Securitization is useful, but not when it is driven primarily by differences in capital requirements for banks

Sir, Alexander Batchvarov writes: “It is claimed that securitisation was one of the main causes of the financial crisis because it was complex, performed poorly and lacked transparency.” “It is time to ditch the ‘toxic’ tag for the sake of Europe’s economy” March 24, 2016

There are deggrees of possible toxicity that are a direct function of how much the securitization process increases the perceived safeness of what is being securitized.

And in this respect what turned out to be really toxic, was not the securitization of relative safe 30 years fixed rate mortgages to the prime sector, but of home equity loans, subprime loans, Option ARM loans, and similar risky affairs.

But even these “risky” underlying loans would not have morphed into truly toxic securities, had it not been for the regulatory benefits awarded to them by means of risk weighted capital requirements for banks.

For instance Basel II assigned a risk weight of only 20 percent for securities rated AAA to AA- , which with a basic capital requirement of 8 percent, meant banks could leverage their equity with these securities a mindblowing 62.5 times to 1 (100/1.6). Those incentives distorted the whole process.

The moment when a securitization, for instance of SME loans, generates a lower capital requirement than non-securitized bank loans to SMEs, that introduces a distortion in the allocation of bank credit that can be very profitable for the banks, but generates little value for the SMEs.

And so if Batchvarov, head of international structured finance at BofA Merrill Lynch Global Research, wants to emphasise proper use of the securitisation technology for the benefit of the broader European economy, he should begin by favoring the elimination of the risk weights differences which cause bank capital requirement differences between what is ex ante perceived as safe and what’s perceived as risky.

And, by the way, that would not increase European financial instability, since there never ever are excessive dangerous bank exposures to something ex ante perceived as risky… that dishonor belongs entirely to what is perceived as safe.

PS. There is something fundamentally dangerous with securitization

@PerKurowski ©

What if “swift execution” had been the pillar of Basel II?

Sir, in May 2003, as an Executive Director of the World Bank, during a workshop on Basel II, I told some hundred regulators: 

“There is a thesis that holds that the old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, was much wiser than today’s no burning at all, that only allows for the buildup of more incendiary materials, thereby guaranteeing disaster and scorched earth, when fire finally breaks out, as it does, sooner or later.

Therefore a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.” 

When we now read Gillian Tett´s “America´s timely lessons in killing off toxic banks” July 17, we should think about what would have happened if “swift execution” had been the pillar of Basel II, instead of those mindless capital requirements based on perceived risks which could only guarantee increased toxicity and the too-big-to-fail banks?

The government needs to provide venture capital for new banks.

Sir George Soros discusses “The right and wrong way to bail out the banks” January 23, as if bailing out the banks was our problem. We need to bail out our economy and if doing so we happen to bail-out the banks, great, if not hard luck.

At this moment we have a regulatory system for the banks that by means of the minimum capital requirements prioritizes risk avoidance. What we need instead is a regulatory system that helps us assure that the banks prioritize what is most needed.

In this respect, with government funds, I would create many new banks, with a fix capital requirement for any credit, for instance 6 per cent, and I would nominate a series of management groups to run these banks giving them the incentive of a generous purchase option for the bank in a couple of years, and asking for a secured indemnity in case of any particularly irresponsible act committed by any of these manager.

Also if these banks want to buy “toxic assets”, because they believe it is in their interest to do so, the better.

Sir I guess that it most probably must have been a very long time since George Soros walked down any Main Street.

Send out the dogs!

Sir Aline van Duyn does very right reminding us that “Messy question of toxic assets still needs an urgent answer” January 9. There must be without any doubt some value in those assets and besides, in these circumstances of uncertainty, even knowing for sure they’re worthless could have some value.

I remember having heard about the possibility of the US government empowering some financial experts to go out and hunt down the value of the toxic assets and paying them a percentage of the bounty. What happened with such a splendid idea… too republican?