James Saft, Reuters Columnist
This will fuel demand for riskier debt, such as mortgage-backed securities and corporate bonds, and takes the financial world a substantial step backwards towards its pre-crisis set of incentives.
But what fuels a boom for banks, capital markets issuance and riskier assets may not translate into a boon for the actual economy, as the new regulations may prove a disincentive to making loans, especially to smaller companies.
Part of an accord originally announced in 2010, and since much weakened, Sunday’s rules cover the amount and types of assets banks must carry as a backstop against a potential depositor run in the event of a crisis.
Assumptions about how quickly and how much depositors would pull from banks in a crisis have been shaved. Banks are also to be given an extra four years, until 2019, to come into compliance with the new regulations.
Even more significantly, a much wider, and riskier, array of assets will now be counted as liquid and assumed to be available to meet demands for withdrawals. Whereas originally only government bonds and cash on deposit with central banks were allowed, now some stock, mortgage bonds and corporate bonds rated all the way down to BBB- make the grade, though all are subject to discounts on face values.
That is a stunning loosening, especially given the role doubtful securities played in the last crisis. Lehman Brothers has quite a lot of stuff which met these criteria, but the market for mortgage debt, even highly rated mortgage debt, simply was not there during in the dark days of 2008.
The regulators, for their part, were responding in part to objections from the financial services industry that proposed tighter regulations would be too costly and would tend to hurt growth by forcing banks to take less risk.
“Nobody set out to make it stronger or weaker,” Mervyn King, head of the group and outgoing governor of the Bank of England, told reporters about the package of rules, “but to make it more realistic.”
The discreet charm of realism
Taking King’s realism as our cue, it is best not to mourn the tighter regulation we did not get but to prepare for the world as it will be.
If you are a banker, especially one working in capital markets, and especially at a bank in Europe, this is great news. This is going to help drive demand for the kinds of securities – think corporate debt and mortgage bonds – which make the cut. Shares in banks with big exposure to those businesses rallied sharply, as did banks thought to face difficulties complying with the earlier proposals.
And remember – as it was in 2005 – demand for safer bonds helps to drive demand for riskier debt, driving down yields and forcing would-be risk takers further out on a limb.
This also will help to underpin the market for funds provided to banks, in part because it helps to entrench the correct view that, when push comes to shove, those banks now standing and now huge, will be officially supported through regulation and through direct intervention if need be.
Banks, in essence, are being encouraged to do what they did before the crisis, pull back from lending to the real economy and act instead as a mix between a hedge fund and an investment bank, earning fees by originating securities deals and holding some of those securities on their balance sheets.
A snap-back rally in bank shares makes sense, maybe even a sustained one, but the sector, from investors’ point of view, is still haunted by a similar set of bad incentives and risks.
What is a lot less clear is what this will do for the broader economy, particularly small and medium-sized companies. Banks simply will have less capacity and desire to originate and service the kinds of direct and illiquid loans small firms need. This is especially important in the euro zone, which is in the midst of a loan drought and which tends to have smaller companies less able to issue bonds.
If you are a bank employee - and those are the people deciding how to run banks, the play is still to keep capital at a minimum and try to make as much as possible during market upswings.
Let the wild misallocation of capital begin (again)!
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)