Lawbitrage

Hedge Funds Are Safely Helping Banks Free Up Capital

Basel III's new capital requirements for loans made to businesses are in some cases higher than banks' internal risk assessment, so banks have been looking for ways to offload loans, or at least the credit risk associated with the loans. Hedge funds are assisting banks in this process, and through structures that seem relatively stable.

A story in FINalternatives last month reported about this phenomenon in the case of a World Bank subsidiary-sponsored hedge fund established to incentivize banks to make loans to developing market companies. Yesterday, a Financial News story by Harriet Agnew shed further light on how hedge funds are helping banks to free up capital, noting that the funds are primarily using synthetic securitization structures to take the first- or second-loss risk from the banks.

Agnew describes the capital-relief transactions as involving banks that

securitise some of the assets on their balance sheets using credit derivatives and other techniques, offloading a portion of the risk to non-bank [hedge fund] investors....

Typically, risk-sharing transactions work by packaging parcels of assets, such as high-grade corporate loans or counterparty risk, and transferring a portion of their risk to a non-bank investor, who agrees to absorb the first or second tranche of losses should the loans go sour or counterparties default.

For the banks, this reconciles the high cost of holding these assets with the need to continue lending money to important clients....For the investors, such transactions based on corporate risk are attractive because they are taking on a very precise credit risk, which is cushioned from falls in the bank’s share price and trading losses in other parts of its business.

Importantly, banks are requiring the funds to lock in their investors' capital for five years, reports Agnew. This feature largely removes any concern that these hedge funds have much in common with the commercial paper conduit transactions that caused banks to take substantial losses when, during the financial crisis, the conduits' short term investors chose not to roll over their debt and reinvest in the conduit.

Another important contrast with conduit transactions is that credit oriented hedge funds tend not to be highly leveraged. A recent estimate found their average gross leverage to be 2.4 whereas, by contrast, conduits were 12-15 times leveraged, assuming they were even capitalized with any equity at all.

The lack of short-term funding and high leverage means that the hedge funds will actually be able to pay the banks if their packaged corporate loans default--the risk is being completely transferred to the funds and their investors. Banks may be wrongly deciding that less capital needs to be held against their corporate loans. However, with these capital-relief transactions structured as they are, it is a decision whose wisdom will fall on the hedge funds and their investors, not the banks. In this respect, hedge fund investors may be helping banks make loans to corporations by subsidizing a portion of their risk.

Two Flaws with the EU Financial Transactions Tax

The tax on all financial transactions between financial institutions proposed on September 28th by the European Union raises a host of issues. But it seems to suffer from at least two basic flaws.

The EU implies that one justification for the tax is the involvement of a broad range of financial transactions in the financial crisis of 2008. However, transactions between financial institutions were not in any general sense responsible. As I argue in my recent article on credit risk transfer, it was only a narrow type of cash and synthetic CDOs that transferred the risk of subprime mortgage-backed securities that caused the massive losses and runs on financial institutions. It was not interest rate swaps, credit default swaps on corporate bonds, futures, leveraged loans, or an extremely wide and diverse range of other transactions that would nonetheless be subject to the tax. While it is true that reform efforts should be forward looking and not merely "fight yesterday's battles," that bit of wisdom should not be a blank check for overly broad measures.

The tax may also be redundant to the extent it is used to reduce systemic risk and not just raise tax revenues or harmonize pan-European tax regimes. Take the case of over-the-counter (OTC) derivatives. Under the Basel III global banking reform efforts, OTC derivatives will be subject to a higher capital charge (page 4) because they are not cleared with a central counterparty. In addition, OTC derivatives trades by dealers and other nonbanks will be subject to new capital, reporting, and conduct requirements by the European Market Infrastructure Regulation proposal. The purpose of these additional tax-like capital charges and requirements, and a host of other regulatory and industry-led efforts, is to reduce systemic risk. Accordingly, to the extent a tax on derivatives transactions is an attempt to do the same, it would be duplicative and for that reason should be viewed with skepticism. Non-tax reform efforts more directly tied to reducing systemic risk will likely be more effective.