Basel III and Regulatory ArbitrageThe FT's Alphaville has recently run some pieces about how regulatory capital arbitrage is possible under Basel III. These make the point that this activity is most certainly happening. The title is "Back to the BISTRO", a reference to some famous JP Morgan deals of the late 90s. I remember at the time trying to work out how these BISTRO deals worked, and it took a while to realise that they were an arbitrage based on moving assets from the banking to the trading book and buying protection from a non-bank.
These days the arbitrage is not banking v trading book, but the transfer of sufficient risk to the non-bank sector to convince regulators that "significant risk" has been transferred. It's a more sophistictaed version of form over substance, but form over substance is what it is.
This one will run and run: in the same way that it is worth the while of big firms to pay expensive advisors to minimise tax, so big banks can afford to pay for ways of freeing up regulatory capital.
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Happy New Year to one and all!
A few points which I think will be relevant in 2012:
-Banks will struggle to fund themselves, particularly in the medium and longer brackets. The FT's Lex said on 2nd Jan what we have been saying for some time: get over the prejudice about securitisation; apart from the bonkers structures (CDO squared, US subprime etc.) this asset class has performed amazingly well since 2007. And the more covered bonds a bank issues, the worse the risk for the unsecured creditors. Securitisation has many benefits!
-The shadow banking sector will increse its influence. This is an inevitable consequence of tighter regulation and increased solvency requirements: hedge funds, private equity and money funds are either unregulated, or regulated much less tightly than banks. One development which would benefit many parties would be bundling credits to loan-starved corporates and distributing them via (properly regulated) funds to income-starved investors.
-Banks will no longer be able to hold off selling assets as they come under increasing presssure to improve solvency ratios. The shadow banking sector will be a big buyer. Funds will be set up for this purpose.
-There will be various attempts at regulatory arbitrage, for example along the lines of RBS's Project Isobel (it's not clear what risk has been transferred in this UK property deal, but it is clear that RBS is "smoothing" losses, i.e. spreading the pain over time. At a price). Another potential structure is where a non-bank posts cash collateral for the equity piece of a portfolio of assets. The bank in turn pays an amount equal to this expected loss plus a profit, and saves a chunk of capital. This is a classic form over substance structure, and regulators will no doubt be onto it.
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An astonishing aside from David Smith in the Sunday Times: "...Britain's AAA credit rating. This, already under closer scrutiny since the autumn statement, could easily go. If it went, Osborne would be honour-bound to go too".
So the finance minister of a major country effectively holds his job at the whim of three unaccountable private sector organisations whose business it is to express opinions (for that is what they are) and which opinions have been at times badly wrong. Remember Asia in 1997 and the AAA subprime bonds in more recent years.
Politicians are in part to blame for this nonsense: they have hardwired ratings as a substitute for thinking and analysing into the financial system under the Basel rules. But we really need to get away from a slavish adherence to what these three not-exactly-oracular organisations opine. That needs both more agencies and a return to thinking for ourselves.
By the way, we are talking about the difference between "minimal" and "very low" credit risk as we go from Aaa to Aa in Moody's ratings, so not exactly a disaster scenario:
Aaa Obligations rated Aaa are judged to be of the highest quality, with minimal credit risk.
Aa Obligations rated Aa are judged to be of high quality and are subject to very low credit risk.
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Just received the latest ABS market report from Markit. They open with a remarkable sentence:
"With most credit investors expecting the worst in Europe and with sovereign spreads going through the roof it seems that ABS securities, senior in particular, continue to be a safe haven of relative stability."
How the tables are turned! It was just three years ago that I was introduced by an old friend to a firm which advises pension funds and insurance companies. I patiently made the case for AAA consumer-asset backed bonds (aggregate default rate 0.07% throughout the crunch, as we now know)-diversification, higher yield, safe home for funds etc. Oh, and they were available for 60% of face value due to bulk sales by Lemming & Co.
This analysis was dismissed out of hand-politely whist I was present, then in quite derogotary terms once I had left the room, according to my friend. Perhaps their advice was to buy EU government bonds. Who knows?
The fact remains that, then as now, consumer ABS represents a good, safe asset. The investor gets this, and the bank gets much-needed term funding. And the economy benefits. Apart from that, there's no upside!
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I commented almost three years ago on the baffling preference amongst anglo-saxon banks for property lending
http://www.robinhoodfinance.com/blog/in ... 230-105742
The thesis is that property has been shown many times to be poor security-big lumpy things whose value can fluctuate wildly, and which do not produce sufficient cashflow to repay loans (sale or refinancing is invariably necessary). Short-term, self liquidating assets such as trade finance are a far better bet.
I have in more recent times had discussions with various Islamic banks, some with a UK presence and some without. One common theme is the desire for "safe" property-based assets and suspicion of "risky" short-term assets, even when the latter are backed by rated (Takaful) insurance.
I have come across Islamic institutions which have a large part of their balance sheets invested in commodity murabaha yielding half a per cent or so with, presumably, at best A or BBB rated counterparties, but who are unwilling to take the "risk" of assets with a similar level of risk but ten times the profit. And some of these banks desperately need to increase profits.
In addition, one of the tenets of Islamic banking is mutuality and benefit to society. Compare here putting money into a building and facilitating trade and commerce.
Once again we're in the realm of the psychological rather than the logical: property is seen as the "safe" option internally. Senior management needs to change its views. There is upside for everyone.
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