Here’s one from left field that I only began to focus on recently. In mid-December, the gnomes of Basel published several “Consultative Documents” on bank capital and credit risk issues. First of all, I’m somewhat suspicious by the open palmed amiability of something called a “Consultative Document.” That suggests a dialogue with regulators but this is Euro-speak for “Proposed Rule.” My experience is that once something gets to the Proposed Rule stage, the relationship between the regulatory and the regulated is short on consultation and long on prescription. But hey… maybe this is different.
In any event, one of these Consultative Documents dealt with credit risk treatment of various mortgage instruments and another with capital floors to prevent banks who are entitled to use their own internal ratings-based regime, as opposed to the Basel one-size-fits-all risk-rating system, to push capital below some baseline level. I’ll think about those later. What I’m focusing on now is the third Consultative Document, which deals with securitization.
This Consultative Document entitled “Criteria for Identifying Simple, Transparent and Comparable Securitizations” purports to establish rule-based criteria which divide the world into simple, transparent and comparable securitizations (“STC” in apparatchiki speak) on one hand and all other securitizations on the other, which I guess are not “simple, transparent and comparable” and, in fact, are probably crafted on the forge of Hell by Satan himself.
What this regime proposes to do is to list on some sort of a registrar all STCs and then allow banks and other regulated financial institutions to hold less capital against STCs than non-STCs. As of right now, Basel is being shy about the magnitude of difference under this regime between holding the naughty and the nice. So we really don’t know how consequential these rules may be. Regrettably, I suspect the differences will be meaningful. After all the hard work to render the market place into a reflection of a Manichaean world of good and evil, it just seems unlikely the regulators will not punish the unwashed.
The new capital rules would appear only to apply, at least initially, to traditional insured depository institutions and life insurance companies but how long before they follow the path first broken by the EU through AIMFD in expanding risk retention from the banks to a whole range of funds across the European Community? We could easily see this STC straightjacket being used to punish non-banks for buying non-STC products. For banks, the punishment will be the obligation to add more capital; for non-banks, it is likely to be fees and penalties.
The new rule will exclude – as far as I can tell – almost all CMBS, all dynamic transaction whether CLO or CRE-CLO, synthetics and a number of other, now common structures. This is to be expected of course. Hostility towards the new and innovative by governments and their regulators is as old as Luddism. News flash: Structural innovation exists because it meets the financial needs of buyers and sellers. That’s called a market. Ok, I know, that’s sooo 20th Century. And oh, by the way, this is Basel after all, so when this document becomes a final rule, it still has to be adopted by every single country that participates in the Basel conventions. Since this regime applies to the buyer and not the seller, every securitization no matter from where it originated around the world (that’s us folks, in the good old USA) would then have to interact with the regulatory authorities of every jurisdiction in which investors might purchase securities to see whether it’s STC or not. Each sovereign state will be entitled to tweak the rule and each will assuredly apply it differently. So what will happen when a securitization is viewed as an STC in London, but not in France, Germany or heaven forbid, the United States?
I know, it’s still just a “Consultative Document” and a long way from adoption and implementation, but this could be a big deal. At best, it would be another set of complicated regulatory gatekeeping rules for securitization – adding more sand in the machinery. It will undoubtedly absorb large quantities of time and energy, not to mention legal fees. Think about it: for every deal, you’ll need to go to the applicable regulator in each jurisdiction where bonds might be sold and try to convince that regulator that you’ve got an STC? When do you do this? How painful would a capital penalty surprise be after the deal is launched? How long will it take? Do they just look at the Offering Document or will you need to submit a brief? How much additional information must you deliver? The list of practical questions goes on and on.
The STC criteria in the Consultative Document are super big picture. It’s going to be a long, hard slog to turn these principles into rules that could be enforced. Unfortunately, industry types following this closely think that while the Consultative Document is very much just a framework today, it is going to be fleshed out and adopted by Basel. Eventually, we are going to have to deal with it.
One of the reasons that has torqued me up here long before this thing becomes a practical worry is that this is another expression of the regulatory instinct to double down on the notion, which is entirely received wisdom in the halls of government, that regulators are smart enough to create detailed prescriptive rules that will order the marketplace like a 19th century clockwork automaton. Don’t they every get tired of making the same mistake? Regulations limited to process and disclosure, while possibly painful and perhaps even of limited value to investors, are tolerable. When regulators try to impose market outcomes, bad things happen. Buy this, don’t buy that? This is the equivalent of a Catholic priest teaching sex education. Markets know what deals are good and what deals are not. Regulators who don’t make actual bets with actual money simply cannot. I can’t imagine that investors think this is any better an idea than issuers. Investors have sophisticated, analytic capabilities and are perfectly capable of understanding the risk and rewards associated with a structure. Do they want to have the government tell them how to risk rate these things? I don’t think so.
How does this make any sense? How does this improve capital formation? How does this improve outcomes and protect financial markets? It, of course, doesn’t and those are, for the regulators and their politician enablers, silly questions. The sun revolves around the earth, right? Of course regulation works. That is not open to debate. Does the public like their government making bankers and investors do the government’s bidding, thereby showing those awful bank and bankers who’s the boss? Now that’s the right question, and isn’t that frightening?
