Regulators must resist banks’ magical thinking

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The writer is a former chair of the US Federal Deposit Insurance Corporation and is a senior adviser to the Systemic Risk Council

The late, great Charlie Munger once said that derivatives trading desks made witch doctors look good. That was certainly true of credit default swaps, used by banks to circumvent capital requirements in the run-up to the 2008 financial crisis. Unbelievably, as regulators now propose further toughening of capital rules through the “Basel III End Game”, banks want more leeway to use similar financial alchemy to counter the impact. Regulators should resist.  

CDS were supposed to make banks safer by magically transferring the risk of loan defaults to counterparties outside the system. Since regulators had assumed the risk transfer was real, they allowed banks to lower their capital levels. But when the 2008 crisis hit, banks found the risk transfer was not always legally binding and even when it was, counterparties could not perform.

Regulators have since tightened the use of CDS to lower capital. But the latest push from banks is to use “credit linked notes” (CLN) for capital relief. To be sure, these have some advantages. With CDS, the counterparty is not obliged to pay the bank until borrowers actually default. With CLNs, banks get the money upfront by issuing bonds with repayment obligations that depend on borrower performance. If borrowers default, the bank’s repayment obligations are reduced, passing along the losses to bond holders. But while this eliminates counterparty risks, CLNs still suffer from fundamental problems which should make regulators wary. 

First, as with other forms of synthetic risk transfer, CLNs do not provide the same level of resiliency as good old tangible common equity. During market turmoil, the appetite for risk transfer instruments quickly dries up. To keep lending, banks have to take more credit risk back on their balance sheets. But they will be in a weaker position to do so if they were allowed to reduce their capital through credit risk transfer.  

I saw this happen first-hand as FDIC chair during the 2008 crisis and, again, as chair of the Fannie Mae board during the pandemic. Fannie, and its sister mortgage agency, Freddie Mac, had issued CLN-type bonds on about $1.7tn of mortgages. Yet, when the pandemic came, not only did the market for these collapse, but investors who had purchased them asked to be relieved of their obligations. A subsequent study by the Federal Housing Finance Agency questioned their utility, given the billions it had cost Fannie and Freddie to pay bondholders who had little appetite to absorb credit losses when it was needed the most.   

Synthetic risk transfers may also make the financial system less stable. Nonbanks buying them are mostly lightly regulated or unregulated entities such as private funds and insurance companies. They are not subject to the same level of capital regulation and disclosure requirements as banks. They are not supported by deposit insurance and central bank lending for liquidity needs. They are not as expert in understanding and pricing credit risk. So even if credit risk transfer is successful in protecting regulated banks, the risk is transferred to nonbank entities which appear less capable of managing and absorbing the losses.  

This issue takes on heightened urgency as so much credit intermediation has migrated to the nonbank sector. Should we have a recession next year — a real possibility — escalating credit losses here could seriously disrupt the flow of credit to the real economy. And again, if regulated banks have lowered their capital through credit risk transfer, they will be in a weakened position to take up the slack.

As pressure from banks grows, the Federal Reserve and other regulators should respond by tightening the rules around all credit risk transfer instruments. They should impose strict, consistent and legally binding limits on how much risk a bank can transfer in aggregate, as well as how much it can transfer to any single counterparty. Banks should be required to assess the financial health of nonbank counterparties and be prohibited from transferring risk to those with concentrated exposures to credit risk instruments. Weak banks should be prohibited from using risk transfer to give capital levels an artificial boost.  

During the 2008 crisis, we learnt that effective oversight requires looking beyond the regulated banking system. We also learnt that tangible common equity is the only kind of loss absorption that is real during a market meltdown. Synthetic alternatives like CDS and CLNs will always have an element of black magic. They may be able to bring some net risk reductions, but only with protective talismans that limit their use among strongly capitalised banks and nonbanks.