One of the effects of capital requirements is that they encourage banks to do a lot of things they otherwise might not.
The entire banking sector, for example, is heavily exposed to mortgage risk because capital rules favor mortgages over other types of loans. Similarly, banks bought lots of credit protection from AIG and bond insurers in part because this was a good way of reducing the amount of capital they had to hold against their assets.
Michelle Wiese Bockmann, Liam Vaughan and Ben Moshinsky have a nice story today that illustrates that financial engineering to skirt regulation is still alive and well.
The story begins last summer, when Societe General sold a portion of its shipping loans to Citigroup. Soc Gen, like many European banks, wanted to downsize its exposure to shipping loans. Bank loans, which accounted for 83 percent of financing for shipping pre-crisis, now make up slightly less than half, according to this analysis by HSBC.
The reason banks have been reducing their holdings of shipping loans is that this asset class is designated as being especially risk by the new Basel III capital accords, which means that they require a lot more regulatory capital than other types of loans.
So when Citigroup bought $1.2 billion of shipping loans, this created a bit of a mystery. Why would Citi have more tolerance for the capital inefficiency of the loans than Credit Suisse?
Now we know. Citi had more tolerance because it planned to engineer a solution. What it did was buy insurance on the loans from Blackstone, which has set up a separately capitalized subsidiary to do this sort of thing. The insurance, according to Bloomberg, reduces the amount of capital Citi has to hold for the loans by 96 percent. Blackstone gets to charge a premium for the insurance as a reward for taking on this "risk."
I put "risk" in quotation markets in that last sentence because that isn't really what Blackstone is selling. Citigroup is not all that worried about the actual riskiness of the shipping loans. If it thought they were too risky, it probably wouldn't have bought them from Soc Gen in the first place. What Citi is really buying from Blackstone is capital regulation relief.
Blackstone, not being a bank, doesn't have to meet Basel III's capital accords. The new capital accords, in other words, have created a new line of business for non-bank financial companies. They can profit directly from their ability to be capital-lite compared to banks.
Blackstone surely has to capitalize the subsidiary running this business with something. But for this whole project to work, that capitalization needs to be less than what Citi would have set aside.
What's more, it's possible that Citi is itself providing much of the capital for the entity doing the insuring. Blackstone would contribute some nominal amount but the fees paid by Citi would make up the bulk of its capital. We don't know if this is how this thing is run because Citi and Blackstone are staying very quiet about their arrangement.
Notice that the overall effect here is that we have less capital backing the same amount of risk. This kind of engineering makes the global financial system more fragile.
Ain't capital regulation grand?
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