Regulators and the Concentration of Risk

Gillian Tett has written an interesting book about CDS and CDOs – Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe (Free Press: 2009). According to the book, in the early 1990s, J.P. Morgan was looking for ways to lower its capital requirements under the Basel I Accord of 1988. The risk weight on what it considered high quality loans was 100%, meaning that there was an 8% capital requirement on such loans. J.P. Morgan went to the OCC and the Fed to see if they could convince these regulators that, if the credit risk was off-loaded through credit derivatives, reduced capital requirements should apply. (See Fool’s Gold, pp. 45-49.)

On August 12, 1996, the Fed issued a “Supervisory Guidance for Credit Derivatives” which indicated that banks could lower their capital requirements through CDS to the risk category of the guarantor. In the case of another bank, the risk weight would be 20%.

When it came to synthetic CDS structures issued by an off-balance sheet entity, the bank retained what came to be called “super senior risk.” Initially the Fed said that to get capital relief on these transactions, banks would have to get rid of this risk (Fool’s Gold, p. 61). J.P. Morgan decided that the perfect counterparty for this was AIG Financial Products (Ibid., p. 62). Then, according to Tett, the OCC and the Fed decided that super senior risk need not be off loaded.

Apparently, though, the regulators in Europe did not see it that way. According to AIG’s March 2009 10-K filing –

“A total of $234.4 billion (consisting of corporate loans and prime residential mortgages) in net notional exposure of AIGFP’s super senior credit default swap portfolio as of December 31, 2008 represented derivatives written for financial institutions, principally in Europe, for the purpose of providing regulatory capital relief rather than for arbitrage purposes. These transactions were entered into by Banque AIG, AIGFP’s French regulated bank subsidiary, and written on diversified pools of residential mortgages and corporate loans (made to both large corporations and small to medium sized enterprises). In exchange for a periodic fee, the counterparties receive credit protection with respect to diversified loan portfolios they own, thus reducing their minimum capital requirements.

“The regulatory benefit of these transactions for AIGFP’s financial institution counterparties is generally derived from the terms of the Capital Accord of the Basel Committee on Banking Supervision (Basel I) that existed through the end of 2007 and which is in the process of being replaced by the Revised Framework for the International Convergence of Capital Measurement and Capital Standards issued by the Basel Committee on Banking Supervision (Basel II). Prior to the adoption of Basel II, a financial institution was required to hold capital against its assets, based on the categorization of the issuer or guarantor of the assets. One of the means for a financial institution to reduce its required regulatory capital was to purchase credit protection on a group of its assets from a regulated financial institution, such as Banque AIG, in order to benefit from such regulated financial institution’s lower risk weighting (e.g., 20 percent vs. 100 percent) that is assigned to those assets under Basel I. A lower risk weighting reduces the amount of capital a financial institution is required to hold against such assets.”

(I was directed to this by a blog post of Arnold Kling.)

Interestingly, as Basel II is implemented, this capital benefit is reduced. The 10-K goes on to say:

“Unlike Basel I, Basel II gives credit to the relative risk of loss associated with the assets, meaning that less capital is required for such assets. After a financial institution has implemented a capital model that is compliant with Basel II and has obtained approval from its local regulator, the CDS transactions provide no additional regulatory benefit in most cases, except during a transition period. The Basel II implementation includes a transition period during which the financial institutions must calculate their capital requirements under both Basel I and Basel II (until December 31, 2009). During this period, the capital required is “floored” at a percentage of the Basel I capital calculation; therefore, until early 2010, these CDS transactions may still provide regulatory capital benefit for AIGFP’s counterparties, depending on each counterparty’s particular circumstances. In addition, in a limited number of instances, counterparties may decide to hold these CDSs for a longer period of time because they provide a regulatory capital benefit, while smaller, under Basel II.”

Regulators both here and abroad seem to have not realized the systemic risk their regulations were creating. Risk got concentrated at AIG and, with respect to super senior risk, some U.S. banks retained it and when the real estate bubble burst, it turned out that this super senior risk was more risky than assumed. CDS and CDOs served not to diversify risk, as regulators, most prominently Greenspan asserted, but concentrated it. (According to Fool’s Gold, J.P. Morgan did not retain much super senior risk. Her book relies heavily on J.P. Morgan sources, which does not mean it is wrong, but could mean that it is less critical of that bank than other writers, with other perspectives, might have been. For those interested in these issues, the book is well worth reading.)

Now that the House has passed the health care legislation, it is likely that there will be more Administration, Congressional, and press attention to financial regulatory reform. It is clear that there were regulatory failures that contributed to the financial crisis (which does not mean that private sector actors do not shoulder a considerable amount of responsibility.) While there should be some sort of regulatory reform, it should be kept in mind that there are limits to what regulation can do. Regulators can make mistakes. One can hope that whatever becomes law makes things safer but that does not create a false sense of security and complacency.