Caution: Though brief, this post will likely be impenetrable to anyone who doesn’t have a working understanding of regulatory capital requirements, securitization, and how rating agencies fit into both.
Here’s an idea for Basel III. Next time we design new capital requirement rules, let’s try to put in the following fail-safe principle to curtail the regulatory arbitrage.
Regulatory Capital Equivalence Principle: If the sum of the capital charges on a group of assets come to X, then the capital charge on a securitization backed by those assets must also equal X.
Let’s break this down with an example. Say I’m a bank and I have a $100 of loans on my books. Suppose the risk-weighted capital charge on those loans is $8. Now let’s say I securitize those loans into three tranches via a CDO thus:
Tranche A: $60 of AAA-rated CDO securities
Tranche B: $30 of BBB-rated CDO securities
Tranche C: $10 of unrated equity in the CDO
Let’s say I find a buyer for 50% of each tranche and retain the rest. On balance, I’ve sold off exactly half the risk in this basket of loans and retained the rest. So my capital charge on what I’ve kept should be half of the original capital charge [$8 x 1/2 = $4]. Simple.
Unfortunately, this isn’t how things work under Basel II. (If I’m getting this wrong, someone please correct me.) Instead, regulators look at my new CDO securities and the ratings thereof to drive my capital charges. Notice how most (60%) of the securities issued by the CDO are rated AAA. AAA-rated securities backed by corporate credits get a pretty low risk weight under Basel II. So my capital charge on the $30 of AAA-rated securities retained is, say, $0.50. Now the other bits that I retained (the BBB and unrated securities) have a much higher risk weight, so for thsoe I have to hold $2 in capital. That brings my total post-securitization capital charge under Basel II to $2.50.
But wait a minute. My original capital charge on the loans was $8. The CDO securitization chopped up the loans and sold-off exactly half the risk to other parties; the other half I retained. Since I own the same proportion of each tranche (50% of each), I didn’t alter the overall credit risk characteristics of what I retained, except to reduce the size of the exposure from $100 to $50. So I should have exactly half the capital charge ($4). But under Basel II’s standardized approach, I get to reduce my capital charge to only $2.50. In other words, regulatory arbitrage freed-up $1.50 in capital.
I’m not sure how prevalant this type of regulatory arbitrage is today, but I would hope a wise regulator would find a way to plug this gap. It strikes me that one simple way to close-down this arbitrage opportunity would be to require that the total risk weight across all tranches of a securitization must equal the risk weight for the underlying assets backing the deal. I recognize that it might be difficult to opperationalize, as you’d have to effectively allocate that risk weight across the different tranches and communicate that risk weight to all holders of the newly issued securities. Perhaps that could be accomplished by tying a risk weight to each tranche of a structured product at issuance, similarly to how ratings are doled out. Of course there are other challenges too, such as how to handle the changing risks weights as time elapses and the risks evolve. But I don’t see those challeneges as fatal flaws in the general principle that capital charges should be substance-based and blind to the legal form in which the risks are conveyed from one party to another.