Making Capital Disappear
By Arnold Kling
In the expansion of the credit bubble, U.S. banks strove to keep their tangible equity to total asset ratios in check by securitizing as much as they could. Unfortunately, a big proportion of what they retained turned out to be highly toxic. European banks let their risk weighted assets balloon while trying to keep a better credit quality, though even that proved beyond them as many AAA rates assets turned out to be anything but.
Let me see if I can understand this. In a structured security, there is a junior tranche, with a relatively low face amount, that is supposed to have most of the risk. There is a senior tranche, which has a large face amount, but it is supposed to be AAA. What I gather that King is saying is that the American capital regulations were based on face amount, while the European capital regulations were based on risk weighting. This gave the American banks a comparative advantage in holding junior tranches (low face amount, high risk) while the European banks had a comparative advantage in holding senior tranches (high face amount, low risk).
[UPDATE: a correspondent emails:
According to Rich Brown, the head of research at the FDIC, Basel I did not give European banks any capital advantage for holding rated securities. That was an American innovation that the FDIC, Fed, OCC, and OTS implemented when they imposed their version of Basel I in 1991. Basel II did impose low risk weights for highly rated securities on European and other non-U.S.banks, but it didn’t go into effect until 1/07.
I think that, relative to what I write below the fold, I would have to either reduce the probability that I comprehend what Matt King is saying or else reduce the probability that what he is saying is correct.]The probability that I have correctly understood what King was saying is about 75 percent. If I am correct about what he was saying, then I think it has about a 75 percent chance of being true. My problem with it is that American banks also had risk-weighting going for them. In January of 2002, when the American regulators gave the green light to allowing banks to weight AA- and AAA-rated securities at only 20 percent of face value, it was possible for an American bank to take a single mortgage pool, slice it into two pieces, and reduce capital requirements. The senior tranche would require capital on the face amount, and the junior tranche would get the reduction for risk-weighting. At least, that was what Freddie Mac and Fannie Mae warned about in the draft regulations (It is possible that the final regulations were not quite so stupid. I need to nail that down.)
Here’s a simple numerical example: $100 mortgage pool. Before it is carved up, the risk weight is 50 percent, and the capital requirement is 8 percent, so the bank needs to hold $4 in capital.
After it is carved up, the $5 junior tranche gets a 100 percent risk weight, but it is for face value only, so the capital requirement is $0.40. The $95 senior tranche gets a 20 percent risk weight, so the capital requirement is $95 * .08 * 0.2 = $1.52. If the bank holds both pieces, it is obviously taking the same risk, but for $1.92 in capital requirements. If it sells the senior tranche to a European bank, then the American bank is taking most of the same risk for only $0.40 in capital.