"Regulatory arbitrage datapoint of the day
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as the banking industry is concerned, even as many other banks are still lobbying for mark-to-market regulation to be repealed."
"As we rebuild the financial system, four things are clear:
1. Capital gluts must be managed, and asset bubbles cannot simply be allowed to
run their course. Regulators have focused on managing risk at the level of institutions,
and have sought to strengthen financial systems against small and local shocks. Major
regulators have largely been successful in this – but in the process, they have
unintentionally increased the system’s vulnerability to global and macro shocks. In the
future, regulators should give stronger focus to macro-prudential supervision. This will
entail greater international information-sharing and cooperation.
2. Securitized loans should, in aggregate, face the same capital requirements as the
underlying loans would if they were held on bank balance sheets. Securitization
would then be driven by a desire to reduce hazardous concentrations of risk, rather
than a desire for capital relief. Regulators should also monitor the quality of the assets
being securitized and the ratings assigned by rating agencies.
3. Lending institutions should be required to mark large loans to market at
origination, forcing symmetry across the recognition of profit and risk. Banks
should not be allowed to defer losses via their commercial banking lines while
recognizing profits immediately in their investment banking units.
4. Lending linked to investment banking activities should be consolidated into the
investment banking arm and subjected to full mark-to-market discipline and all
regulatory and accounting rules that apply to trading assets. This would eliminate
the ability to exploit differences in regulation or accounting. Further, financial
institutions involved in investment banking should be required to have an
independent, appropriately staffed and fully-resourced control group to mark and
manage the resulting risks.
Accordingly:
• All activities associated with investment banking activities, including lending, should
be consolidated within the investment banking unit. This would subject them to the full
discipline of mark-to-market, as well as the capital, leverage and other regulatory
restrictions that apply to “investment banking.”
• Lending institutions that engage in both investment banking and lending with a single
client should be required to mark large loans to market as soon as they are originated.
This would erase the timing arbitrage that currently exists, by forcing banks to
recognize the losses from below-market loans at the same time that they recognize the
associated fee income. This in turn should reduce the incentives for poor lending
practices.
• Securitized assets should have to remain in the investment bank unless sold outside
the holding company entirely.
Whatever the specific form of future regulations, the intent should be to force companies
to treat transactions consistently, regardless of how they are handled, and to impose a
consistent valuation and timing of recognition of profits, losses and risks, regardless of
where the assets are held or how they are structured.
Despite their best efforts in the months ahead, it is unlikely that governments, regulators
and market participants can build a regulatory system so flawless that it can perfectly
manage another influx of capital like the one we have just seen. Accordingly, the best
solution will include finding ways to offset capital imbalances that may occur in the future,
while simultaneously developing a stronger regulatory system that limits the spread of the
damage."
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