit (in terms of fees). Se for example our March piece http://expectedloss.blogspot.com/2009/03  /regulatory-capital-arbitrage.html
If we wanted to stop the game, we would have to delink ratings from reg capital requirements. Tough, but possible. And it may help mitigate against systemic risk issues.

Posted by Gene | Report as abusive

The minimum capital requirements for banks based on risk assessments by third parties is the greatest interference ever in the risk allocation system of the market and is much better scrapped altogether

Hello, you used to write fantastic, but the last several posts have been kinda boring… I miss your super writings. Past several posts are just a little bit out of track! come on!

Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/