Banks Using ‘Smart Securitization’ To Lower Capital Costs

goldmanNot only are some Wall Street banks reportedly pushing compensation back to pre-crisis levels, but the Financial Times today found that Goldman Sachs and Barclays Capital may also be resurrecting some of the securitization practices that led to the last financial meltdown. Only this time, they’re using securities to avoid the capital cost of risky assets:

Investment banks, including Goldman Sachs and Barclays Capital, are inventing schemes to reduce the capital cost of risky assets on banks’ balance sheets, in the latest sign that financial market innovation is far from dead. The schemes, which Goldman insiders refer to as “insurance” and BarCap calls “smart securitisation”, use different mechanisms to achieve the same goal: cutting capital costs by up to half in some cases, at the same time as regulators are threatening to force banks to increase their capital requirements.

As Yves Smith put it, “you’d think it was spring 2007 all over again. Maybe that’s the objective.”

One of the causes of the financial crisis was institutions not having enough capital on-hand to cover their losses when the housing bubble burst (think of Merrill Lynch, leveraged at 40 to 1). So a facet of the Obama administration’s regulatory reform package is more stringent capital requirements, particularly for institutions that are large enough to pose risks to the entire financial system.

The bankers are justifying their new financial wizardry as “smart securitization,” claiming that “this is all about restructuring portfolios of assets to achieve risk, capital and funding efficiency in a transparent and less complex way.” However, regulators and even other investment bankers are already expressing concern that this is just a way to get around capital requirements. “This is a system of capital arbitrage,” one investment banker told FT. “The need for capital just miraculously disappears.”

In its Lex column, FT advised regulators to keep an eye on these schemes, lest they become a more prevalent practice for ducking capital rules:

Regulators should be watching carefully to ensure such schemes do not develop into a widespread form of capital arbitrage. Bankers say the new securitisation is a way of managing risk in a more transparent way. But the ever more complex forms of securitisation that grew up in recent years were also touted by the industry as a way of reducing financial system riskWhen the banking system should be strengthening its capital foundations, new instruments must not become another way of gaming the rules.