Regulatory Arbitrage, AIG Edition
By Arnold Kling
In an email, Houman Shadab writes,
AIGFP was treated as a bank for its counterparties’ risk-weighting purposes, but AIGFP was not regulated as a bank (or an insurance company) for its own CDS credit exposures (had it been, it would’ve had to set aside capital/reserves)
This sounds like a great way to make capital requirements magically vanish.
Houman has an outstanding paper in the works on credit default swaps, and when he has a version that’s on line I’ll be sure to link to it.
Something tells me that the hue and cry over AIG executive bonuses is nothing more than an attempt to distract attention away from the larger issue of a bailout that should never have taken place in the first place. In the name of “protecting the financial system,” the government used AIG as a conduit to funnel taxpayer money to not-so-deserving counterparties who participated in this game of hide-and-seek with capital requirements.
UPDATE: The whiff of scandal grows stronger. Thanks to Nick Schulz for passing this one along.
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.