Why Not 'Pawn Off' Risk to Nonbanks?

The SEC couldn't catch Bernie Madoff, and the combined resources of BP and the U.S. government needed three months to plug the Gulf oil leak. So it should come as no surprise that financial regulators frequently get it wrong when they try to figure out how much capital that complex, modern banks require. As "Risk Lies in the Risk-Based Capital Approach of Basel III" [American Banker, July 15] observes, several banks that appeared to be best capitalized under the Basel rules were the first to be bailed out.

The article is surely correct to question whether refinements to Basel II can be relied on to prevent another crisis. Any set of fixed rules for measuring capital adequacy will fail to capture a great deal of risk, and rules will never match bankers' ingenuity for engaging in regulatory arbitrage. Basel II, which has been adopted in most developed countries other than the U.S., improves on Basel I by plugging loopholes, but its very complexity makes the whole enterprise harder for managers, shareholders, creditors, rating agencies, regulators and politicians to follow.

Considering the limitations of mechanical rules, the article's advice that "effective capital rules would have to [make sure] … risk isn't pawned off on entities outside the system" seems backward. Transferring credit risk to insurance companies, hedge funds and anyone else who wants it will free the banking system as a whole from dependence on shaky formulas that no one fully trusts.

The article's main example considers Bank A that buys a corporate bond, then buys credit protection from Bank B, which in turn buys credit protection from an insurance company. Bank A's capital charge is reduced by 80% under Basel I while Bank B's capital charge is minuscule. The total capital the two banks together have to hold is a fraction of the amount required if Bank A simply held the bond. (The calculation for Bank B in the article mixes the Basel I and Basel II calculations and would not apply to any particular bank. However, in either regime, it is true that Bank B would not have to hold much capital against a matched pair of credit default swaps assuming it buys the protection from a highly rated counterparty.)

Should we be troubled by this outcome? The insurance company at the end of the chain bears the ultimate credit risk. Assuming Bank B prudently manages its counterparty relationship with the insurance company, the banking system no longer needs to worry about the bond issuer's credit. As a result, the two banks should have to hold less capital to support their exposure to the bond.

Let's make this example more realistic to show how "pawning off" can create value for all the participants in the chain. Bank B doesn't add anything to the analysis, so assume Bank A directly faces the nonbank credit protection seller. Make the credit protection seller a hedge fund. Since the bank would have no particular reason to buy a bond as in the original example, assume instead that the borrower is a long-term client of Bank A seeking a term loan in excess of its existing credit lines.

Then the bank can buy credit protection from the hedge fund on the amount of the loan above the existing credit line. The client gets the loan it wants, the bank makes a profit from intermediating and keeps its customer satisfied, and the hedge fund earns a credit spread if it bets correctly and loses otherwise.