Regulatory arbitrage attempt of the day

By Felix Salmon
July 7, 2009

Patrick Jenkins gives a good example of why insurance is not a sensible way to think about or regulate financial products:

Investment banks, including Goldman Sachs and Barclays Capital, are inventing schemes to reduce the capital cost of risky assets on banks’ balance sheets…

The schemes, which Goldman insiders refer to as “insurance” and BarCap calls “smart securitisation”, use different mechanisms to achieve the same goal: cutting capital costs by up to half in some cases…

Under Goldman’s idea, it would sell an insurance product to a bank with a toxic portfolio, effectively shifting the risk of the underlying assets off the balance sheet. The insurance would require far less capital to be carried against it than the original assets.

The insight here (I believe Goldman considers it “financial innovation”) is that insurance is fundamentally more leveraged than finance. Rolfe Winkler is wrong when he says that regulating financial products as insurance would force banks to reduce leverage — quite the opposite.

Think about a pair of banks, A and B. Each has $1 billion in loans on its books, and needs $80 million in capital to be held against those loans. But then B insures A against any losses on its loan book, while A insures B against any losses on its loan book. Presto, each bank is now fully insured against loss, and needs much less capital. Each bank also, of course, has a large contingent liability should the other bank’s loans go bad. But the amount of capital that an insurer needs to hold against such contingent losses is much smaller than the amount of capital that a bank needs to hold against its own loans.

The fact that it’s Goldman coming up with this bright idea is particularly ironic since it was Goldman which revealed the way in which banks could use securitization to reduce their capital requirements. The bank even proposed a very sensible new principle:

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

I wonder whether Goldman’s financial innovators got the memo.

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Comments
5 comments so far

I don’t see how your example about banks A and B is any different than the problems caused by AIG and Bear Stearns not having enough collateral to back up the insurance they sold. What is different? If you buy insurance from a seller who doesn’t have the capacity to pay off in case of a default, then risk hasn’t been lessened, and the capital requirements shouldn’t have been changed.

It sounds like more of the same shell game, where risk is moved around, split up, combined with other risks, and then hidden somewhere else so nobody knows for sure what the real risk is. In your simple 2-bank example, the idea that the two banks sharing each other’s risk somehow reduces the overall risk because it’s unlikely they will both suffer defaults is the exact same mentality that created the current disaster. What am I missing?

Posted by KenG | Report as abusive

Felix, I think instead of regulation by constraint, regulation by separation is the best move. Risk is easy to measure when not obfuscated by structure. Glass Steagall worked great for a long time. I think some form of seperating the participating entities may be useful. Even if that left only a CDS (offerers) as mostly speculative bodies, it would provide price information and hopefully more transparency. Risk is OK, obfuscated risks or balance sheet are dangerous.

KenG, that’s exactly Felix’s point. Insurance, as currently regulated, may allow banks to get around capital requirements but it should not.

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Posted by youpijiufang | Report as abusive

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This past or being plundered all the people should be awake, such as Germany, boycott, these hybrids

Posted by youpijiufang | Report as abusive
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