Risk Outsourcing Is Not Regulatory Arbitrage By Definition

In an effort to reduce its Risk Weighted Assets (RWA) Citigroup entered into a Credit Default Swap deal with Blackstone Group. With the help of this deal Citigroup insured itself against the initial losses (typically 10% – 15%) on a USD 1.2 bln portfolio of shipping loans.

By using this synthetic securitization, Citigroup transfers the credit risk of the portfolio to Blackstone Group, while retaining the loans on its balance sheet and at the same time significantly reducing the capital requirement of the portfolio.

The advantage of the transaction is that Citigroup can reduce its RWA on the portfolio, so that its capital can be redeployed for other loans or it can be used to increase its Basel ratios (or a combination of both).

Overregulation can harm the financial sector. If all banks have to issue stock at the same time in order to comfortably attain the Basel III minimum capital ratios, this may reduce their efficiency and lead to rapid deleveraging at the cost of a credit crunch. For a bank, buying synthetic credit protection for a given pool may be an attractive option if the premium is lower than the marginal cost of capital of the pool.

The deal has met with much criticism. In a reaction, a spokesperson of the credit research department of PIMCO, says:

It’s a form of financial engineering. It was dead but it seems to be coming back as investors scramble for yield. If you saw this on a massive scale, you would certainly question whether this was the best way for regulators to de-risk the system.

He adds:

Banks are always trying to find pain-free ways to boost capital ratios, whether that is fiddling RWAs or outsourcing risk. Some deals are legitimate but it is ultimately regulatory arbitrage. We are supposed to be moving to a world where bank balance sheets are more transparent and less complex and this goes backwards.

Is it that simple? Is outsourcing risk equal to regulatory arbitrage by definition? I don’t think so.

Basel II rules

The use of guarantees and synthetic securitization is a recognized way to reduce the credit risk of a portfolio. Basel II uses the term ‘credit risk mitigation’ and states quite explicitly (art. 109):

Banks use a number of techniques to mitigate the credit risks to which they are exposed. For example, exposures may be collateralised by first priority claims, in whole or in part with cash or securities, a loan exposure may be guaranteed by a third party, or a bank may buy a credit derivative to offset various forms of credit risk.

And (art. 140):

Where guarantees or credit derivatives are direct, explicit, irrevocable and unconditional, and supervisors are satisfied that banks fulfil certain minimum operational conditions relating to risk management processes they may allow banks to take account of such credit protection in calculating capital requirements.


CDS gross notional amounts, source BIS, Detailed tables on semiannual OTC derivatives statistics at end-June 2012

The Basel II framework allows banks to reduce the RWA of a loan to a counterparty if the protection seller has a lower risk weight than the counterparty of the loan. In that case, the bank may, under certain restrictions (a.o. the credit derivative must represent a direct, irrevocable, unconditional claim on the protection seller), substitute the risk weight of the counterparty for the lower risk weight of the protection seller.

Banks that use the Internal Rating Approach for their credit risk may also use the double default approach (again, under certain restrictions), meaning that the credit risk takes into account that a credit loss arises if both the counterparty and the protection seller default.

Recognition of the double default approach is only allowed if the protection seller is a bank, investment firm or insurance company that is regulated according to the Basel standards “where there is appropriate supervisory oversight and transparency/market discipline.” (art. 307)

Also, the creditworthiness of the protection seller and the counterparty of the loan should not have an “excessive correlation”.

In my opinion, these rules make sense: the transfer of the credit risk is only recognized if the deal is enforceable and the protection seller maintains its rating by having a capital buffer that reflects the credit risk that the protection seller assumes (for the double default approach). And this should be transparent (meaning that the CDS position is publicly disclosed) and subject to proper supervision.

Concerns about capital arbitrage

The concern about capital arbitrage is not new. It has been raised by the Basel Committee itself in December 2011. The Basel Committee asks supervisors to closely scrutinize credit risk mitigation techniques, but starts to underline the basic principle:

The Basel capital framework recognises that credit risk mitigation techniques can significantly reduce credit risk and can serve as an effective risk management tool.

The concerns of the Basel Committee focus on a specific area where regulatory arbitrage could be expected, sc. if there is a delay in the recognition of the costs of protection in a bank’s earnings, while the bank receives an immediate recognition of the capital relief.

Hence, the Basel Committee asks supervisors to assess a number of factors such as the timing of the payments under the transaction by the protection buyer and the analysis of whether the bank can prudently afford the premium given its earnings, capital and overall financial condition.

We conclude that the Basel Committee raises concerns about specific credit protection deals, but underlines that credit risk mitigation can be an effective risk management tool.

2013 Developments

In a new Basel III paper, Recognizing the cost of credit protection purchased, March 2013, the Basel Committee reiterates its statement that the purchase of credit risk protection can be an effective risk management tool. However, it also points out the risk of regulatory arbitrage especially if the costs of protection are delayed while the capital relief is immediate. In the paper, some modifications to the Basel treatment of credit protection are proposed.

The new rules can enforce a bank to calculate the present value of the premia of credit protection and hold an additional buffer equal to 100% of this present value if such costs have not been recognized in earnings or capital. The present value of the premia is calculated with the help of a risk-free discount rate. According to Reuters, the aim of the new rules is to prod banks into recognizing the cost of insurance upfront rather than later.

Back to the shipping loans

Back to the Citigroup – Blackstone deal. Bloomberg immediately mentions the regulatory critique:

Regulators have criticized banks for trying to meet the target by adjusting the models they use to calculate risk- weighted assets rather than raising capital. The Basel Committee, which brings together regulators from 27 nations, said in a January report that there are “substantial variations” in how banks determine the riskiness of assets.

I don’t think this is justified. As stated, the Basel Committee stresses the importance of credit risk mitigation as a risk management tool. However, it points out that certain premium payment flows may indicate regulatory arbitrage and it repairs this weakness in a new proposal for the recognition of credit risk mitigation.

Also, the quote about the “substantial variations” is irrelevant. The Basel Committee concluded in a January 2013 report that the RWA calculation of a hypothetical portfolio led to “substantial variations”. However, this analysis had to do with Market Risk RWA instead of Credit Risk RWA. The report is called Regulatory consistency assessment programme – Analysis of risk-weighted assets for market risk, and the full quote (from the executive summary) is:

The analysis of public reports on mRWAs, and the hypothetical test portfolio exercise, provided a clear picture of substantial variation in mRWAs across banks.

So this deals with Market Risk RWA and has nothing to do with credit risk and (synthetic) securitization.

A better attack, from CNBC, runs as follows:

Blackstone, not being a bank, doesn’t have to meet Basel III’s capital accords. The new capital accords, in other words, have created a new line of business for non-bank financial companies. They can profit directly from their ability to be capital-lite compared to banks. Blackstone surely has to capitalize the subsidiary running this business with something. But for this whole project to work, that capitalization needs to be less than what Citi would have set aside.

Of course, the deal is only efficient for Citigroup if the premium paid for the CDS is lower than the marginal costs of capital if it wouldn’t have transferred the risk to Blackstone. And Blackstone needs to be scrutinized as a creditworthy counterparty of the deal.

Citigroup runs some risk that the local supervisor terminates the capital relief by refraining to allow the designation of Blackstone as an “eligible guarantor”. And the structure of the deal would certainly run counter to the application of the double default framework.

Equating synthetic securitization with regulatory arbitrage is tempting for some. But before we conclude about regulatory arbitrage, we need a close assessment of the deal characteristics, instead of sentiment and irrelevant quotes from other risk domains.


Over Folpmers
Financial Risk Management consultant, manager van een FRM consulting department, bijzonder hoogleraar FRM

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