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Banks Already Slipping Through New Capital Requirements

The French bank Credit Agricole is planning on major changes to the way it operates in order to avoid new capital requirements being imposed by global financial regulators.

In his first interview with an international newspaper since becoming head of Credit Agricole’s corporate and investment banking arm, Jean-Yves Hocher tells the Financial Times that the third-largest bank in France has found a way to continue to pursue project and trade finance deals, despite unfavorable capital treatment under the Basel III rules.

Many banks in Europe, including French rivals BNP Paribas and Societe General, have been shrinking or exiting the project finance business altogether. Others are attempting to find ways to stay in the business while partially avoiding the new capital requirements — which is what Credit Agricole plans to do.

“Crédit Agricole CIB is number three in project financing worldwide; we are a big player and this is a very safe business with very good margins...we will defend our leadership position,” Hocher says in the interview.

Under the Basel III rules, the cost of funding project finance deals will increase by 10 basis points, according to this report on how to handle Basel III from McKinsey. Project finance includes providing credit for ships, aircraft, and energy-related ventures.

Credit Agricole’s plan is to avoid incurring the additional capital costs by selling 80 percent of its exposure on new project finance loans to outside investors, including insurance companies and pension funds. The bank will accomplish this by forming a new unit within the investment bank that will both originate the loans and sell them to investors.

This is pretty much straight out of the McKinsey playbook.

Banks must strive to improve their ability to transfer risks in three ways. One is to improve cooperation between the lending organization and product development, such that both teams are committed to increasing the volume of credits that can be securitized, sold, or syndicated. Contract standardization is essential here, especially as far as maturities are concerned. Incentive systems can help raise the extent of such cooperation.

Another way to transfer risk is to broaden the bank’s base of syndication and securitization partners, both geographically and by industry. Banks should court government funds, insurance companies, and other investors to improve their ability to sell into secondary markets. The return of nongovernmental investors such as private equity firms and hedge funds may offer further opportunities for transferring risks.

Syndication, club deals, and private placements have all proved resilient through the crisis. As a third step, banks must develop their investment banking capabilities for these outlets, to better steer asset volumes and exposures.

You’ve probably already noticed that risk transfer was at the heart of the much derided “originate-to-distribute” model of mortgage lending that many blame for the deterioration of underwriting standards.

Hocher describes his model as “distribute-to-originate.” That’s clever. It makes it very clear that Credit Agricole believes that under Basel III the only way it can carry on doing a substantial project finance business is to distribute the risk. Distribution enables origination.

But is this really all that different from what we saw before the financial crisis? Many of those engaged in originate-to-distribute home lending would have said precisely the same thing. They had to get the mortgages of the books through securitization to keep making home loans.

And, incidentally, they would have also described their business as “a very safe business with very good margins.”

As McKinsey’s report spells out, combining the originators and distributors is probably necessary to make this kind of business work. You need to have the bankers underwriting and structuring the loans working closely with those who are pitching them to investors. But this also invites mischief, since the bankers know that they’ll be rewarded both for making the loan and selling it off — and perhaps everyone will be retired and living on the Riviera before it all goes wrong.

What’s more, the bankers can reduce their risk to the retained portion through credit default swaps . In fact, it’s all too easy to see Abacus-like deals developing here. Bankers could make loans, sell off 80 percent of their exposure, over-insure the retained portion, effectively becoming net short on their own loan.

But won't the investors keep the bank honest?

Well, if you believe that, I have a bridge finance project in Brooklyn I'd like to sell you.

One of the things we witnessed in the period before the financial crisis is that the buy-side are not good monitors of risk. If a deal can get a good credit rating, there are likely to be buyers. It’s more or less impossible for outside investors to efficiently monitor credit risk — and, often enough, there are actually regulatory penalties for second-guessing what regulators and ratings agencies think about risk.

In any case, the fact that Basel III is leading Credit Agricole into an originate-to-distribute business model is probably not the result many of those advocating stronger capital requirements were aiming for.

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