Risk weighted assets are the worst tools for calculating bank capital, apart from all the others — as Churchill might almost have said. Open to all manner of complex abuse, reliant on a bank’s own internal calculations and crucially requiring the supervision of overworked regulators, the basic principles of Basel II and III can be criticised by all sides.
But no risk-weighting at all encourages banks to load up on risk, while external rating-based approaches to risk-weighting promote more egregious and transparent abuse than even IRB.
And financial alchemy can actually be a good thing. A regulatory regime should be neutral between transactions of the same economic substance, and this should be our guide when looking at financial alchemy.
When an institution switches bonds from a banking book to a trading book to benefit from trading book capital treatment, or marks above-par instruments in an available-for-sale book to benefit from unrealised gains accounting, or marks profitable hedges away from the unprofitable business lines they were supposed to hedge, it’s not pretty.
It’s not fun for the analysts and regulators who have to sift through the mounds of accounting nonsense to gradually build up a realistic picture of a business, and it isn’t much fun for those who have to structure it either.
Tricks like the above can flatter P&L, capital ratios, and will no doubt be enthusiastically wielded to deal with the new liquidity ratio. But it’s the proverbial lipstick on a pig.
By contrast, financial alchemy that allows a fund to buy the equity risk of an asset portfolio is surely constructive.
It’s hard to see why it should matter whether this is through listed shares in a subsidiary, a credit-linked note, investment in a fund platform, or a credit default swap — provided the risk transferred is economically equivalent.
Regulation has a long way to go before it reaches this enlightened point, but “alchemy” bridges the gap. If a bank can sell off risk, in whatever format, it should get full equity credit for selling it. Risk transfer trades can be a legitimate, constructive solution to some of the capital problems facing large banks.
There is no shortage of investor appetite for some of the assets held on bank balance sheets — just an understandable reluctance to get involved in all of the messy “bank” stuff that gets in the way.
Bank balance sheets will shrink, and this will partly be through “alchemy” techniques — creating synthetic exposures to specific portfolios, ringfencing asset books or using whatever legal format fits the regulatory environment at the time. We shouldn’t let bank accounting shenanigans obscure the real economic benefit of such deals.