Bank capital manipulation: the regulatory capital trade

One of the reasons that Basel bank capital ratios are a truly horrible idea is the ease with which banks can manipulate the ratios to deceive financial market participants, including the bank regulators.

Previously, your humble blogger has discussed how banks game the capital ratios by changing the assumptions underlying the models used to risk-weight their exposures.

Bloomberg reports on a different technique that banks use to game the capital calculation:  the regulatory capital trade.

Blackstone Group LP, the world’s largest private-equity firm, has devised a way to profit from regulation: It’s helping banks meet tougher capital rules without the pain of selling assets or raising equity. 

The firm last year insured Citigroup Inc. (C) against any initial losses on a $1.2 billion pool of shipping loans, said two people with knowledge of the transaction, who asked not to be identified because the matter is private. 

The regulatory capital trade, Blackstone’s first, will let Citigroup cut how much it sets aside to cover defaults by as much as 96 percent, while keeping the loans on its balance sheet, the people said. 

For banks, the transactions offer a way to redeploy capital more profitably while meeting the stiffer requirements of the latest round of Basel rules. Critics say the practice doesn’t make the lenders any safer and pushes the lending risk into the unregulated shadow-banking industry. 

“It’s a form of financial engineering,” said Philippe Bodereau, London-based head of European credit research at Pacific Investment Management Co., the world’s largest bond investor. “It was dead but it seems to be coming back as investors scramble for yield. If you saw this on a massive scale, you would certainly question whether this was the best way for regulators to de-risk the system.”

Under the Basel Committee on Banking Supervision’s rules, banks are required to set aside a set amount of capital based on the likelihood a borrower will default....

Regulators have criticized banks for trying to meet the target by adjusting the models they use to calculate risk- weighted assets rather than raising capital. The Basel Committee, which brings together regulators from 27 nations, said in a January report that there are “substantial variations” in how banks determine the riskiness of assets.

Variations that regular readers know would go away if banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Blackstone closed the transaction at the end of last year “very quietly,” said Jasvinder Khaira, a principal in the firm’s Tactical Opportunities Group, a specialist unit that invests in unusual, illiquid deals. 

“Why would Blackstone be interested in doing this deal? The short answer is” because of “changes to the Basel III framework and in general to how regulators are viewing loan exposures,” he told delegates at Marine Money’s 4th Annual London Ship Finance Forum, without identifying Citigroup.

The trades, also known as synthetic securitizations, work by transferring part of the credit risk on a pool of assets to a third party through derivatives such as credit-default swaps in exchange for capital relief from regulators. 

Deals range from simple transactions between two firms to more complex structures, where special-purpose companies are set up to provide protection to the bank and are in turn funded through the sale of notes to investors. 

Blackstone has set up a separately capitalized company, which has written the credit-default swaps on the loans, one of the people said. They declined to say how much the firm has injected as collateral to cover any potential losses. 

By buying credit protection on the first 10 percent or 15 percent of losses, lenders are able to reduce the amount of capital they need to hold to close to zero under Basel rules. 

The extent of the capital relief is based on banks’ own internal risk-weightings and approved by regulators. Unlike in traditional, or cash, securitizations, the assets stay on the balance sheet.

Perhaps I am misreading the highlighted text, but it appears that a bank can obtain capital relief by buying credit protection without having to determine if the seller of the credit protection can actually perform.

If the seller cannot perform, what good is the credit protection?

Why would the authors of the Basel III capital requirements allow banks capital relief for buying worthless insurance?

The Blackstone deal is one of the first examples involving a private-equity firm, which traditionally look to take a more active role in managing assets. It demonstrates the extent to which banks are prepared to pay up for capital when other sources, such as issuing shares or unsecured bonds, are closed.... 

And why can't banks issue shares?

Because without ultra transparency, banks are 'black boxes' and no market participant knows what is inside.

Buying bank shares or unsecured bank debt is simply blindly gambling on the contents of a black box.

Blackstone’s Khaira described the Citigroup deal as an “elegant solution” for banks and investors, amid an industry- wide shipping crisis that’s extending into a fifth year.... 

“Banks are always trying to find pain-free ways to boost capital ratios, whether that is fiddling RWAs or outsourcing risk,” said Bodereau.“Some deals are legitimate but it is ultimately regulatory arbitrage. We are supposed to be moving to a world where bank balance sheets are more transparent and less complex and this goes backwards.”

Please re-read the highlighted text as it nicely summarizes what your humble blogger has been saying about the substitution of the combination of complex rules and regulatory oversight for the combination of transparency and market discipline.

We are suppose to be moving to a world where bank balance sheets are more transparent (hint: ultra transparency).

However, bank regulators, through Basel III capital requirements and other complex rules, are moving us away from transparency and towards more opacity.