Glenn Blasius is the chief executive of Ovid Capital Advisors LLC. He has worked with many large international banks on regulatory capital transactions involving real risk transfer over the last decade.
Increased media attention has been paid to a recent surge in “regulatory capital†transactions by banks. This has spurred criticism of this technique from some quarters.
We believe these transactions are valid and effective tools for banks to reduce risk while enabling them to continue to run their core businesses, which are at the heart of the economic recovery. Since the purpose and operation of these transactions appear superficially complex, they merit a brief description.
A bank’s capital serves as a cushion against unexpected losses that can arise in the course of business and endanger both the banking system and the real economy. “Expected losses†in the form of occasional loan defaults or operational miscues are a cost of doing business, much like a grocer who has to account for the risk of spoilage of his produce in determining the price of his goods.
Banks cover expected losses in their lending business from annual revenues, but the coverage of unexpected losses must be provided by the banks’ capital base. The definition and amount of required capital is set independently by the banking regulator, which is why we refer to it as regulatory capital. The goal of these requirements is to ensure the stability of the banking system.
Banking regulations, from the first set of Basel accords through to the current Basel III framework, have increased the strength of the link between the amount of capital required and the riskiness of a bank’s business model. The riskier the loan or business, the greater the required capital. The latest Basel agreement has increased both the amount and the quality of regulatory capital.
A bank can meet the new requirements by increasing its common equity or by reducing the riskiness of its business. The latter can be achieved by entering into a regulatory capital transaction: private investors agree to cover losses on a designated part of the bank’s portfolio in return for a fee; this is similar to buying reinsurance against losses in any other business. The transaction transfers a quantum of risk of loss from the bank to a third party. The counterparty’s obligation is fully collateralized with high quality assets, guaranteeing the transaction’s performance. The risk to the bank of a catastrophic loss event is therefore reduced.
Regulatory capital transactions offer banks a valuable tool to manage the risk of business without having to resort to selling prized assets. Banks may not wish to sell illiquid parts of their businesses for good reasons: a) they may wish to retain part of the risk of a portfolio considered a core business; b) transferring illiquid assets to a third party can be very difficult, and as a result banks may not receive an acceptable price.
An essential feature of regulatory capital transactions must be real risk transfer from the bank to investors. Here, regulators play an important oversight role, by setting the rules for capital relief transactions and by determining whether specific transactions meet appropriate standards.
Investors who work with regulatory relief specialists like Ovid Capital Advisors can enter into a partnership with the bank: the bank indirectly provides the investors with the strength of its underwriting and loan servicing, while the investors provide the means to absorb unexpected risk of loss. In this manner, the banks can reduce risk while retaining the banking relationships at the core of their business.
There is nothing murky about a transaction designed to transfer unexpected losses from the banking system to pools of private capital in a manner that has been approved by the regulator. Risk transfer is one of the primary roles of a well-functioning financial market, and takes place daily across equity, debt and commodity markets worldwide.
These transactions should be encouraged as a way to privatize some of the risks taxpayers across the globe unwittingly bear. The baby should not be thrown out with the bath water - regulatory capital transactions have a vital role to play in the rehabilitation and management of banks’ balance sheets in a way that minimizes the negative effect on Main Street.
By privatizing risk, these transactions allow the banks to continue lending to the businesses they value most, an important element of continuing a global economic recovery.
