March 24, 2016

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.
@PerKurowski ©