More Regulation On The Way

The Financial Services Authority (FSA) in the UK is planning to conduct a "significant reappraisal" on how banks use securitization to free-up capital (see Financial Times article) given that mortgage bonds and other asset-backed securities are becoming more complicated than originally believed. This is important for US investors given that the FSA is the leading voice on the Basel Committee. Adjustment beyond current Basel II regulations and guidelines are already being discussed with regard to raising bank capital requirements. The problem is that as new products are developed, it is difficult to know exactly what risk are being created for all counterparties. Since the risk is often managed at the point of origination, or sold off, there has at times been less interest in formally quantifying the risk, leaving counterparties on the other side with a product that is less understood than others in terms of market and credit risk exposure.

One person close to the issue was quoted as saying that securitization of ordinary loans turned out to be "considerably more complicated than originally thought." Yes, but in many cases it was not that they were more risky than previously calculated, but that the risk was never really calculated or considered in the first place. As risk was sold off and transferred, there was often an assumption that someone else was bearing the risk. In the end, the risk was not only larger than some predicted, but it was not transferred to others as expected. Contagion in the system was not hedged away as expected.

While new regulation is a given, hopefully some type of clearing house for credit derivatives and related products will also be considered to help price these assets, which will in turn will allow the markets to observe the level of risk that is currently being reflected in market prices. Regulation that encourages such transparency would be a good and necessary first step. On the other hand, if new regulation is just another way to require extra regulatory capital without really developing a mechanism for understanding the risk of the assets in question, we will once again be back where we started - not fully understanding the risk will result in companies continuing to be under-capitalized and at risk, or forced to set aside too much capital for the current levels of risk exposure. Such an outcome will simply prevent the efficient flow of capital that is necessary to spur economic growth without really addressing the problem of knowing the true levels of risk and exposure.