Regulations caught red-handed in search for subprime crisis culprits

Tracing the roots of a crisis is never a simple journey and the current financial turmoil is no exception. There is no single cause for the subprime fallout and the credit crunch, but you can be sure that the regulatory regime is one of the culprits.

Since the 1988 Basel Accord, regulators have (inadvertently or not) been encouraging the regulatory arbitrage that sees banks push loans off the balance sheet. This has created an opaque, parallel banking system that is largely the cause of the market’s liquidity crunch.

Banking regulations have been found wanting in terms of liquidity, too. The recent turmoil has exposed the vulnerability of a regulatory framework that places so much emphasis on how well capitalised a bank is, but makes little reference to whether it has an adequate cushion of cash and highly liquid securities to see it through a period of market indigestion. The Basel II regime, when it comes into effect in January 2008, will probably fail to improve the regulators’ track record.

Unintended consequences

While Basel II will make securitisation less attractive to banks, it will not stop it and may lead to some unintended consequences.

Banks will generally be required to hold less capital against rated securitisation positions than against unrated positions.

Further, the optimal capital strategy for banks using the internal ratings-based (IRB) approach to regulatory capital – probably the largest and most complex institutions – will be to invest in rated securitised notes, rather than hold a comparable portfolio of unsecuritised assets directly on the balance sheet.

On the other hand, the regulatory capital incentives for banks using the standardised approach to regulatory capital – probably the smaller institutions – will steer them towards investment in lower rated securitisation positions which may erode the credit quality of their structured notes portfolio. Basel II will also encourage banks to minimise their exposure to sub-investment grade tranches with strong capital incentives.

This is more than simply a restatement of arcane rules. Such rules define behaviour. If banks are encouraged by capital treatment to off-load the unrated, first-loss tranche, there is far less incentive for them to care about the quality of the structures and products that they create. Moreover, the model steers the most sophisticated institutions to sell the first-loss or equity tranche, while encouraging the less sophisticated to invest lower down the capital structure in the riskier assets. This will not improve the health of the financial system.

If we are already in a crisis (at least partly) of regulation, then regulation itself looks set to deepen the crisis.