Banks get creative with capital relief – bloomberg emitra electricity bill payment

##

• Its shareholders. This is a good outcome for lots of reasons: It forces the owners of the bank to internalize its risks, it puts risk on securities that are meant to bear risk and on holders who can afford it, it matches with expectations about how corporations work, etc. And so in practice this is the favored option of bank regulators and commentators in almost all circumstances. On the other hand the shareholders don’t like it. Specifically, banks want to have as little capital—as much leverage—as possible, so that they can make more profits for shareholders while putting less shareholder money at risk.

• Taxpayers. This is the one that everyone complains about. This is “government bailouts.” It is obviously bad. The thing to realize is that it is in some sense inevitable in the limiting case. Banks cannot have infinite equity, and can always find a way to lose more than all of their equity. Then someone is on the hook. Depositors are not a good option. The government—or the central bank, etc.—is the inevitable option of last resort. Banks are in essence a public-private partnership to turn risk-free deposits into risky loans; you cannot cut the public risk in that partnership to zero. You can minimize it! (With more equity, etc.) But you can’t make it zero.

• Its creditors. This is fine—banks can issue bonds meant to bear losses—but conceptually it is simplest to think of a bank as being made up of (1) deposits and (2) capital. Some of a bank’s non-deposit debt (repo loans, etc.) will be functionally deposits: It is supposed to be risk-free, and if it bears losses then that is systemically unattractive. Some of the bank’s non-deposit debt (“total loss-absorbing capital” bonds, etc.) will be functionally equity: It will be issued with a high coupon and specific provisions describing how it will bear losses, and people who buy it ought to internalize the bank’s risk. So this category—non-deposit bank debt—is really just a combination of categories 1 and 2. People argue over the specifics of how risk-bearing debt compares to equity, or how risk-free the non-risk-bearing debt is supposed to be, but for our purposes, never mind.

• Its employees. This is a clever one and people talk about it occasionally; it has some obvious appeal (make the people who take the risks internalize them!) but it doesn’t seem practically important for loss absorption. If a bank loses a billion dollars you’re not really going to get the billion dollars back from the employees who lost it.

• Someone else who agrees to take the risk. Like, if you are a bank and you make loans, you can buy credit-default swaps on those loans from someone else. An insurance company, or a pension fund, or whoever. And then your losses are its problem. This can be great (you’re offloading credit risk from a flighty deposit-funded bank to a pension fund with a long time horizon) or terrible (you’re offloading credit risk from a prudent regulated bank to some weird short-term-funded shadow-banking entity), but whatever it is is in some sense no longer the bank’s problem. The bank has dealt with its risk; now the risk is elsewhere.

The basic dance of bank regulation is that banks want to minimize (2)—they want as little equity as they can get away with—while regulators want to minimize (3)—they want as little taxpayer risk as they can manage. This is mostly a simple game: The more equity is at risk, the less taxpayers are at risk. But finance is a creative industry, and people are constantly looking for an outside-the-box escape from this dilemma. What if there were some way to put less equity at risk, without putting taxpayers more at risk? (Or, if you are a bank: What if there were some way to put less equity at risk, without regulators noticing that taxpayers are more at risk?)

The trades typically work like this: The bank bundles loans—usually to companies—and calculates the capital it needs to hold against potential defaults on that portfolio. The bank then pays a fee to an investor, such as the EIF, a hedge fund or pension fund, to insure against a chunk of the future losses.

If the underlying loans default, the bank can claim compensation from the investor up to a predefined amount. Investors insist the bank also takes the risk of some loss on the loans to ensure they aren’t being handed dud credits. The attraction for the investor is often a double-digit yield on assets it can’t normally access.

I mean, all of that is just a standard description of capital-relief trades, except for one clause: “such as the EIF.” The EIF is the European Investment Fund, “a public-private partnership between the EU, commercial banks, and other financial institutions.” Get it? This trade looks like (6): It looks like the bank transfers its loan risk to some willing third party, finding a way out of the shareholder-versus-taxpayer dilemma. It’s just that the third party is a taxpayer-backed fund. The way out of the dilemma is to give the risk to taxpayers, but in a weird form. “Taxpayers Are on the Hook in Banks’ Financial Engineering” is the Wall Street Journal’s headline.

If European governments want to recapitalize or subsidize the banking sector, then they should just inject equity or other loss-absorbing capital, not use complex structures, said Peter Hahn, professor at the London Institute of Banking & Finance. “At least it’s more visible and you know what the real exposure is.”

Yeah but that is … that is like the opposite of the point of finance. The point here is to make it less visible, to create an arbitrage, to make everyone feel like they’ve gotten a win, to find a way out of the zero-sum shareholders-versus-taxpayers dilemma, or at least, a way out of thinking about it as a zero-sum dilemma. This trade is what banking is all about; this is the heart of how finance works; this is what the creativity is for. If you don’t like this trade then you don’t really like finance. Which is perfectly reasonable of you!