The Eurobanks’ Latest Scheme to Escape the Pain of Recapitalization: Pull More Financial Firms into the TBTF Complex

As much as I like to think I have a reasonably active imagination, it never ceases to amaze me how a bad situation can easily become worse.

Readers probably know the European authorities have been stunningly late to wake up to the fact that EU banks are undercapitalized, apparently being the only ones to believe their PR exercise known as a stress test. The banks’ options would seem to be limited. One is to raise more equity, which is kinda difficult now since no one is terribly keen about banks in general, and the ones in most need of more capital are the least attractive. Second is to let existing loans roll off. The authorities don’t like that idea, since less lending will increase downward economic pressures. And since bank CEO pay is correlated with size of institution, the banksters aren’t too keen about that either. Third is to cut pay to help accelerate earning their way out. You can guess how likely that is to happen. Last is to suffer state-assisted recapitalization, which under EU rules, would be a draconian exercise.

But never fear, the financiers have an “innovative” way around this problem. And this innovation is a remarkably destructive idea. From the Financial Times:

Banks are striking deals with private equity groups, hedge funds and insurance companies in an effort to preserve their precious regulatory capital.

A growing number of investors is moving to provide beleaguered lenders with special targeted transactions to help them share their risks – for lucrative fees – through a fast developing class of “regulatory capital relief” funds.

Interest in such vehicles comes as banks, particularly those in Europe, scramble to develop new funding tools and identify ways of protecting capital, as they grapple with the prospect of sovereign defaults, forced recapitalisations and new Basel III rules.

The schemes typically involve writing partial guarantees for the assets sitting on banks’ balance sheets through bespoke securitisations, meaning insurance companies or funds absorb the losses on the riskiest portions of banks’ loans.

Such transactions allow banks greatly to decrease the amount of money they must hold in reserve as a backstop for potential losses in their lending books.

David Peacock, co-head of corporate credit at the Cheyne Capital hedge fund in London, which has been striking such deals with banks since 2004, says: “This is a means of capital raising which has been used over a number of years, but the need now is much more acute than it has ever been before.

The Japanese had an interesting attitude toward regulation, which is that they’d tolerate all sorts of things on small scale, but reserved the right to stop any activity cold if it got big enough to warrant scrutiny and they concluded they didn’t like it. Here, the “difference in degree is a difference in kind” logic is even more operative.

Regulatory capital relief is a gimmick that never should have been tolerated in the first place. The lesson of the crisis just past is that the biggest cause was the widespread selling of underpriced insurance by financial firms that were already highly geared. Eurobanks and US investment banks hedged AAA rated CDOs with credit default swaps where the guarantee failed or similarly bought AAA tranches that were synthetic (meaning made of CDS) where the protection writer failed to perform. This is a basic risk management error, called wrong way risk: buying a hedge from a counterparty that it pretty likely to be impaired if the bad event you are worried about comes to pass.

Any regulator that tolerated regulatory capital relief is an idiot. Banks rarely get trouble in isolation; the pattern more often is that multiple banks have fallen victim to the same bad exposures or economic risks. A lot of hedge funds were pummeled in the crisis and quite a few liquidated. Quite a few insurance companies suffered as well. So some, perhaps many, of these guarantees are likely to prove worthless if they are ever put to the test.

And its impact on a larger scale is even worse. The biggest failing of our financial system is its tight coupling. In tightly coupled systems, there are not enough firebreaks and events propagate across the system unchecked. It’s like a badly designed electrical system, where a lightening bolt hitting a single transformer will take down the entire East Coast.

One of the dangers of tightly coupled systems is that actions that are intended to reduce risk actually increase them. We discussed on the blog risk reduction efforts in the pre-Lehman phase of the crisis that made matters worse. For instance, efforts in January 2008 by Congress to use Fannie and Freddie to help deal with the mortgage crisis led Fannie and Freddie spreads to blow out, setting off a chain of events that led to the collapse of Bear Stearns.

The most important thing that needed to happen in the crisis and didn’t was reducing the tight coupling of the system. The stymied Bank of England effort to separate retail from wholesale/investment banks would have been a step in the right direction.

This regulatory capital relief effort gimmick is a massive step in the wrong direction. It enmeshes other financial players into the already-too-tightly connected grid of major financial firms, particularly the big dealer banks at the core of the global debt/over the counter trading markets. It has the effect of enlarging the “too big to fail” complex, so that if any large player gets in trouble, the damage done by its unraveling are greater and even more difficult to analyze in advance. And it creates more points of failure. Recall how the downgrading of comparatively small monolines led to losses at banks as they had to write down the instruments they guaranteed. If key providers of regulatory capital relief were to come into doubt, banks considered to be adequately capitalized would also come up short.

The very fact that this device will apparently be tolerated on a large scale is proof that the officialdom is completely unwilling to stand up to continued banking industry looting and will allow schemes almost certain to create the need for even bigger bailouts to be foisted on ordinary citizens. This is neofeudalism wrapped in the mantle of modern financial technology. I can only hope things blow up quickly enough that the authorities who cast a blind eye on these practices are held to account.

This post originally appeared at naked capitalism and is reproduced with permission.